S Corporation Modernization Act of 2025
- Sponsor
- Sen. Sheehy, Tim [R-MT]
- Committees
- Finance Committee (primary)
- Last action
- Jun 10, 2025
Bottom line
The bill aims to modernize S corporation rules and simplify deferred compensation, potentially easing tax burdens and increasing flexibility for businesses and investors, while also introducing new compliance requirements for international shareholders.
What it actually does
This bill proposes significant changes to the Internal Revenue Code affecting S corporations and deferred compensation. It introduces a deduction for built-in gains on S corporation stock inherited at death, relaxes passive investment income rules for S corporations, permits nonresident aliens and IRAs to be S corporation shareholders, and repeals Section 409A governing nonqualified deferred compensation plans. Additionally, it allows suspended losses to transfer upon a shareholder's death and aggregates employees for S corporation shareholder limits.
Proponents argue
Supporters argue that the bill will modernize outdated S corporation rules, reduce administrative burdens for small businesses, and provide greater flexibility for business owners in areas like estate planning and access to capital. The repeal of Section 409A is presented as a simplification that will reduce compliance costs for employers and employees involved in deferred compensation arrangements.
Opponents contend
Critics may contend that the bill could lead to significant federal revenue losses due to new deductions and expanded S corporation benefits. Concerns might also be raised about the potential for increased tax avoidance through more flexible S corporation structures and the repeal of Section 409A, which was originally enacted to curb perceived abuses in deferred compensation.
The bill text is technical and requires a solid understanding of tax law. An informed reader would need adequate time to fully grasp the implications of each section, especially the new definitions and cross-references.
Sec. 2, amending Part II of subchapter S of chapter 1 by adding Sec. 1369
Deduction for S Corporation Built-In Gain Amount Upon Death of Shareholder
This provision allows a person inheriting S corporation stock to deduct the 'built-in gain amount' (the difference between the stock's stepped-up basis at death and its prior adjusted basis, limited by the S corporation's total built-in gain). This deduction is generally amortized over 15 years, but can be accelerated if the S corporation disposes of certain built-in gain property. It aims to reduce the tax burden on inherited S corporation interests.
Supporters argue
Supporters argue this provision provides much-needed relief for families inheriting S corporation stock, preventing a potential 'double tax' burden and facilitating the smooth transfer of family businesses across generations. It aims to align S corporation treatment more closely with partnerships in this regard.
Critics contend
Critics may contend that this provision is a significant tax break for wealthy individuals and could lead to substantial revenue losses. They might argue it adds complexity to the tax code and could be exploited for tax planning purposes.
Tradeoffs
The provision balances the desire to ease the tax burden on inherited family businesses and promote intergenerational wealth transfer against concerns about federal revenue loss and potential for tax avoidance strategies.
Sec. 3, amending Sec. 1375(a)(2) and Sec. 1362(d)
Modifications to S Corporation Passive Investment Income Rules
This section increases the permissible percentage of passive investment income for S corporations with accumulated earnings and profits from 25% to 60% of gross receipts. Crucially, it also repeals the rule that automatically terminates an S corporation's election if it exceeds this passive income limit for three consecutive taxable years. It also expands the definition of passive investment income to include certain exceptions for lending/finance companies, banks, and dividends from C corporations where the S corporation holds a controlling interest.
Sec. 4, amending Sec. 1361(b)(1) and adding Sec. 1447
Nonresident Alien Individuals Permitted as S Corporation Shareholders
This provision removes the restriction that prevents nonresident alien individuals from being S corporation shareholders. To address the tax implications, it introduces new rules: gain or loss on 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 pro rata share of gain/loss from a deemed asset sale. It also establishes a new withholding tax on a nonresident alien S corporation shareholder's pro rata share of effectively connected taxable income.
Sec. 5, amending Sec. 1361(c) by adding paragraph (7)
Employees of a Firm Counted as a Single Shareholder Toward Shareholder Limit
This provision modifies the S corporation shareholder limit (currently 100 shareholders) by treating all employees (and their estates) of a corporation and its wholly-owned business entities as a single shareholder. This aims to facilitate broader employee ownership structures within S corporations without exceeding the statutory shareholder cap.
Sec. 6, amending Sec. 1361(c)(2)(A)(vi) and Sec. 4975(d)(16)
Expansion of S Corporation Eligible Shareholders to Include IRAs
This provision amends the Internal Revenue Code to allow individual retirement accounts (IRAs), including Roth IRAs, to hold stock in S corporations. Currently, IRAs are generally prohibited from holding S corporation stock. It also makes a conforming amendment to the prohibited transaction rules under Section 4975, clarifying that certain sales of S corporation stock by an IRA are exempt.
