S-Corp Tax Modernization

Summary#

This bill makes several changes to how S corporations are taxed and who may own S corporation stock. It mainly changes tax rules that apply when an S shareholder dies, raises the limit on passive investment income for S corporations, allows some new types of shareholders, treats employees together for the shareholder-count limit, and repeals a rule about deferred compensation taxation.

• Creates a new tax rule that lets a person who inherits S corporation stock take a deduction for an “S corporation built-in gain amount” (an increase in value at death or the corporation’s unrealized gain), amortized over 15 years, with special rules if the corporation sells property or the stock is later sold.
• Raises the passive investment income threshold from 25% to 60% and removes passive-income-triggered termination of S status; it also revises what counts as passive receipts.
• Allows nonresident alien individuals to be S corporation shareholders, and adds rules treating some sales of S stock by nonresident aliens as connected to a U.S. trade or business, with new withholding obligations for S corporations and buyers.
• Treats all employees of a corporation (and their estates) as a single shareholder for the S-corporation shareholder-count limit.
• Permits IRAs (including Roth IRAs) to be S corporation shareholders and adjusts certain prohibited-transaction rules.
• Allows suspended S-corporation losses to transfer on a shareholder’s death.
• Repeals Internal Revenue Code section 409A (the current tax rule that treats most nonqualified deferred compensation as included in income) and makes related conformity changes.

What it means for you#

• S corporation shareholders and heirs

  • If you inherit S-corp stock, you (or the estate) may get a new deduction tied to the step-up in basis or the corporation’s unrealized gains. That deduction is generally spread over 15 years.
  • If the corporation later sells property or you sell the stock, some or all of those deductions can accelerate and affect whether gains are treated as ordinary income.
  • The new rule applies only if the S corporation makes the election to apply the rule for that shareholder (the bill leaves specifics to Treasury guidance).

• S corporations (management and tax officers)

  • May need to track and report new items about built-in gain amounts and the allocable shares to shareholders. The bill adds reporting requirements under current partnership/corporation information rules.
  • If nonresident aliens are shareholders, the S corporation must withhold tax equal to the top individual tax rate times the nonresident shareholders’ share of effectively connected income and follow new rules when shareholders sell stock.
  • If the corporation has higher passive receipts (between 25% and 60%), it no longer risks termination of S status under the passive-income rule.

• Nonresident alien individuals

  • Can own S-corporation stock under this bill. When they sell S stock, part of the gain may be taxed as U.S.-effectively connected income. Buyers or transferees may have to withhold 10% on dispositions in some cases.
  • Nonresident shareholders get a credit for withholding paid by the S corporation.

• Employees

  • All employees of a corporation (and their estates) are counted together as a single shareholder for the 100-shareholder limit for S status. This could affect whether a company remains eligible as an S corporation.

• Retirement accounts and IRA owners

  • IRAs (including Roth IRAs) can hold S-corp stock under this bill. The bill also adjusts prohibited-transaction rules tied to such sales.

• People with deferred compensation

  • The repeal of the current deferred-compensation inclusion rule would change when certain deferred pay plans are taxed. The bill replaces some definitions and rules in related areas but does not provide detailed transition guidance in the text.

Expenses#

No publicly available information.

• The bill text does not include a fiscal note, budget estimate, or an official estimate of federal revenue effects or administrative costs.
• Likely areas of cost or administrative impact (not quantified in the bill text) include IRS rulemaking, new withholding and reporting systems for S corporations, and taxpayer compliance and filing changes.
• Changes to deferred-compensation taxation could affect federal revenues, but the bill gives no estimate.

Proponents' View#

• The bill appears intended to modernize S corporation rules to reflect common ownership and investment realities.
• Supporters may argue the new death-related deduction smooths tax treatment when stock receives a basis step-up at death by allowing heirs to recover built-in gains over time.
• Raising the passive-income threshold to 60% and removing termination for excessive passive income could help S corporations that have more passive receipts avoid losing S status.
• Allowing nonresident aliens and IRAs to be shareholders broadens who can invest in S corporations and may increase capital access for those businesses.
• Treating employees as one shareholder could enable broader employee ownership arrangements without breaking the S-shareholder limit.
• Repealing the deferred-compensation inclusion rule could simplify taxation of certain deferred-pay arrangements (as the bill also amends related provisions).

Opponents' View#

• One concern is lost or uncertain federal revenue from repealing the current deferred-compensation inclusion rule; the bill provides no revenue estimate.
• The new death-related deduction and expanded shareholder eligibility (nonresident aliens and IRAs) could create opportunities for tax planning that are difficult to monitor, raising enforcement and compliance questions.
• The requirement for S corporations to withhold tax for nonresident shareholders and for transferees to withhold on sales could add record-keeping and cash-flow burdens on small corporations and buyers.
• Treating all employees as a single shareholder could be complex to apply in practice and could be gamed if definitions of “wholly owned business entities” or employee status are unclear.
• The bill leaves many details to Treasury rulemaking (for example, how the S corporation elects the new death-related rule, the “applicable valuation date,” and how calculations are to be reported), which may delay practical implementation and create uncertainty.
• The text contains an unclear phrase in the definition of “applicable valuation date” (it refers to “the date months after the decedent’s death” without a number), making a key timing rule unclear in the bill as written.