The "S Corporation Modernization Act of 2025" proposes substantial changes to the Internal Revenue Code, primarily aimed at modernizing S corporation regulations and repealing Section 409A. A key provision allows a deduction for the amortizable S corporation built-in gain amount when a shareholder dies, with the stock's basis determined under section 1014(a). This deduction is generally amortized over 15 years, but can be accelerated upon the disposition of built-in gain property, and any gains from such dispositions are recharacterized as ordinary income to the extent of the deduction.

The bill significantly modifies S corporation passive investment income rules by increasing the percentage limit from 25% to 60% and repealing the provision that excessive passive income can terminate an S corporation's status. It also refines the definition of passive investment income, introducing exceptions for certain interest, income from lending or finance businesses, and dividends from C corporations where the S corporation holds a significant equity interest. These changes aim to provide greater flexibility for S corporations with accumulated earnings and profits from prior C corporation years.

Furthermore, the Act expands S corporation eligibility by permitting nonresident alien individuals to be shareholders, a significant departure from current law. To address potential tax avoidance, it treats gain or loss from the sale of S corporation stock by nonresident aliens as effectively connected with a U.S. trade or business, and mandates a withholding tax on S corporations for nonresident alien shareholders' pro rata share of effectively connected income. Another expansion allows Individual Retirement Accounts (IRAs), including Roth IRAs, to hold S corporation stock, with related sales exempted from prohibited transaction rules.

Other reforms include treating all employees and their estates of a corporation and its wholly-owned entities as a single shareholder for purposes of the S corporation shareholder limit, simplifying compliance for businesses with employee ownership. The bill also permits the transfer of suspended S corporation losses incident to the death of a shareholder, preventing their forfeiture. Finally, the Act repeals Section 409A of the Internal Revenue Code, eliminating the rules governing the timing of income inclusion for nonqualified deferred compensation plans and making conforming amendments to related sections.