IRS Targets Billionaire's Lucrative Tax Strategy

The Internal Revenue Service is fighting with billionaire Philip Anschutz to force the Denver-based mogul to pay back taxes totaling $143.6 million. The court battle is part of a broad attempt by tax authorities to crack down on complex transactions used to defer paying capital-gains taxes.

The imbroglio stems from transactions that Mr. Anschutz entered into involving shares he owned in Union Pacific Corp. and Anadarko Petroleum Corp. in 2000 and 2001. The deals netted him cash, as well as a share of any future rise in the stock price, with a total value of roughly $429 million. The arrangement is also set up to protect him against losses if the stock price falls.

He contends the deals technically weren't completed sales for tax purposes, and thus didn't trigger tax obligations, according to filings in U.S. Tax Court in Washington. As a result he hasn't paid capital-gains taxes on the transactions.

Mr. Anschutz -- an oil, railroad and media investor identified as the 41st-richest man in the U.S. by Forbes -- isn't the only person to use such an arrangement. Executives at companies including Starbucks Corp., Costco Wholesale Corp., Tyson Foods Inc., IAC/InterActive Corp., Cablevision Systems Corp. and Apollo Group Inc. have all used similar "variable prepaid forward contracts" to cash in shares in these companies and related entities, according to securities filings.

The tax treatment of these executives' arrangements isn't public, so it isn't clear whether the transactions involved deferral of taxes of the type the IRS is targeting. Experts say tax deferral is a typical component of such arrangements.

The companies either didn't respond to requests for comment or declined to comment.

These types of arrangements are particularly popular among company founders or high-ranking executives. That's because they help them limit the investment risk of holding a sizeable chunk of their personal wealth in their own company's stock.

The IRS is turning up the heat. In February, the agency issued an advisory to its agents declaring that some versions of these prepaid forward contracts should trigger immediate taxes. The IRS invited its agents to examine whether they should seek substantial penalties against investors who used them. The companies themselves wouldn't generally be targeted in the initiative unless the companies did such transactions with shares they owned.

Cash Up Front

In transactions like the one used by Mr. Anschutz, an executive agrees to turn over his shares to an investment bank on a specific date in the future, and meanwhile loans the bank the same amount of stock. The bank gives the executive cash up front, generally equal to as much as 80% of the shares' fair market value.

Investors argue they don't owe taxes until they conclude the transaction fully, by delivering the shares for good. Several tax experts disagree. "You've got all the elements of a completed sale: One guy's got the money, and the other guy's got the stock," said Robert Willens, a former Wall Street tax analyst who runs his own corporate-tax advisory firm in New York. "What more do you need for a sale?"

An IRS spokesman declined to comment on how many audits it had undertaken of such deals.

Tax-litigation attorneys say they expect a slew of cases. "The IRS is definitely focused on these types of transactions and I'd anticipate seeing more of these types of cases in the future," said Bryan Skarlatos, an attorney at Kostelanetz & Fink LLP in New York who specializes in tax disputes. He said his firm is representing one client whom the IRS has challenged over such a deal, and is aware of others.

Focus on Tax Breaks

Much attention in the current presidential campaign has focused on tax breaks for the wealthy, including the cutting of the capital-gains tax rate to 15% early in the Bush administration. But less noticed is how some of the wealthiest Americans sometimes don't even pay that full 15% rate, by deferring their taxes for many years. In Mr. Anschutz's case, the transaction is scheduled to defer the taxes for nearly a decade.

Critics say such transactions could undermine the progressive nature of the income-tax system, because the deferrals effectively lower the taxes paid by the extremely wealthy. "There's a clear progressivity issue here," said Joel Slemrod, a tax economist at the University of Michigan's business school and former senior tax economist for President Reagan's Council of Economic Advisers.

