New Tax Bill Jumps S Corp Passive Income Limit to 60%, Allows IRAs and Foreign Investors to Buy Stock

The aptly named S Corporation Modernization Act of 2025 is a massive overhaul of tax rules for S corporations, those popular small and mid-sized businesses that pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. If you own an S corp, are planning to inherit one, or use an IRA for investing, this bill is a game-changer.

The Passive Income Lifeline

This is the biggest operational change for many businesses. Currently, an S corp can lose its status and face penalties if more than 25% of its gross receipts come from passive investment income—think rent, dividends, interest, and royalties. Section 3 of this bill cranks that limit way up, increasing the threshold from 25% to a generous 60%. Even better, it completely removes the rule that automatically terminates an S corporation’s status if it exceeds the passive income limit for three straight years. For a business owner who wants to hold a chunk of cash in an interest-bearing account or use real estate assets for rental income without worrying about the IRS kicking them out of S corp status, this is huge. It gives businesses far more flexibility in how they manage their assets and cash flow, especially during slow periods.

Inheritance Just Got Less Taxing

Section 2 addresses a long-standing pain point for families inheriting a successful S corp. When a shareholder dies, the stock often has "built-in gains"—profits the company earned but hasn't paid tax on yet. Previously, the heirs were still on the hook for those gains. The new rule allows heirs to take a special deduction based on that built-in gain amount, which is spread out evenly over a 15-year period. If the corporation sells the underlying assets, the heir can accelerate the deduction. This provision provides significant tax relief and liquidity for families inheriting the business, making it easier to keep the company running rather than being forced to sell just to cover the tax bill.

Opening the Doors to New Investors

Sections 4 and 6 fundamentally change who can own S corp stock. Section 6 allows Individual Retirement Accounts (IRAs), including Roth IRAs, to become shareholders. This opens up a new avenue for retirement savings to be invested directly into private businesses, potentially fueling growth for small companies while offering new opportunities for everyday investors. Section 4, meanwhile, allows Nonresident Aliens to own S corp stock for the first time. This brings in foreign capital, but it also introduces complexity. The S corp must now withhold tax on the nonresident alien’s share of U.S.-connected income at the highest individual tax rate, and the buyer of the stock must withhold 10% of the sale price. While this opens up the market, it adds a new layer of administrative burden and compliance for S corps dealing with international investors.

Simplifying Ownership and Compensation

Two other changes address operational headaches. Section 5 tackles the shareholder limit. Currently, S corps generally can't have more than 100 shareholders. If a company wants to offer stock to a large number of employees, they often hit this ceiling. This bill simplifies things by treating all employees (and wholly-owned subsidiaries) as if they were just one single shareholder for the purpose of meeting that 100-shareholder limit. This makes broad-based employee ownership far more feasible for growing companies.

Section 8 is a major win for simplification, especially for high-earning executives and companies that use incentive plans. It repeals Section 409A entirely. That section was a notoriously complex set of rules governing when nonqualified deferred compensation had to be taxed, often catching businesses and employees off guard. By striking 409A, the bill aims to streamline deferred compensation rules, relying on the updated Section 457A instead. For busy HR departments and payroll specialists, this is a welcome reduction in bureaucratic red tape, though they will need to quickly adapt to the new rules under 457A.

Finally, Section 7 updates the rules for suspended losses. If a shareholder had tax deductions they couldn't use in a previous year, those losses can now be transferred when that person dies, preventing those deductions from simply vanishing.