Wealthy clients may be able to use a little-known way to lower taxes when selling stock.

The Protecting Americans from Tax Hikes Act of 2015 renewed the capital gains exclusion for small business stock in Section 1202 of the Internal Revenue Code. Designed as an incentive for taxpayers to invest in small businesses, 1202 is also a handy tool to exclude capital gains from federal tax.

“If the stock was acquired directly from the company after [2010], held for more than five years and the company was worth less than $50 million when the stock was acquired, you can exclude up to $10 million,” said Lawrence Pon, a CPA/PFS at Pon & Associates in Redwood City, Calif. “This was huge for many clients who invested in start-up companies that went public or were acquired.”

“The vast majority of taxpayers are most likely not aware of 1202 and ... it’s been significantly underutilized since it was enacted back in 1993,” added John Vento, a CPA/CFP and president at Comprehensive Wealth Management in New York.

The exclusion applies to gain on the sale of qualified small business (QSB) stock and could be 50 percent, 75 percent or 100 percent. To get the full exclusion, qualified stock needed to be purchased after Sept. 27, 2010. This is some of the other criteria:

• The stock must be in a C corporation (not allowed for S corporations).

• The stock was originally issued after Aug. 10., 1993, in exchange for money or property not including stocks, or as compensation for a service rendered.

• The qualified small business must meet the active business test—80 percent of assets used in active conduct of business.

• A qualified trade or business must be conducted by the company in question. “There’s a long list of excludable businesses,” Vento added.

• There are annual and lifetime limits on the exclusion for QSB stock for any one issuer.

Section 1202 comes with some problems—first and most obviously uncertainty, and the exclusion depends on criteria often difficult to predict in the early years of a company. Stock can drop in value or the company's worth can suddenly break the $50 million ceiling. Some say the potential of 1202 has also been hampered by the combination of a formerly high federal corporate tax rate and taxation of dividends distributed by the corporation to its shareholders (the “double taxation” of C corp profits). Tax reform has lowered the corporate rate, however, making 1202 more attractive.

The exclusion is also a consideration for choice of entity when starting a business. Most small businesses set up as corporations will also become Subchapter S corporations to avoid double taxation, according to Vento, rendering them ineligible for 1202.

“If your primary purpose for entering this business is to create value so that it can be sold off within five or more years, then foregoing Subchapter S status could be the most advantageous from a [1202] point of view,” Vento said. “This is especially true if you don’t anticipate large profits from the business for the first few years,” which will keep the company’s worth under the criteria ceiling.

Audits of 1202 treatments require strong backup, such as evidence of when the stock was acquired—receipts, cancelled checks, stock purchase confirmations and so on—as well as copies of the stock prospectus and financial statements.

“Usually the companies are small at the time, so they may not have financial statements,” Pon said, adding that during a recent 1202 audit, he successfully used the tax returns of the corporation for relevant years.

“Take a look at state tax law” regarding 1202, Pon added. “Some states conform [to the federal exclusion] and many do not.”