S Corporation Modernization Act of 2026
- Sponsor
- Rep. Carey, Mike [R-OH-15]
- Committees
- Ways and Means Committee (primary)
- Last action
- Jul 22, 2026
Bottom line
This bill significantly reforms S corporation rules to enhance flexibility, broaden ownership, and simplify certain tax treatments, while also repealing Section 409A related to deferred compensation.
What it actually does
This bill proposes significant reforms to the Internal Revenue Code of 1986, primarily targeting S corporations. It introduces a new deduction for built-in gains upon the death of an S corporation shareholder, relaxes passive investment income rules, allows nonresident alien individuals as shareholders, and increases the maximum number of shareholders from 100 to 250. Additionally, it permits Individual Retirement Accounts (IRAs) to hold S corporation stock and repeals Section 409A, which governs nonqualified deferred compensation plans.
Proponents argue
Supporters argue that the bill modernizes outdated S corporation rules, reduces administrative burdens for small businesses, and fosters economic growth by making S corporation status more accessible and flexible. They contend that repealing Section 409A would simplify deferred compensation arrangements, reducing compliance costs for businesses.
Opponents contend
Critics might argue that some provisions, such as the new built-in gain deduction or the relaxation of passive income rules, could create new avenues for tax avoidance or disproportionately benefit wealthier individuals and large S corporations. The repeal of Section 409A could be seen as removing important oversight and protections related to executive compensation, potentially leading to less transparent or more abusive practices.
The bill is moderately complex due to its technical tax language and numerous amendments to the Internal Revenue Code, requiring careful reading and a solid understanding of tax law to grasp its full implications.
Section 2, adding new IRC Section 1369
Deduction for S Corporation Built-In Gain Upon Shareholder Death
This provision allows a deduction for a portion of an S corporation's built-in gain when a shareholder dies, effectively providing a step-up in basis for the deceased shareholder's stock. The deduction is amortized over 15 years, with accelerated deductions possible upon the disposition of built-in gain property. It also includes rules for recharacterizing subsequent gains as ordinary income to the extent of the deduction taken.
Supporters argue
Supporters argue this provision provides a more equitable tax treatment for inherited S corporation stock, aligning it more closely with the step-up in basis rules for other assets and preventing a double taxation scenario for heirs.
Critics contend
Critics might contend that this deduction could be exploited for tax planning purposes, potentially leading to significant revenue loss and disproportionately benefiting wealthy individuals who own S corporations.
Tradeoffs
This provision balances the desire to provide relief to heirs of S corporation owners with concerns about potential tax avoidance and the fiscal impact of new deductions.
Section 3, amending IRC Sections 1375 and 1362
Relaxation of S Corporation Passive Investment Income Rules
This section increases the threshold for passive investment income from 25% to 60% of gross receipts for S corporations with accumulated earnings and profits. It also repeals the rule that terminates an S corporation's election if it has excessive passive investment income for three consecutive years. The definition of passive investment income is also refined, with new exceptions for certain lending or finance companies, dividends from controlled C corporations, and income from banks.
Section 4, amending IRC Sections 1361, 864, and adding new Section 1447
Nonresident Aliens Permitted as S Corporation Shareholders with Withholding Rules
This section removes the prohibition against nonresident alien individuals holding S corporation stock, significantly broadening the potential ownership base. To address the tax implications, it establishes that gain or loss from the sale of S corporation stock by a nonresident alien will be treated as effectively connected with a U.S. trade or business to the extent of the underlying built-in gain/loss. It also introduces a new withholding tax requirement for S corporations with nonresident alien shareholders on their share of effectively connected taxable income, and a withholding tax on transferees in dispositions of S corporation stock by nonresident aliens.
Section 5, amending IRC Section 1361(c)
Employees of a Firm Counted as a Single Shareholder
This provision modifies the S corporation shareholder limit by treating all employees (and their estates) of a corporation and its wholly-owned business entities as a single shareholder for the purpose of the shareholder count. This change aims to simplify compliance with the shareholder limit, especially for businesses with employee stock ownership plans or other forms of employee equity.
Section 6, amending IRC Sections 1361(c)(2)(A)(vi) and 4975(d)(16)
Individual Retirement Accounts (IRAs) as Eligible S Corporation Shareholders
This section expands the types of trusts that can hold S corporation stock to include individual retirement accounts (IRAs), including Roth IRAs. It also amends the prohibited transaction rules to exempt the sale of S corporation stock held within an IRA when an S corporation election is made, facilitating the transition for existing IRA holdings.
