Tax Reform and its Impact on Funds and Portfolio Companies

The recently enacted One Big Beautiful Bill (OBBB) represents comprehensive tax legislation impacting private equity and portfolio companies. Many new provisions will encourage additional capital investment, generate increased cash flow for portfolio companies, and provide tax certainty for investors. Some of the proposed punitive measures, like increases to capital gains tax rates and changes to the taxation of carried interest, were not enacted in the final law.

Here's what you need to know about its impact on funds and portfolio companies.

Fund Level Considerations

Tax Rates Extended and QBI Deduction Permanency.

The individual tax rates created as part of the Tax Cuts and Jobs Act of 2017 (TCJA) are now permanent, meaning the highest applicable federal rate is 37%. These rates were set to expire at the end of the 2025 tax year (reverting to higher rates).

Additionally, the qualified business income deduction (QBI deduction) under section 199A is also permanent, meaning certain business income passing through a portfolio company (organized as a tax partnership) to a fund could be taxed at a preferential 29.6% tax rate.

Capital Gains Rate and Treatment of Carried Interest Unchanged.

Some recent tax proposals include increases to the capital gains rate and treating income allocated to a carried interest holder as compensation or ordinary income (rather than capital gain income). The OBBB does not enshrine either of these proposals, meaning capital gains continue to be taxed at a maximum 20% federal rate (plus, if applicable, the net investment income tax) and carried interest can continue to receive capital gains treatment.

QSBS Gain Exclusion Enhanced.

Gain from the sale of qualified small business stock (QSBS), as defined under section 1202, has been eligible for at least a partial exclusion since 1993. This benefit incentivizes early-stage capital investment into startup companies organized as C corporations.

Under the OBBB, investors can realize a larger gain exclusion amount and opportunities for a partial gain exclusion for stock held less than five years (stock must be held for at least five years to claim the full gain exclusion). Additionally, a previous cap on the size of a qualified corporation has been raised, meaning more companies can qualify for the QSBS gain exclusion.

SALT Deduction and PTET Elections.

For taxpayers with taxable income below $500,000, the deduction for state and local taxes (SALT deduction) is now capped at $40,000, rather than $10,000, phased down as income exceeds $500,000.

Also, so-called pass-through entity tax (PTET) elections remain viable. They allow, for example, a fund to elect to pay income tax at the entity level, potentially providing a full deduction for all investors, regardless of any taxable income limitations.

Portfolio Company Considerations

100% Bonus Depreciation.

The OBBB permanently enacts 100% bonus depreciation for qualified assets placed into service after January 19, 2025, allowing their costs to be immediately recovered.

R&D Expensing.

Specified domestic research or experimentation costs can now be immediately expensed under Sec. 174 for tax years beginning after December 31, 2024, rather than amortized over five years. Foreign costs must be amortized over 15 years. Small businesses can also retroactively expense those costs from 2022 through 2024.

Interest Expense Limitations.

Business interest expense can again be deducted without regard to depreciation and amortization. Since 2022, businesses with high amounts of depreciation and amortization could have their business interest expense deductions limited. The new formula applies for tax years beginning after December 31, 2024. Portfolio companies with large amounts of leverage and depreciation can expect a benefit for the 2025 tax year and beyond.

Phase Down of Energy Credits.

Certain tax credits created as part of the Inflation Reduction Act will be eliminated at the end of the 2025 tax year, including tax credits for new and used clean vehicles. Clean energy investment and production tax credits for wind and solar are now only allowed for projects that begin by July 4, 2026, or which are placed in service before the end of 2027. Given these phasedowns, businesses relying on these credits for current or future financing may need to reconsider their current structure.

Next Steps for Private Equity and Portfolio Companies

Most of the OBBB changes are favorable for both private equity funds and portfolio companies. Some proposed changes, which would have negatively affected investors and businesses, did not make it into the final law. Our tax team can help you digest this new tax law and its effects on funds and portfolio companies.