Inventors as Sole Proprietors: Is This the Best Form for Your Business?

A sole proprietorship isn't always the best legal form for every inventor.

Most inventors in the United States are sole proprietors. However, this doesn't mean that a sole proprietorship is always the best legal form for every inventor. There are a number of potential legal forms that one can choose from, including limited liability companies ("LLCs"), partnerships, and corporations.

To decide whether sole proprietorship is really the right form for you, consider the following questions:

  • How expensive and difficult will it be for you to form and operate a sole proprietorship, compared with the other potential legal forms?
  • How is a sole proprietorship taxed?
  • To what extent will you be liable for debts and lawsuits in a sole proprietorship?

Expense and Complexity of a Sole Proprietorship

The sole proprietorship is by far the cheapest and easiest way for you to legally organize your inventing business. You do not need permission from the government, you do not pay any fees, and there are no complex legal documents to be drafted, meetings to attend or forms to file. Consequently, you generally do not need a lawyer to "begin" the business.

The primary exception to this simple structure is if you want to use a name other than your own to identify your business. In this event, you’ll have to file a fictitious business name statement, typically with your state's "department of state" or "secretary of state." (Depending on your state, you might also need to obtain a business license, though usually this is a fairly easy process).

After you get started, running a sole proprietorship is relatively simple from a legal perspective. There are no legal formalities you need worry about. However, you do need to keep good records, and it is wise to have a separate bank account for your inventing business.

Tax Treatment for Sole Proprietorships

Probably the most important factor to consider when deciding on a business form is taxation. If, like most independent inventors, you expect to incur losses for some time, either a sole proprietorship or a partnership is probably your best choice.

When you are a sole proprietor, you and your inventing business are one and the same for tax purposes. Sole proprietorships do not pay separate 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, such as 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 do not pay payroll taxes on a sole proprietor’s income or withhold income tax from any compensation.

However, sole proprietors do have to pay self-employment taxes, namely 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. But, sole proprietor inventors need only pay self-employment taxes if they earn a profit from inventing. Inventors who incur losses do not have to worry about these taxes.

Consider an 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.

Liability Concerns for Sole Proprietors

Because sole proprietors personally own their businesses, they face a high degree of liability. This means that a sole proprietor is personally liable for all the business’s liabilities and debts. The lack of liability protection is a shortcoming of the sole proprietorship, compared to other business entities such as LLCs, which limit liability and create a corporate shield.

Business debts

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 potentially recover against 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, such as a person or company to whom you owe money for personal items, can recover against your business assets, such as business bank accounts and equipment.

Lawsuits

Besides being liable for debts, inventors should also be 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 you 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. However, if you're unsure whether this is the best legal form for your inventing business, consult an experienced business attorney or tax professional. You can discuss your concerns regarding each of these three factors, and in a relatively short consultation meeting, the professional will probably be able to give you some guidance on which form fits your current needs.

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