Most inventors are sole proprietors. However, this doesn't mean that a sole proprietorship is always the best legal form for every inventor. To decide whether to invent as a sole proprietor or form a separate legal entity such as a corporation or limited liability company, you should consider three main factors:
- Expense and complexity: How expensive and difficult is it to form and operate a sole proprietorship?
- Tax treatment: How is a sole proprietorship taxed?
- Liability concerns: How and to what extent will you be liable for debts and lawsuits?
Expense and Complexity
The sole proprietorship is by far the cheapest and easiest way for you to legally organize your inventing business. You don’t need permission from the government, you don’t pay any fees, and there are no complex legal documents to be drafted, meetings to attend or forms to file. The only exception is if you want to use a name other than your own name to identify your business. In this event, you’ll have to file a fictitious business name statement. Depending on where you’re located, you might also need to obtain a business license. Neither task is very difficult.
After you get started, running a sole proprietorship is a breeze. There are no legal formalities you need worry about. However, you do need to keep good records and it’s wise to have a separate bank account for your inventing business.
Probably the most important single factor to think about when deciding on a business form is taxation. If, like most independent inventors, you expect to incur losses for some time, a sole proprietorship or partnership is your best choice.
When you’re a sole proprietor, you and your inventing business are one and the same for tax purposes. Sole proprietorships don’t pay taxes or file tax returns. Instead, you must report the income you earn or losses you incur on your own personal tax return, IRS Form 1040. If you earn a profit, the money is added to any other income you have and that total is taxed. If you incur a loss, you can generally use it to offset income from other sources -- for example, salary from a job, interest or investment income or your spouse’s income if you’re married and file a joint tax return. From a tax standpoint, this makes sole proprietorships ideal for independent inventors who expect to incur losses for some time.
Although you are taxed on your total income regardless of its source, the IRS does want to know about the profitability of your business. To show whether you have a profit or loss from your sole proprietorship, you must file IRS Schedule C, Profit or Loss From Business, with your tax return. On this form you list all your business income and deductible expenses.
Sole proprietors are not employees of their business; they are owners. Their businesses don’t pay payroll taxes on a sole proprietor’s income or withhold income tax from his or her compensation. However, sole proprietors do have to pay self-employment taxes -- that is, Social Security and Medicare taxes -- on their net self-employment income. These taxes must be paid four times a year along with income taxes in the form of estimated taxes. (See Chapter 8, Section D.) But, sole proprietor inventors need only pay self-employment taxes if they earn a profit from inventing. Inventors who incur losses don’t have to worry about these taxes.
EXAMPLE: Lisa is a sole proprietor inventor who also holds a full-time job as an electrical engineer. During her first year of inventing, she incurs $10,000 in expenses and earns nothing, giving her a $10,000 loss from her inventing business. She reports this loss on IRS Schedule C, which she files with her personal income tax return (Form 1040). Since Lisa is a sole proprietor, she can deduct this $10,000 loss from any income she has, including her $100,000 annual salary from her engineering job. This saves her about $4,000 in taxes for the year. Because Lisa earned no money from inventing for the year, she did not have to pay any self-employment taxes.
Since sole proprietors personally own their businesses, they have what is often called "limited liability." This means that a sole proprietor is personally liable for all the business’s liabilities and debts. At first glance, lack of liability protection would appear to be a terrible shortcoming of the sole proprietorship. However, the other business entity forms available don’t do a much better job of protecting you. For this reason, the sole proprietorship remains a good choice for the inventor.
When you’re a sole proprietor, you are personally liable for all the debts of your business. This means that a business creditor -- a person or company to whom you owe money for items you use in your inventing business -- can go after all your assets, both business and personal. This may include, for example,your personal bank accounts, stocks, your car and even your house. Similarly, a personal creditor -- a person or company to whom you owe money for personal items -- can go after your business assets, such as business bank accounts and equipment.
Besides being liable for debts, inventors are also concerned about lawsuits. If you’re a sole proprietor, you’ll be personally liable for the costs of business-related lawsuits. Such lawsuits could come in many forms:
- premises liability for injuries or damages occurring at your office, workshop, lab or other place of business
- infringement liability when someone claims that you have infringed on their patent
- employer liability for injuries or damages caused by an employee while working for you
- product liability for injuries or damages caused by a product that is manufactured and sold to the public, and
- negligence liability for injuries or damages caused by your failure to use reasonable care.
When to Talk to a Lawyer
You don't need a lawyer to form a sole proprietorship; but if you're unsure whether this is the best legal form for your inventing business, consult an experienced business attorney.