Sec. 7, amending Sec. 1366(d)(2)(B)
Transfer of Suspended Losses Incident to Death
This provision amends the rules for suspended losses of an S corporation shareholder. Currently, suspended losses (losses that exceed a shareholder's basis and cannot be deducted in the current year) generally disappear upon the shareholder's death. This amendment allows these suspended losses to be transferred to the estate or beneficiary of the deceased shareholder, similar to how they are treated in a divorce.
Sec. 8, striking Sec. 409A and making conforming amendments
Repeal of Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans (Section 409A)
This provision completely repeals Section 409A of the Internal Revenue Code, which established complex rules for nonqualified deferred compensation plans to prevent perceived abuses. The repeal eliminates the requirements for deferral elections, distribution events, and the penalties for non-compliance. It also redefines 'nonqualified deferred compensation plan' within Section 457A and makes numerous conforming amendments throughout the tax code.
Recharacterization of Gains as Ordinary Income to Extent of Deduction: This rule specifies that if S corporation stock or built-in gain property (amortizable or non-amortizable) for which a deduction was allowed under the new Section 1369 is disposed of at a gain, that gain will be treated as ordinary income to the extent of the aggregate deductions previously allowed under this section.
Sec. 2(d), amending new Sec. 1369(d)
Why it matters:This is standard legislative practice for tax provisions to include recapture rules to prevent taxpayers from receiving both a deduction and favorable capital gains treatment on the same economic gain. It ensures the deduction is not double-counted.
Case for: Proponents would argue this rule is essential for the integrity of the new deduction, ensuring that the tax benefit is not abused and that the government eventually recoups the deferred tax revenue when the underlying assets are disposed of.
Case against: No specific case against this recapture rule itself, as it's a standard anti-abuse measure. However, opponents of the underlying deduction might point to the complexity it adds.
Estimated impact: This provision prevents potential revenue loss by ensuring that deductions taken on inherited S corp stock are recaptured as ordinary income upon disposition, thereby preserving the tax base.
Detailed Rules for Nonresident Alien S Corporation Stock Dispositions and Withholding: While the main provision allows nonresident aliens as shareholders, the specific mechanics for treating gain/loss on stock sales as effectively connected income (Sec. 864(c)(9)) and the detailed withholding tax rules (Sec. 1447), including exceptions and cross-references to Section 1446(f) for transferees, are highly technical and complex.
Sec. 4(b) and (c), amending Sec. 864(c) and adding Sec. 1447
Why it matters:This is standard legislative practice for international tax provisions, which are inherently complex and require detailed rules to prevent tax avoidance and ensure proper collection. The cross-references streamline drafting by leveraging existing mechanisms.
Case for: Proponents would argue these detailed rules are crucial for maintaining the integrity of the U.S. tax system when opening S corporations to nonresident alien investors. They ensure that foreign investors pay their fair share of U.S. taxes on effectively connected income and capital gains.
Case against: Critics might argue that the complexity of these rules creates significant administrative burdens for S corporations and transferees, potentially deterring foreign investment despite the primary intent of the provision.
Estimated impact: These provisions ensure the collection of U.S. tax revenue from nonresident alien investors in S corporations, potentially generating new revenue that would otherwise be lost.
Expanded Exceptions to Passive Investment Income Definition: While the main change is increasing the passive income limit, this subsection significantly expands the definition of 'passive investment income' to include new exceptions for interest on notes from sales of inventory, gross receipts from active lending or finance businesses, dividends from controlled C corporations, and interest/dividends for banks and depository institutions.
Sec. 3(c)(1), amending Sec. 1375(b)
Why it matters:This is a common drafting technique to consolidate definitional changes within the relevant definitional section. While not intentionally evasive, it requires careful reading to uncover the full scope of the policy changes.
Case for: Proponents argue these exceptions are vital for ensuring that legitimate active businesses in specific sectors (like lending, finance, or banking) are not unfairly penalized by passive income rules, allowing them to operate as S corporations without fear of termination.
Case against: Critics might argue that these expanded exceptions could be exploited by businesses that are not truly 'small' or 'active' in the traditional sense, allowing them to benefit from S corporation tax treatment while primarily engaging in passive investment activities.
Estimated impact: These exceptions could significantly reduce the number of S corporations that face passive income issues, particularly in the financial sector, potentially preserving S corp status for many businesses and affecting federal revenue.