S-corp ownership modernization

Full Title:
S Corporation Modernization Act of 2026

Summary#

This bill changes many tax rules for S corporations (small, pass-through corporations). Major changes include new tax treatment when a shareholder dies, looser limits on passive income and shareholder types, permission for IRAs and some nonresident aliens to be shareholders, and repeal of one federal rule on deferred compensation. The bill aims to modernize S corporation rules and ease ownership and succession issues.

Key changes:

  • Creates a new deduction for heirs who inherit S‑corp stock when the stock basis is stepped up at death; that deduction is generally spread (amortized) over 15 years and can be accelerated or recaptured when the corporation or its property is sold.
  • Raises the S‑corp passive investment income threshold from 25% to 60% and removes excessive passive income as a cause to terminate an S election.
  • Allows nonresident alien individuals to be S‑corp shareholders, and sets rules for treating and withholding tax on gains or effectively connected income attributable to those shareholders.
  • Treats all employees of a firm (and their estates) as a single shareholder for the S‑corp shareholder-count limit.
  • Permits IRAs (including Roth IRAs) to hold S‑corp stock.
  • Allows suspended S‑corp losses to transfer on death.
  • Repeals section 409A (the current federal rule that governs taxation of many nonqualified deferred compensation plans) and makes related technical changes.
  • Increases the maximum number of S‑corp shareholders from 100 to 250.

What it means for you#

  • S corporations (businesses):

    • Could keep S status even with more passive income (threshold becomes 60%).
    • Can have up to 250 shareholders instead of 100 (effective 2027).
    • Can elect to apply the new 15‑year amortization deduction for built‑in gain amounts tied to a deceased shareholder’s basis step-up.
    • If nonresident alien individuals are shareholders, the S‑corp must handle new withholding and reporting rules for effectively connected income.
    • If the S‑corp has employees and the company treats employees as one shareholder for the limit, employee‑ownership arrangements may be easier to organize under S rules.

  • Shareholders and potential shareholders:

    • Heirs/Estates: An heir who receives S‑corp stock after a shareholder’s death may get a deduction based on the basis step‑up, generally spread over 15 years; certain sales can accelerate deductions or convert some gain to ordinary income.
    • Nonresident alien individuals: May now own S‑corp stock. Gains or losses on sale of that stock can be treated as effectively connected with a U.S. trade or business to the extent tied to a deemed asset sale; purchasers and S corps face new withholding rules.
    • IRAs (including Roth IRAs): Can be S‑corp shareholders starting January 1, 2027. The bill also adjusts prohibited‑transaction rules for sales of S‑corp stock inside IRAs.
    • Employees: All employees of a company (and their estates) count collectively as one shareholder for the shareholder cap. This changes how employee stock ownership or broad employee ownership counts against the shareholder limit.
    • Beneficiaries of estates/trusts: Transfers of stock from an estate or trust are treated so the beneficiary becomes the taxpayer for the new deduction and other rules.

  • Tax professionals and payroll/finance staff:

    • Will face new compliance tasks: calculating and reporting the new amortizable deduction, new withholding for nonresident shareholders, and changes from repeal of 409A.
    • Must follow new reporting rules that treat certain S‑corp items as corporate items to be furnished to shareholders.

Expenses#

No publicly available information.

Possible fiscal and administrative effects the bill text implies:

  • Potential changes in federal tax receipts from allowing more shareholders, nonresident shareholders, higher passive income threshold, and repeal of 409A — the bill text does not include a budget or revenue estimate.
  • Increased compliance and administrative costs for S corporations to calculate amortization deductions, handle new withholding, and meet new reporting rules.
  • Possible IRS enforcement or guidance costs (the bill requires the Secretary to issue regulations for some provisions).
  • Potential changes in tax administration for estates and beneficiaries (calculating income‑in‑respect‑of‑the‑decedent adjustments).

Proponents' View#

The bill does not include an explanatory revenue or policy note in the text supplied. Based on the changes in the bill, possible arguments in favor include:

  • The bill appears intended to modernize S‑corp rules to reflect current business practices (for example, more owners and retirement account ownership).
  • Raising the passive income threshold and removing termination for excessive passive income could reduce forced conversions to C corporations for businesses that hold some investments.
  • Allowing IRAs and nonresident individuals as shareholders could expand access to S‑corp investments and simplify retirement or estate planning.
  • The new deduction for heirs could ease tax consequences when S‑corp stock receives a basis step‑up at death, smoothing business succession.
  • Treating employees as one shareholder may make it simpler to run broad employee‑ownership programs without hitting shareholder caps.

(These are inferred from the bill text and phrased as possible arguments; the bill text itself does not include sponsor statements in the material supplied.)

Opponents' View#

From the bill text alone, reasonable concerns and trade‑offs include:

  • One concern is the likely fiscal impact. The bill does not include a cost or revenue estimate, and changes (e.g., broader shareholder eligibility, higher passive income threshold, repeal of 409A) could reduce tax receipts.
  • Repeal of section 409A may remove existing rules that limit tax deferral and impose penalties on certain deferred compensation arrangements. It is unclear from the text how similar protections (if any) will be preserved elsewhere.
  • Allowing nonresident aliens as shareholders adds new withholding and reporting duties and could create compliance complexity; the bill requires regulations but details are limited.
  • The 15‑year amortization deduction for heirs involves complex valuation and tracking. The bill allows recapture or recharacterization when assets are sold, but administration may be complex for businesses, estates, and the IRS.
  • Expanding permitted shareholders to include IRAs and counting employees as one shareholder may create opportunities for tax planning that rely on the new definitions; the bill does not detail anti‑abuse limits.
  • Several provisions rely on future Treasury regulations or guidance. The bill does not fully specify implementation rules, so practical effects could depend heavily on follow‑up regulation.

What is unclear from the bill text:

  • Exact revenue impact and who would bear the largest tax changes.
  • How broadly Treasury will interpret the new elections, elections timing, and anti‑abuse rules.
  • How repeal of section 409A will interact with other tax provisions affecting deferred compensation.