Federal, State and Local Tax Developments
On July 4, 2025, the One Big Beautiful Bill Act (“OBBBA”) was signed into law. The OBBBA makes sweeping changes and modifications to key U.S. Internal Revenue Code (“IRC”) provisions first passed in the 2017 Tax Cuts and Jobs Act (“TCJA”). These changes impact a wide range of industries, including investment funds, real estate, family offices and other businesses. The full impact of the provisions will become clearer over time with forthcoming regulations, IRS guidance and other administrative interpretations.
Additionally, the California Franchise Tax Board has finalized longstanding proposed regulations that would impose tax on asset managers based on the proportion of fees received by the asset manager from investors residing in California. This may impose California tax on asset managers that have no physical presence in California. The City of San Francisco has also proposed adopting a similar approach for gross receipts taxes on asset management fees based on the location of investors. This is a trend that we expect to continue, as other states and cities have adopted or proposed similar “market-based” sourcing rules.
Key impacts from these tax changes are summarized below. The tax attorneys of Shartsis Friese LLP will be closely monitoring any implementing guidance and are available to discuss any changes that may affect you.
Business Interest Limitation (IRC Sec. 163(j))
Historically, taxpayers were limited as to the amount of interest expense that can offset and decrease taxable income. In 2017, the TCJA limited the amount of business interest expense that taxpayers could deduct to the sum of a taxpayer’s business interest income, 30% of its adjusted taxable income and floor-plan financing interest for the year. Adjusted taxable income generally was calculated by reference to EBITDA, but beginning with tax year 2022, it was calculated by reference to EBIT only. With no add back for depreciation, amortization and depletion, many taxpayers’ business interest expense limitation was significantly tightened in tax year 2022.
The OBBBA permanently adopts the more generous EBITDA calculation as used prior to 2022 for tax years beginning after 2024. However, the adjusted taxable income definition was modified to exclude income inclusions from certain controlled foreign corporation income, which may reduce the limitation for some taxpayers with international operations (e.g., investments in foreign portfolio companies). The limit will apply to interest capitalized to assets, such as interest capitalized to specified production property, for tax years beginning in 2026.
The OBBBA kept the ability for “real property trades or businesses” to elect out of this business interest expense limitation. However, as before the OBBBA, a real property trade or business election is generally irrevocable and requires the taxpayer to adopt the alternative depreciation system (“ADS”) for its depreciation deductions. Property required to use ADS is generally not eligible for bonus depreciation.
Takeaway: Investment funds will see their leveraged portfolio companies able to deduct previously disallowed interest expense that has been carried forward. Real estate taxpayers should model the effect of increased interest expense deductions with the loss of depreciation deductions (including certain of those now available for qualified production property, as described below). The looser interest expense deduction limitation may make it less desirable to make a real property trade or business election.
Bonus Depreciation (IRC Sec. 168(k))
Bonus depreciation is a tax incentive that allows businesses to immediately deduct a significant portion of the purchase price of qualifying assets, rather than recovering the purchase price ratably over a longer period. The TCJA allowed taxpayers to take an additional depreciation deduction (so called “bonus depreciation”) equal to 100% of the adjusted basis (generally cost basis) of qualified property that has a recovery period of 20 years or less. Examples of such property include appliances, cabinets, fixtures, office furniture, land improvements such as fences, sidewalks, landscaping and interior non-structural improvements to commercial buildings. This 100% depreciation deduction began to phase down in tax year 2023, was 40% in 2025 and would have been 0% in 2027.
The OBBBA permanently restores the 100% bonus depreciation deduction for property acquired and placed in service after January 19, 2025.
In addition, the OBBBA made the 100% bonus depreciation available for a new category of “qualified production property,” which is property used by the taxpayer as an integral part of manufacturing, production, or refining. Bonus depreciation for qualified production property is not permanent. Property construction has to begin after January 19, 2025, and before January 1, 2029, and the property must be placed into service before January 1, 2031.
Takeaway: Real estate investors and developers may consider cost segregation studies to access bonus depreciation for building components. For investment funds, this may increase the value of any IRC Sec. 743(b) basis adjustment related to a purchase of an interest in an operating partnership.