Tax authorities and some members of Congress also are taking note of other tax-deferral transactions aimed at the wealthy. In December, the IRS began to examine the fast-growing market for exchange-traded notes, or ETNs, which let investors buy derivatives that are similar to mutual funds, but which can defer tax obligations for decades. Late last year, Rep. Richard Neal of Massachusetts, a Democratic member of the House Ways and Means Committee, introduced a bill that would overhaul the tax treatment for a wide array of prepaid contracts. A House subcommittee chaired by Rep. Neal held a hearing on the issue in March.

Variable prepaid forward contracts are only one in a series of arcane structures offered by investment banks to help executives limit the risk of holding big blocks of their own company's stock. Older variants go by such names as "costless collars" or "exchange funds."Most of these arrangements let the investor defer capital-gains taxes.

Starbucks Chairman and Chief Executive Howard Schultz entered into a prepaid variable contract in exchange for $55 million back in 2001, securities filings show. His tax position isn't disclosed, but under normal circumstances Mr. Schultz would not have paid taxes until he delivered the shares last year.

A Starbucks spokeswoman declined to comment.

Peter Sperling, vice-chairman of the board and a son of the company founder at Apollo Group, a higher-education provider, has received $182 million through similar deals since 2004, including one entered into 10 months ago, filings show. His assistant said Mr. Sperling couldn't be reached.

The 68-year-old Mr. Anschutz has made billions of dollars over the years in industries including oil, telecommunications, professional sports and newspapers. A movie company he owns produced the current Hollywood film "Chronicles of Narnia: Prince Caspian." (Mr. Anschutz has partnered in ventures with News Corp., the owner of Dow Jones & Co., the publisher of The Wall Street Journal.)

One of Mr. Anschutz's ventures was in the railroad industry, owning and chairing Southern Pacific Railroad, which later became Union Pacific. In May 2000, Mr. Anschutz started to trim his substantial holdings in Union Pacific, entering into an arrangement with a Cayman Islands subsidiary of financial-services company Donaldson, Lufkin & Jenrette Inc., court papers show. Investment banks benefit by charging wealthy clients fees for services like these.

DLJ is now part of Credit Suisse Group, which declined to comment.

In the arrangement, over the next 11 months, Mr. Anschutz received cash and the future stock-appreciation rights in exchange for agreeing to sell DLJ up to nine million shares of Union Pacific and Anadarko Petroleum roughly a decade hence. The number of shares he will ultimately deliver could vary depending on changes in the companies' stock price.

Hedging Risk

An important part of the arrangement involved Mr. Anschutz also loaning nine million shares to DLJ for the length of the transaction. That would allow the investment bank to engage in a "short sale" of the shares as a way to hedge its risk against a loss in the original transaction stemming from a drop in the stock price. (In a short sale, an investor sells borrowed shares with the idea that, if the share price falls, it will be possible to buy back the shares at a lower price and profit from the difference.)

The short sales help the bank protect itself from the downside risk created by the initial part of the transaction, in which it agrees to buy the shares years in the future.

Between 2009 and 2010, according to the agreement, the contracts are scheduled to end and Mr. Anschutz will have to either hand over the shares for good or else return some amount of cash. If he hands over the shares, only then will he will be on the hook for the capital-gains tax hit, his attorney says in court papers.

A year ago, the IRS sent formal notices to Mr. Anschutz asserting he owed taxes on the arrangements. Mr. Anschutz responded by filing a pair of lawsuits to contest the tax bill.

Mr. Anschutz's attorney argues in court filings that the deals weren't completed sales for tax purposes, because Mr. Anschutz could terminate the share loans and get the stock back.

The IRS's position on such deals has shifted over the years. In 2003, the agency issued guidance indicating that the transactions didn't immediately trigger taxes. That opened the floodgates, prompting investment banks to widely market strategies like these.

But in 2006, the IRS publicly declared that if the deal also included a share loan, the transaction was akin to a sale, thus triggering immediate taxes. Since then, the number of similar transactions has fallen dramatically, according to people who work on these deals, and the prepaid forward contracts that also include a share loan from the investor have ceased.

Write to Jesse Drucker at jesse.drucker@wsj.com

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