Smart Business Moves for Successful Inventions

You have toiled many years in an effort to bring success to your invention and that day now seems to be approaching quickly. Suddenly, you realize that during all that time while you were staying up late at night and working weekends toward marketing or licensing your invention, you failed to give any thought to some basic business fundamentals: Should you form a corporation to run your newly acquired business? A limited partnership perhaps or maybe a sole-proprietorship? What are the tax repercussions of choosing one of these options over the other? What potential legal liability may you encounter? These are often asked questions, and those who possess the correct answers might find that some careful thought and planning now can prove quite beneficial in the future.

To begin with, we need to take a cursory look at some fundamental business structures. The most well known is the corporation. To many, the term “corporation” connotes a complex legal and financial structure, but this is not really so. A corporation, once formed, is treated as though it were a distinct person. It has the ability buy, sell and lease property, to enter into contracts, to sue or be sued in a court of law and to conduct almost any other types of legitimate business. The benefits of a corporation, as you might well know, are that its liabilities (i.e. debts) can not be charged against the corporations, shareholders. In other words, if you have formed a small corporation and you and a friend are the only shareholders, neither of you may be held liable for debts entered into by the corporation (i.e. debts that either of your or any employees of the corporation entered into as agents of the corporation, and on its behalf).

The benefits of this are of course quite obvious. By incorporating and selling your manufactured invention through the corporation, you are protected from any debts that the corporation incurs (rent, utilities, etc.). More importantly, you are insulated from any legal judgments which may be levied against the corporation. For example, if you are the inventor of product X, and you have formed corporation ABC to manufacture and sell X, you are personally immune from liability in the event that someone is harmed by X and wins a product liability judgment against corporation ABC (the seller and manufacturer of X). In a broad sense, these are the basic concepts of corporate law relating to personal liability. You should be aware, however that there are a few scenarios in which you can be sued personally, and you should therefore always consult an attorney.

In the event that your corporation is sued upon a delinquent debt or product liability claim, any assets owned by the corporation are subject to a court judgment. Accordingly, while your personal assets are insulated from corporate liabilities, any assets which your corporation owns are completely vulnerable. If you have bought real estate, computers, automobiles, office furnishings and the like through the corporation, these are outright corporate assets and they can be attached, liened, or seized to satisfy a judgment rendered against the corporation. And just as these assets may be affected by a judgment, so too may your patent if it is owned by the corporation. Remember, patent rights are almost equivalent to tangible property. A patent may be bought, sold, inherited and even lost to satisfy a court judgment.

What can you do, then, to avoid this problem? The answer is simple. If you chose to go the corporate route to conduct business, do not sell or assign your patent to your corporation. Hold your patent personally, and license it to the corporation. Make sure you do not entangle your personal finances with the corporate finances. Always be sure to write a corporate check to yourself personally as royalty/licensing compensation. This way, your personal assets (the patent) and the corporate assets are distinct.

So you might wonder, with all these positive attributes, why would someone choose not to conduct business through a corporation? It sounds too good to be true!. Well, it is. Conducting business through a corporation has substantial tax drawbacks. In corporate finance circles, the problem is known as “double taxation”. If your corporation earns a $50,000 profit selling your invention, this profit is first taxed to the corporation (at an exceptionally high corporate tax rate which can approach 50%). Any moneys remaining after this first layer of taxation (let us assume $25,000 for our example) will then be taxed to you personally as a shareholder dividend. If the remaining $25,000 is taxed to you personally at, for example, a combined rate of 35% after federal, state and local taxes, all that will be left as a post-tax profit is $16,250 from an initial $50,000 profit.

As you can see, this is a hefty tax burden because the profits are being taxed twice: once at the corporate tax level and once again at the individual level. Since the corporation is treated as an individual entity for liability purposes, it is also treated as such for tax purposes, and taxed accordingly. This is the trade-off for minimizing your liability. (note: there is a way to shield yourself from personal liability yet still avoid double taxation - it is known as a “subchapter S corporation” and is usually quite sufficient for most inventors who are operating small to mid size businesses. I highly recommend that you consult an accountant and discuss this option if you have further questions). If you do choose to incorporate, you should be able to locate an attorney to perform the process for under $1000. In addition it can often be accomplished within 10 to 20 days if so needed.

And now on to one of the most common of business entities - the sole proprietorship. A sole proprietorship requires nothing more then just operating your business under your own name. If you wish to function under a company name which is distinct from your given name, your local township or city may often require you to register the name you choose to use, but this is a simple process. So, for example, if you wish to market your invention under a company name such as ABC Company, you simply register the name and proceed to conduct business. This is completely different from the example above, where you would need to go through the more complex and expensive process of forming a corporation to conduct business as ABC Inc.

In addition to its ease of start-up, a sole proprietorship has the benefit of not being subjected to double taxation. All profits earned by the sole proprietorship business are taxed to the owner personally. Of course, there is a negative side to the sole proprietorship in that you are personally liable for any and all debts and liabilities incurred by the business. This is the trade-off for not being subjected to double taxation.

A partnership may be another viable option for many inventors. A partnership is an association of two or more persons or entities engaging in business together. Like a sole proprietorship, profits earned by the partnership are taxed personally to the owners (partners) and double taxation is avoided. Also, similar to a sole proprietorship, the owners of partnership are personally liable for partnership debts and liabilities. However, in a partnership, each partner is personally liable for the debts, contracts and liabilities of the other partners. So, if your partner injures someone in his capacity as a partner in the business, you can be held personally liable for the financial repercussions flowing from his actions. Similarly, if your partner enters into a contract or incurs debt in the partnership name, even without your approval or knowledge, you can be held personally responsible.

Limited partnerships evolved in response to the liability problems inherent in regular partnerships. In a limited partnership, certain partners are “general partners” and control the day to day operations of the business. These partners, as in a regular partnership, may be held personally liable for partnership debts. “Limited partners” are those partners who may not participate in the day to day functioning of the business, but are protected from liability in that their liability may never exceed the amount of their initial capital investment. If a limited partner does take part in the day to day functioning of the business, he or she will then be deemed a “general partner” and will be subject to full liability for partnership debts.

It should be understood that these are general business law principles and are in no way intended to be a substitute for thorough research on your part, or for retaining an attorney, accountant or business adviser. The principles I have outlined above are very general in scope. There are many exceptions and limitations which space constraints do not permit me to go into further. Nevertheless, this article should provide you with enough background so that you will have a rough idea as to which option might be best for you at the appropriate time.

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