Qualified Business Income Deduction (IRC Sec. 199A)
The qualified business income deduction under IRC Sec. 199A was enacted by the TCJA to allow certain taxpayers to deduct 20% of pass-through business income. It was set to sunset at the end of 2025, but the OBBBA made this deduction for pass-through business income permanent. The deduction is generally not available for income from financial services, brokerage services, investing, trading and dealing in securities. It is available for income from REITs, banking, direct lending and certain portfolio companies that are flow-through operating businesses.
Takeaway: The deduction’s permanence offers stability and predictability to plan for investment funds that utilize REITs or that directly lend. Individuals and trusts owning real estate directly or through passthroughs may also benefit.
Itemized Deduction Limitations (IRC Sec. 67 and Sec. 68)
Various limitations apply to itemized deductions, which reduce adjusted gross income as “below-the-line” deductions. The TCJA temporarily disallowed deductions that arise from miscellaneous itemized expenses, such as investment expenses (other than investment interest expenses). In addition, the TCJA temporarily eliminated the so-called “Pease limitation,” which required taxpayers to reduce itemized deductions by 3% for every dollar of taxable income above certain thresholds, capped at a reduction of 80% of the total value of the itemized deduction.
The OBBBA permanently disallowed miscellaneous itemized expense deductions, so that expenses are generally required to be ordinary and necessary expenses incurred in carrying on a trade or business to be deductible. It also permanently eliminated the Pease limitation but replaced it with another 2/37 limitation on itemized deductions. For income above the 37% income tax bracket, the 2/37 limitation is intended to cap the tax benefit of itemized deductions to a benefit calculated from only offsetting income taxed at 35%.
Takeaway: Investment expenses such as management fees paid by taxpayers invested in private equity funds, venture capital funds and funds that are deemed to be investing for income tax purposes will generally be disallowed. In addition, investment expenses that are allowed (such as investment interest) will generally be subject to this 2/37 limitation. Family offices may find it worthwhile to consider using a C-corp management company structure (and otherwise evaluate the Tax Court case Lender Management v. Commissioner) in light of these limitations on the deductibility of asset management expenses.
Excess Business Losses (IRC Sec. 461(l))
An excess business loss is the amount by which a non-corporate taxpayer’s total trade or business deductions exceed the combined total of their trade or business gross income, gains and an inflation-adjusted threshold amount. For non-corporate taxpayers, the TCJA enacted a limitation on the deductibility of net losses incurred in trades or businesses such that these losses are deductible only up to a capped amount (up to $313K for single and $636K for married filing jointly filers for tax year 2025). These deduction limitations are applied after the partnership basis, at-risk and passive loss rules. Remaining losses after application of those rules are then capped under the excess business loss rules. Disallowed losses are carried forward as net operating losses, so excess business loss rules would generally apply only in the year the loss arises. This excess business loss limitation applied to tax years 2021 to 2028.
The OBBBA made this limitation permanent. There was no change to the federal treatment of carryforward amounts as net operating losses, making this limitation largely a timing issue for federal tax purposes. However, states may not conform to this treatment (for example, California would subject the carryforward to this excess business loss rule as well).
Takeaway: Asset managers must consider this rule in determining whether they can recognize losses on a current basis. Funds that are considered to be “traders in securities” may realize income and losses that are generally subject to this limitation, other than losses from sales or exchanges of capital assets. However, the rule may apply differently for trader funds that elect the IRC Sec. 475(f) mark-to-market treatment, and losses may then be subject to these excess business loss rules. In addition, non-corporate investors in funds that invest in operating flow-through portfolio companies may find that their share of income and loss from the portfolio company are also subject to this limitation.
Qualified Small Business Stock (IRC Sec. 1202)
The qualified small business stock (“QSBS”) gain exclusion has been enhanced under the OBBBA. Before the OBBBA, 100% of gain from a sale of QSBS held for more than 5 years was entitled to be excluded from income. The OBBBA added a tiered system with a 50% exclusion for stock held for at least 3 years and a 75% exclusion for stock held for at least 4 years.
In addition, the OBBBA raised the cap on the amount of gain that a taxpayer may exclude from taxation from the greater of $10 million or 10x basis per company to the greater of $15 million or 10x basis.
Finally, the OBBBA expanded the gross asset threshold for a company to qualify as eligible to issue QSBS from $50 million to $75 million, allowing larger startups to qualify for QSBS benefits.
