Dolan Play Could Trigger Huge Tax Hit

There appears to be a big pot of gold for Uncle Sam at the end of the Rainbow spin-off, and it may have to come out of Cablevision shareholders' pockets.

In a world where companies work overtime to avoid enriching the IRS, investors are surprised--maybe astounded is more the term--to find that Chuck Dolan’s planned buyout of Cablevision Systems could force both the company and its shareholders to incur, unexpectedly, hundreds of millions of dollars in taxes.

Cablevision Chairman Dolan and his family plan to take Cablevision private, keep its lucrative cable systems, and spin its slow-growing Rainbow Media programming division back out to shareholders. The plan calls for public shareholders to receive $7.9 billion, or $33.50 per share. Investors would get $21 of that in cash and $12.50 in Rainbow Media stock.

The cash portion of buyouts are nearly always taxable. The surprise lies in the Rainbow spin-off. Media companies execute similar spin-offs fairly routinely. Structuring them to be tax-free is not dramatically complicated.  “I couldn’t believe it,” says Robert Willens, highly-regarded accounting analyst for Lehman Bros., who wrote a detailed report on the Rainbow tax problem on Tuesday. “Having looked at 20 million spin-offs in my day I can tell you that [this doesn't] doens’t come around that often.”

A source close to the transaction acknowledged that the spin-off could well be taxable, but even if Dolans’ deal is approved by Cablevision’s board, it would take months for the IRS to rule on its tax implications.

A taxable spin-off can be a nasty trick to play. Investors receive stock, but they have to fork over cash to the IRS. It’s like winning a Lincoln Navigator on Wheel Of Fortune, then having to pay taxes on it.

Broadly speaking, the IRS wants to tax you if someone writes you a check. But the spin-off of a division is essentially handing shareholders assets they already own. So tax laws give companies a number of ways to prevent spin-offs from becoming taxable events. But if ownership of the assets does actually change hands along the way, the IRS wants to be paid.

This is precisely how the Dolan family has structured this deal. Based on loan documents the Dolans have filed in connection with the deal, accounting analysts believe that Cablevision shareholders will be paying extra taxes.

Even worse, the spin-off will be taxed twice. Willens says the transaction could be taxable not just to shareholders, but to Cablevision itself. That could burn up a few hundred million dollars more.

Media analysts said they were working to understand precisely how big a tax hit Cablevision and investors would incur.

There are other ways for the Dolans to get Cablevision’s systems without necessarily triggering the additional taxes. Cablevision, for example, could simply sell the systems to the family and leave Rainbow behind in the existing corporation.

But the Dolans’ proposal offers them protection from rival bids. The company’s board could reject the family’s bid as too cheap. But any bid would have to pass muster with shareholders. And since the Dolans control 71% of the company’s shareholder votes, they could reject any other buyer.