WorldCom Inc. set up a flawed tax shelter on the advice of current auditor KPMG LLP before filing the biggest U.S. bankruptcy, giving it grounds to sue KPMG for hundreds of millions of dollars, a court examiner said. The KPMG/WorldCom plan was an “aggressive design” that converted something otherwise legitimate into something that ‘appears improper’, the Examiner’s report says.

The strategy was designed to minimize WorldCom’s payment of state taxes, former U.S. Attorney General Richard Thornburgh wrote in a report commissioned by U.S. Bankruptcy Judge Arthur Gonzalez. WorldCom said it won’t sue KPMG, though it may go after others in the report. Citigroup Inc. was cited for helping former Chief Executive Officer Bernard Ebbers breach his fiduciary duty.

Thornburgh’s conclusions raise questions about KPMG just as the auditing firm and Ashburn, Virginia-based WorldCom, the No. 2 U.S. long-distance telephone company, seek to convince U.S. regulators they’ve cleansed the books of $11 billion in accounting irregularities. WorldCom must restate 2000 to 2002 financials before it can exit creditor protection next month.

“Their goal is to emerge from bankruptcy with a clean slate, and the report puts into question the work of one of WorldCom’s most important partners in the process of moving forward,” said Jacob Frenkel, a partner with Smith Gambrell & Russell LLP in Washington, who used to be a federal prosecutor. KPMG would need to resign if WorldCom sued the firm, he said.

WorldCom likely avoided hundreds of millions of dollars in taxes between 1998 and 2001 by charging subsidiaries in various states more than $20 billion in royalties for services such as `the foresight of top management,’ Thornburgh’s report says. The units deducted the royalty expenses for state-tax purposes, while the parent company was lightly taxed for them.

The shelter was “yet another example of the company converting what could be legitimate into something that appears improper as a result of its aggressive design and implementation,” Thornburgh’s team said in the 500-page report posted on the Web site of the U.S. Bankruptcy Court in Manhattan.

More than 20 states, including New York and Massachusetts, are examining internal transactions at WorldCom, which trails AT&T Corp. by sales, to determine if they’re owed money.

WorldCom reviewed the tax strategy and concluded that KPMG’s advice in 1997 and 1998, before it was WorldCom’s auditor, was appropriate, General Counsel Stasia Kelly said in a statement.

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