If you work together with one or more co-inventors who share ownership of the business, you can't be a sole proprietor. Instead, if you don't form a corporation or limited liability company, you will automatically become partners in a partnership. However, the partnership form is not necessarily the best one for coi-nventors. You should consider three main factors in deciding whether to operate your invention business as a partnership:
- Expense and complexity: How expensive and difficult is a partnership to form and operate?
- Tax treatment: How is a partnership taxed?
- Liability concerns: How and to what extent will you be liable for debts and lawsuits?
Expense and Complexity
Partnerships are the cheapest business form for joint owners to start and operate, but, they are more complicated than sole proprietorships. Partnerships may be operated informally-- that is, there is no need to have annual meetings, elect officers or to document all important decisions with minutes. However, because there are two or more owners, the partners have to decide:
- the duties of each partner
- how each partner will share in the
- partnership profits or losses
- how partnership decisions will be made
- what happens if a partner leaves or dies,
- how disputes are resolved.
Although not required by law, you should have a written partnership agreement answering these and other questions. You can draft such an agreement yourself.
There are no special legal formalities you need to follow, forms you need to file or registration fees to pay to create a partnership. However, as with a sole proprietorship, you may need to file a fictitious business name statement and obtain a local business license.
One area where partnerships are more complicated and expensive than sole proprietorships is tax filings. Partnerships must file their own informational tax returns with the IRS and with each partner. These returns are complicated -- as is the subject of partnership taxation in general. You may need to hire a tax professional to help you with them. Partnership accounting is also more complicated than for a sole proprietorship, especially if the partners decide to allocate profits and losses differently than the proportions of their contributions to the partnership.
Partnerships receive much the same tax treatment as sole proprietorships. Like proprietorships, partnerships do not pay taxes. Instead, partnership income and losses are passed through the partnership directly to the partners and reported on their individual federal tax returns.
Although partnerships pay no taxes, they are required to file an annual tax form (Form 1065, U.S. Return of Partnership Income) with the IRS. Form 1065 is used to report partnership revenues, expenses, gains and losses. The partnership must also provide each partner with an IRS Schedule K-1, listing the partner’s share of partnership income and expenses (copies of these schedules are attached to the Form 1065 sent to the IRS). Partners must then file IRS Schedule E with their returns showing their partnership income and deductions.
Like sole proprietors, partners are neither employees nor independent contractors of their partnership; they are self-employed business owners. A partnership does not pay payroll taxes on the partners’ income or withhold income tax. Like sole proprietors, partners must pay income taxes and self-employment taxes on their partnership income.
The partnership form is particularly useful for co-inventors who expect to incur losses while developing their invention. As with a sole proprietorship, these losses generally can be deducted from the partners’ income -- whether from a job, investments or any other source. Moreover, partners have great flexibility in deciding how to allocate profits and losses with each other. Their share of profits and losses doesn’t have to be proportionate to their capital contributions (the rule for corporations).
EXAMPLE: Rich and Andrea are co-inventors in a partnership. They decide that Rich should be allocated 60% of their partnership’s profits and losses because he will spend more time on the invention than Andrea. Because they are in a partnership, they are free to do this even though they both contributed the same amount of money to the partnership. In its first year, the partnership business loses $10,000. $6,000 of this loss passes through to Rich’s personal tax return and $4,000 to Andrea’s. When they do their income taxes for the year, they can each deduct these losses from their income, such as the salaries they earn from their regular jobs.
Partners are personally liable for all partnership debts and lawsuits, the same as sole proprietors . However, partnership creditors are required to proceed first against the partnership property. If there isn’t enough to satisfy the debts, they can then go after the partners’ personal property.
In addition, each partner is deemed to be the agent of the partnership when conducting partnership business in the usual way. This means you’ll be personally liable for partnership debts your partners incur while carrying on partnership business, whether you knew about them or not. Moreover, each partner is personally liable for any wrongful acts committed by a copartner in the ordinary course of partnership business.
When to Talk to a Lawyer
If you elect to operate your invention business as a partnership, you should hire an experienced business attorney to draft a written partnership agreement for all the partners to sign.