Section 1202 of the tax code excludes from taxes 50% of profits from certain small business investments. For example, if Jane Jones made $1 million by investing in a new social networking site, she would only have to report $500,000 in profits on her tax return. What's more, if Jane rolled over her sales proceeds to another small business, she could defer paying any tax at all on that gain.

This might sound like a prime tax shelter, but Section 1202 has been "ignored" for years, according to Liddy Karter, president of the Angel Investor Forum, a venture capital advisory firm in Old Lyme, Conn. To jump-start investor interest in the provision, Congress raised the ante early this year; it bumped the tax exclusion to 75% on gains from the sale of certain small business stock issued after the date of enactment (Feb. 17, 2009) and before Jan. 1, 2011. "That's better, but Section 1202 needs more changes before people really start to use it," Karter says.

Luckily for affluent investors, more changes just may be in the cards. In the meantime, financial planners should take a long look at Section 1202 and see if it can benefit their clients, be they angel investors or entrepreneurs.

THE NUMBERS

Why the lack of enthusiasm for Section 1202? When this provision was created in 1993, the tax rate on long-term capital gains was 28%. Even though the long-term capital gains rate was subsequently reduced to 20% and then 15%, the Section 1202 50% exclusion always applies to a 28% tax rate. Therefore, that exclusion sets the tax on qualified sales at 14%. When everyone can get a 15% tax rate on long-term gains, jumping through the hoops of Section 1202 to get a 14% rate is not appealing.

The American Recovery and Reinvestment Act of 2009 expands the Section 1202 tax exclusion to 75% from 50%. With the same 28% base rate, a 75% exclusion brings the effective tax rate on Section 1202 gains down to 7%, a much more attractive number, at least on the surface.

The real-world impact of the greater tax exclusion will be muted, according to Luis Villalobos, founder of Tech Coast Angels in southern California, the largest angel investment network in the United States. "Part of the gain excluded from regular income tax under Section 1202 is considered a preference item for the alternative minimum tax," he says. "Many angel investors are subject to the AMT. Even with a 75% exclusion, the AMT paid by those investors will take away most of the tax advantage newly gained from Section 1202."

THE BASICS

Despite the AMT drawback, there are times when Section 1202 can be valuable. Villalobos says that Section 1202 has helped him save tax on investment gains in some prior years. What's more, a 7% tax rate on an investment made in 2009 or 2010 could turn out to be very appealing if a client realizes a small company investment profit in a future year when the default tax rate on long-term gains is 20% or higher, as now seems likely.

Therefore, financial planners who advise entrepreneurs or angel investors may do well to know the basics rules of Section 1202. The exclusion is available only for investments in what is called "qualified small business stock" (QSBS). Only shares issued by regular C corporations can qualify as QSBS.

Besides the C corporation requirement, there are other hurdles that must be cleared to qualify for the Section 1202 exclusion. The stock must be acquired at its original issue, and the shares must be held for at least five years.

In addition, when the stock is issued, "the company must have aggregate gross assets of less than $50 million, including the proceeds of the stock sale," explains Matthew Bartus, a partner in the Palo Alto, Calif., office of the law firm Dorsey & Whitney. "And at least 80% of the value of the corporation's assets must be used in the active conduct of a qualified trade or business," Bartus adds.

A trade or business can issue QSBS only if it does not operate in certain prohibited areas. Specifically, QSBS cannot be issued by companies in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, farms, hotels, restaurants and the production or extraction of minerals, oil or natural gas.

That leaves many types of businesses eligible for the 1202 tax exclusion, Karter notes. "Angel investors usually want to back companies that have high growth potential," she says. "Often, that leads to investments in technology areas, such as biotech. However, you can get the tax exclusion from lower-growth businesses like computer repairs or metals distribution, for example."

If your clients want to claim the 1202 tax exclusion, there is one more rule they must follow, according to Karter. A business owner or investor who profits from the sale of QSBS can exclude gains up to 10 times his or her basis in stock issued by the corporation and disposed of during the year, or $10 million reduced by any gain excluded in prior years, whichever is greater.