Senate Allows ESOPs in Subchapter S Companies, Eliminates Section 133 Loans

The Senate has agreed to legislation that would allow Subchapter S companies to have ESOPs. The same bill would also eliminate section 133 of the Internal Revenue Code, a provision allowing lenders to exclude 50% of the interest income they receive from loans to ESOPs owning over 50% of the company's stock and passing through full voting rights on shares acquired by the loan.

The legislation was passed as part of the bill to increase the minimum wage. The House has already passed its version of the legislation. It also eliminates section 133, but its effective date is October 1995; the Senate version would be effective in June 1996. The Subchapter S provision, which would become effective at the start of 1998. The House bill does not allow Subchapter S companies to have ESOPs.

These differences would have to be ironed out in a conference committee of the two houses. At this point, it is not possible to say which side is likely to prevail. Because the bill is attached to the minimum wage bill, it appear likely that some action will be taken, however.

The section 133 provision has been used only rarely in the 1990s. Until 1989, it was available to all ESOPs, and was very popular, especially in large public firms. Because of the costs it incurred, Congress limited its application in 1989. Since then, only a handful of transactions have used it each year. The Subchapter S change may also have a limited effect.

The Senate proposal would allow "S" companies to have ESOPs, but would be tax-neutral. "S" corporations do not pay tax; their owners pay tax on an allocated share of earnings. The ESOP trust is normally non-taxable, however. The legislation would require the ESOP to pay its share of taxes, presumably through additional contributions the company would make (and that would also count as allocations to employees). In addition, Subchapter "S" ESOPs would not be eligible for the "ESOP rollover" in sales to an ESOP, would not be allowed to deduct dividends paid to employees, and would have to count interest on a loan when calculating the contribution amount for annual limitations on contributions to employees. As a result, ESOPs would have limited applicability in "S" companies.