These expanded rules generally apply to QSBS acquired or issued after July 4, 2025. To determine if these rules apply, if the QSBS is issued in exchange for contributed assets in a carryover basis transaction, the acquisition date of the QSBS relates back to the acquisition date of the contributed assets, which may cause stock issued or exchanged after July 4, 2025, to be deemed to have been acquired earlier.
Takeaway: Private equity and venture capital funds have increasingly invested in QSBS in recent years. The above changes will make the QSBS benefits more accessible, and investors will have more flexibility in choosing when to exit those investments. In addition, it may be worthwhile to consider whether, and how, ownership interests in or assets held by flow-through entities that were previously not QSBS may qualify as QSBS under expanded rules.
Controlled Foreign Corporations (IRC Sec. 951-965)
U.S. persons whose ownership exceeds set thresholds in certain foreign corporations, known as controlled foreign corporations (“CFCs”), are subject to annual tax and reporting requirements, even if no cash is received from the corporation. Ownership is determined under complex attribution rules, including that of “downward attribution,” which causes stock owned by foreign persons to be attributed downward to their U.S. subsidiaries. The TCJA repealed a long-standing statutory prohibition of downward attribution for these CFC determinations, which caused many more foreign corporations to be treated as CFCs. The OBBBA reinstated the pre-TCJA prohibition so that downward attribution is disallowed in CFC determinations.
Instead, the OBBBA introduces a narrower rule under which downward attribution may apply. For tax years of foreign corporations beginning after December 31, 2025, only “foreign controlled U.S. shareholders” that own more than 50% of “foreign controlled foreign corporations” (“FCFCs”) are subject to tax on a current basis from those FCFCs.
Takeaway: Clients with foreign corporations in their structure (for example, credit funds structured as foreign corporations for U.S. tax purposes that have significant U.S. owners) may wish to revisit whether such corporations are considered CFCs or FCFCs after these OBBBA changes.
Other OBBBA Matters
Notably, the OBBBA made no changes to the tax treatment of carried interest and the availability of pass through entity tax (also known as PTET) “workarounds” to the cap on state and local tax deductions.
California Finalizes Sourcing Rules for Asset Management Fees
In general, California sources the percentage of business income earned by a business to be taxable in California based on the percentage of that business’s sales receipts assigned to California’s sales factor. On September 10, 2025, the California Franchise Tax Board (“FTB”) finalized long-issued proposed regulations (the “Regulations”) that assign receipts from “asset management services” to the California sales factor based on the proportion of fees received from California resident investors.
For tax years beginning on or after January 1, 2026, these Regulations require that asset managers source fees to the domicile of a fund’s investors, or, where an investor holds the investment for beneficial owners, to the domicile of such investor’s beneficial owners. Domicile is determined using the billing address in the fund’s or manager’s records unless either has actual knowledge of a different primary residence (for individuals) or principal place of business (for entities).
For each tax year, the portion of receipts assigned to California is the average of the beginning‑of‑year and end‑of‑year percentages of fund value held by California‑domiciled investors and beneficial owners. If precise percentages cannot be determined, a reasonable estimate is permitted, as the FTB considers the effort and cost involved in obtaining such information.
The Regulations provide an example where the fund manager does not know the domicile of the beneficial owner of an investor but knows that the investor’s business is investing the capital of public employees of another state. As a result, the fund manager reasonably estimates that the domiciles of the beneficial owners of the investor is in the other state.
There are legal challenges pending in California attempting to strike down the use of market-based sourcing tax rules in other contexts, and it is possible industry participants will make a similar challenge to these Regulations.
The City of San Francisco has proposed adopting similar new regulations to source asset managers’ fees to San Francisco based on investor location for purposes of the city’s gross receipts tax. The San Francisco proposed sourcing regulations have not been finalized as of the date of this alert.
Takeaway: Many asset managers have already adopted the new market-based sourcing approach in the Regulations, and the finalization of the Regulations provides certainty when planning for 2026 California tax returns. Asset managers should continue to collect relevant address information from their investors in the subscription process.
If you have questions regarding the OBBBA or the California sourcing rules for asset management fees, please contact one of the Shartsis Friese attorneys in the Taxation Group.