Income Tax Basics for Inventors
If you earn a profit, the government wants to tax it!
If you’re one of the fortunate independent inventors who earns a profit from inventing, you’ll discover that all levels of government -- federal, state and local -- will want a piece of it. You need to be familiar with the requirements of each.
The federal government puts the biggest tax bite on all self-employed people, including inventors. When you’re in business for yourself, the federal government imposes a number of taxes on you, the primary ones being:
- income taxes, and
- self-employment taxes.
In addition, as explained below, the federal government requires that you pay your income taxes and self-employment taxes quarterly throughout the year -- a procedure known as estimated taxes.
Unless you’ve formed a C corporation, you’ll have to pay personal income tax on the profits your inventing business earns.
By April 15 of each year, you’ll have to file an annual income tax return with the IRS showing your income and deductions for your inventing business for the previous year and how much estimated tax you’ve paid. You must file IRS Form 1040 and include a special tax form in which you list all your business income and deductible expenses. If, like most independent inventors, you’re a sole proprietor, you use IRS Schedule C, Profit or Loss From Business.
Tax matters are more complicated if you operate your inventing business with others, or choose to incorporate your one-person invention business or form a one-owner limited liability company.
If you operate a partnership, you must file a partnership return (IRS Form 1065 also known as Schedule K-1) which lists the partnership’s income and deductions and each partner’s share of partnership profits or losses. You use this information to report your partnership income or losses on your personal tax return (IRS Form 1040).
If you incorporate your business and choose S corporation tax status, the entity must file an information return with the IRS on Form 1120S. This form is also referred to as a Schedule K-1, but it’s different from the K-1 partnership’s filing. The shareholders use the information on the S corporation K-1 to report their income or losses on their personal tax returns (IRS Form 1040).
If you incorporate your business as a C corporation, it will have to file its own tax return and pay taxes on its profits. You’ll be an employee of your corporation; you’ll have to file a personal tax return and pay income tax on the salary your corporation paid you.
If you form an LLC, the rules for filing depend on whether you choose to be taxed as a partnership, C corporation or sole proprietorship (if the LLC has only one owner)..
You’ll also have to pay Social Security and Medicare taxes on the money you earn from your inventing business. These taxes are called self-employment taxes, or SE taxes. You must pay SE taxes if your net yearly earnings from your business are $400 or more. When you file your annual tax return, you must include IRS Form SE, showing how much SE tax you were required to pay.
Paying quarterly estimated taxes
Federal income and self-employment taxes are pay-as-you-go taxes. You must pay these taxes as you earn or receive income during the year. Unlike employees, who usually have their income and Social Security and Medicare tax withheld from their pay by their employers, business owners normally pay their income and Social Security and Medicare taxes directly to the IRS. These tax payments, called estimated taxes, are usually made four times every year on April 15, June 15, September 15 and January 15. You have to figure out how much to pay; the IRS won’t do it for you.
Life would be too simple if you were only required to pay federal taxes. States get into the act as well, imposing their own income and sales taxes to fund their governments.
State income taxes
Except for Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming, all states impose income taxes on business owners. New Hampshire and Tennessee impose income taxes on dividend and interest income only. Most states charge a percentage of the income shown on your federal income return. Depending on the state in which you live, these percentages range anywhere from 3% to 12%.
In most states, you have to pay your state income taxes during the year in the form of estimated taxes. These are usually paid at the same time you pay your federal estimated taxes.
You’ll also have to file an annual state income tax return with your state tax department. In all but six states -- Arkansas, Delaware, Hawaii, Iowa, Louisiana and Virginia -- the return must be filed by April 15, the same deadline as your federal tax return.
If you’re incorporated, your corporation will likely have to pay state income taxes and file its own state income tax return.
Each state has its own income tax forms and procedures. Contact your state tax department to learn about your state’s requirements and obtain the forms.
State sales taxes
If you sell a product based on your invention, you’ll likely have to pay sales taxes. Almost all states and many municipalities impose sales taxes of some kind. The only states without sales tax are Alaska, Delaware, Montana, New
Hampshire and Oregon. You’ll have to fill out an application to obtain a state sales tax number. Many states impose penalties if you make a sale before you obtain a sales tax number. Generally, you pay sales taxes four times a year, but you might have to pay monthly if you make lots of sales.
Miscellaneous State Business Taxes
In addition to income and sales taxes, some states impose other, sometimes obscure business taxes. For example, Nevada imposes a Business Privilege Tax of $100 per year per employee. Hawaii imposes a general excise tax ranging from .15% to 4.5% of the gross receipts businesses earn. These miscellaneous taxes are sometimes difficult to ferret out. Check with your state government website to learn more about miscellaneous business taxes in your state.
You can find each state’s sales tax rate att he Federation of Tax Administrators website (www.taxadmin.org).
You might have to pay local business taxes in addition to federal and state taxes. For example, many municipalities have their own sales taxes which you may have to pay to a local tax agency.
Some cities and counties also impose property taxes on business equipment or furniture. You may be required to file a list of such property with local tax officials, along with cost and depreciation information. Some cities also have a tax on business inventory. This is why many retail businesses have inventory sales: They want to reduce their stock on hand before the inventory tax date.
A few large cities -- for example, New York City -- impose their own income taxes. Some also charge annual business registration fees or business taxes.
Your local chamber of commerce should be able to give you good information on your local taxes. You can also contact your local tax department.