Section 7, amending IRC Section 1366(d)(2)(B)
Transfer of Suspended Losses Incident to Death
This provision amends the rules for suspended losses in S corporations, allowing these losses to be transferred incident to the death of the transferor. Currently, suspended losses generally expire upon the death of a shareholder. This change would permit the inheritor of S corporation stock to utilize the deceased shareholder's suspended losses, providing a benefit to the estate or beneficiaries.
Section 8, striking IRC Section 409A and amending other sections
Repeal of Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
This section repeals Internal Revenue Code Section 409A, which established strict rules for nonqualified deferred compensation plans to prevent abusive tax deferral strategies. The repeal eliminates the complex compliance requirements and penalties associated with 409A. Conforming amendments are made to other sections of the Code, and Section 457A is amended to redefine 'nonqualified deferred compensation plan' and related rules, effectively shifting some oversight to 457A for certain plans.
Section 9, amending IRC Section 1361(b)(1)(A)
Increase in S Corporation Shareholder Limit
This section increases the maximum number of shareholders an S corporation can have from 100 to 250. This change allows S corporations to attract more investors and grow larger without being forced to convert to a C corporation, which has different tax implications.
Recharacterization of Gains as Ordinary Income to Extent of Deduction
Section 2(d), new IRC Section 1369(d)
Why it matters:This is standard legislative practice for anti-abuse or recapture rules, which are often placed within the specific sections they modify.
Case for: Proponents would argue this ensures the deduction is not abused, preventing taxpayers from converting ordinary income into capital gains by taking the deduction and then disposing of the property.
Case against: Critics might argue that the complexity of this recapture rule could add administrative burden and uncertainty for taxpayers, potentially offsetting some of the simplification benefits of the main deduction.
Estimated impact: Ensures that the tax benefit from the built-in gain deduction is limited to its intended scope, preventing unintended tax arbitrage.
Gain or Loss of Nonresident Aliens From Sale or Exchange of S Corporation Stock Treated as Effectively Connected Income
Section 4(b), new IRC Section 864(c)(9)
Why it matters:This is standard legislative practice for integrating new rules into existing complex tax frameworks, ensuring consistency and proper application.
Case for: Proponents argue this provision is essential to ensure that nonresident alien investors in U.S. S corporations are subject to U.S. tax on gains derived from their U.S. business interests, preventing tax avoidance.
Case against: Critics might argue that this adds complexity for international investors and could potentially deter foreign investment if the tax treatment is perceived as overly burdensome or unclear.
Estimated impact: Significantly alters the U.S. tax treatment of S corporation stock sales by nonresident aliens, ensuring U.S. tax jurisdiction over such gains.
Special Rules for Withholding on Dispositions of S Corporation Stock by Nonresident Aliens
Section 4(e)(2), new IRC Section 1447(e)(2)
Why it matters:This is a common legislative technique to avoid redundant text and ensure consistency by applying existing, similar rules to new situations.
Case for: Proponents would argue that applying existing withholding mechanisms simplifies implementation and provides a familiar framework for transferees, ensuring tax collection on sales by nonresident aliens.
Case against: Critics might argue that the cross-referencing adds a layer of complexity, requiring taxpayers and practitioners to navigate multiple sections of the code to understand their obligations.
Estimated impact: Establishes the practical mechanics for withholding tax on sales of S corporation stock by nonresident aliens, ensuring effective tax collection.
Redefinition of 'Nonqualified Deferred Compensation Plan' within Section 457A
Section 8(b)(3), amending IRC Section 457A
Why it matters:This is a technical re-scoping of an existing tax provision to adapt to the repeal of a related section, a common practice in tax legislation.
Case for: Proponents would argue that this redefinition ensures that certain types of deferred compensation remain subject to appropriate tax rules, even after the repeal of 409A, preventing a complete regulatory vacuum.
Case against: Critics might argue that by redefining and expanding the scope of 457A, the bill is not truly simplifying deferred compensation rules but merely shifting the complexity to a different section of the code, potentially creating new compliance challenges.
Estimated impact: Determines which deferred compensation arrangements will continue to be subject to specific tax rules under Section 457A, influencing future compensation plan design.