In 2004, Walden Venture Capital invested $9 million in the internet radio provider Pandora, which at the time was still a small tech company.

Pandora investors at the time were able to take advantage of a little-known tax exclusion on capital gains for “qualified small business stock,” which is defined in Section 1202 of the Internal Revenue Code. Walden represented Pandora as a qualified small business, promising partners a 50% reduction in taxes come payday.

Today, Pandora is worth over $6 billion. Walden’s investors saved millions.

Taxes on this type of stock are lower than ever. Actually, in some cases, the sale of qualified small business stock is not even taxable.

Here, we will explain some of the law covering these investments, highlighting opportunities for investors, employers, entrepreneurs and employees.

Overview Of Qualified Small Business Stock
The requirements for this qualified stock are strict and complex. Broadly, the stock must be held for more than five years and must have been acquired after August 10, 1993, at original issue, meaning that the stock must have been acquired from the company directly.  To qualify, the company must:

• Be a domestic C corporation;

• Have less than $50 million in aggregate gross assets; and

• Allocate at least 80% of assets (by value) to an active (qualified) business.

The businesses cannot be involved in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, banking, insurance, financing, leasing, investing or farming. Moreover, no more than 10% of the issuing company’s assets (by value) may be stock in other corporations, unless they are subsidiaries controlled by the company.

The Exclusion
Overall however, those requirements are reasonable, especially considering the rewards.

Some investors will owe 7% of the excluded gain as part of their alternative minimum tax, but only on stock acquired on or before September 27, 2010. Consider an investor who acquired qualified small business stock on February 1, 2009, for $100,000. If the investor sold the stock at $200,000 more than five years later and then owed AMT, $50,000 would be taxed at the long-term capital gains rate, and another $50,000 would be taxed at 7%.

However, under the Creating Small Business Jobs Act of 2010, qualified small business stock acquired after September 27, 2010, is free from federal income tax, and no alternative minimum tax is added back. Nonetheless, the exclusion may not exceed the greater amount of $10 million or ten times the aggregate adjusted basis of the stock (which is often equal to the price of the stock at acquisition).

Most important, after the enactment of the PATH Act (the “Protecting Americans from Tax Hikes Act of 2015”) the 100% exclusion is permanent.

Tax-Free Rollover
Investors should keep some things in mind if they are looking at these exclusions.

Those looking to hold qualified small business stock five years or less can perform a tax-free rollover. All gains reinvested in other qualified small business stock is free from tax, as long as the replacement stock meets the requirements of an active business for at least a month. Also, the investor must hold the original stock for at least six months, and must acquire the replacement stock in less than 60 days. If a stockholder reinvests only part of the gain, the reinvested part is free from tax, and the remainder is taxable.

State Taxes
Regardless of the federal government’s ease on these taxes, the states might still tax qualified small business stock. In Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming, there is no income tax, but in other states the law is more complicated, requiring some research. For instance, in Massachusetts, gains from qualified small business stock are taxed at 3% instead of at the 5.1% rate for income, but there is no exclusion of taxable income. In addition, companies must be located in Massachusetts and incorporated on or after January 1, 2011, to be eligible for the 3% rate. They need not be C corporations.

If a partnership (a non-corporation)holds qualified small business stock, the gain allocable to each partner is excludable, as long as each was a partner for as long as the partnership held the stock.

Recruiting and Retaining Employees
Since the gain from qualified small business stock is excludable, the stock is valuable for recruiting and retaining employees, especially executives. Still, stock options themselves are not qualified. If an employee owns options for qualified small business stock, he or she must hold the stock for more than five years after the exercise of those options for the capital gains to be free from tax.

Engaging Investors
Because federal long-term capital gains rates can be as high as 20%, the exclusion on qualified small business stock can give these stocks an edge as they compete for investor money. Yet investors are not always aware of the qualified small business stock exclusion.

As a best practice, a qualified company should document that its aggregate gross assets are less than $50 million and that the company is a C corporation as well as an active business. It’s important that the company provide such documentation for investors and employees; investors will find that a conversation with the company’s legal or financial department is far better than a conversation with the IRS.

As an advisor, you can help keep these investments in the minds of investors, employers, entrepreneurs and employees. Your best way to add value is simply by knowing about it, since so few know about Section 1202, qualified small business stocks to begin with.

Michael Syer is a senior associate financial counselor at the Colony Group in Boston.
Joshua Nathanson is an intern at the firm and a student at Cornell University.