Inventors Who Incorporate

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Some inventors elect to form corporations to run their inventing businesses. However, incorporating is not necessarily best for every inventor. To decide whether to incorporate your invention business, you should consider three main factors:

  • Expense and complexity: How expensive and difficult is a corporation to form and operate?
  • Tax treatment: How is a corporation taxed?
  • Liability concerns: How and to what extent will you be liable for debts and lawsuits?

Expense and Complexity

Corporations are the most costly and complex of all business forms. The IRS and state corporation laws require corporations to hold annual shareholder meetings and document important decisions such as choosing a federal or state tax election with corporate minutes, resolutions or written consents signed by the directors or shareholders. Small businesses with only one or a few shareholders and directors usually dispense with holding real annual meetings. Instead, the secretary of the corporation prepares minutes for a meeting which takes place only on paper.

If you’re audited and the IRS discovers that you have failed to comply with corporate formalities, you may face drastic consequences. For example, if you fail to document important tax decisions and tax elections with corporate minutes or signed consents, you may lose crucial tax benefits and risk substantial penalties.

It is absolutely necessary that you maintain a separate corporate bank account if you incorporate. You’ll need to keep a more complex set of books than if you’re a sole proprietor. You’ll also need to file a somewhat more complex tax return, or file two returns if you form a C corporation. And, since you’ll be an employee of your corporation, you’ll need to pay yourself a salary and file employment tax returns. All this costs time and money. You’ll probably need to use the services of an accountant or bookkeeper, at least when you first start out.

Finally, there are some fees and taxes you’ll have to pay if you incorporate that are not required if you’re a sole proprietor. For example, since you’ll be an employee of your corporation, it will have to provide unemployment compensation for you. The cost varies from state to state, but is at least several hundred dollars per year.

Tax Treatment

Your tax affairs are much more complicated when you incorporate your business. First of all, you automatically become an employee of your corporation if you continue to work in the business, whether full-time or part-time. This is so even if you’re the only shareholder and are not subject to the direction and control of anybody else. In effect, you wear two hats -- you’re both an owner and an employee of the corporation.

If you wish, you may pay yourself a salary (of course, you probably won’t want to do this if your inventing business is making no money). But, if you do, Social Security and Medicare taxes must be withheld from any employee salary your corporation pays you and money must be paid to the IRS just as for any employee. However, your total Social Security and Medicare taxes are about the same as if you were a sole proprietor.

In addition, you must decide how you want your corporation to be taxed. You ordinarily have the choice of being taxed as a C corporation (sometimes called a regular corporation), or as an S corporation, also called a small business corporation.

Regular C corporations

When you form a corporation, it automatically becomes a C corporation for federal tax purposes. C corporations are treated separately from their owners for tax purposes. C corporations must pay income taxes on their net income and file their own tax returns with the IRS using either Form 1120 or Form 1120-A. They also have their own income tax rates which are lower than individual rates at some income levels. C corporations generally take the same deductions as sole proprietorships or partnerships to determine their net profits, but have some special deductions as well.

In effect, when you form a C corporation you take charge of two separate taxpayers: your corporation and yourself. You don’t pay personal income tax on C corporation income until it is distributed to you in the form of salary, bonuses or dividends.

This separate tax identity is not good for owners of businesses that lose money. Because a C corporation is a separate taxpaying entity, its losses must be subtracted from its income and can’t be directly passed on to you -- that is, you can’t deduct them from your personal income taxes. This makes the C corporation a poor choice for inventors who expect to incur losses from their inventing businesses.

When you form a C corporation. Any direct payment of your corporation’s profits to you will be considered a dividend by the IRS and taxed twice. First, the corporation will pay corporate income tax on the profit and then you’ll pay personal income tax on it. This is called double taxation. To avoid double taxation, instead of taking dividends, small C corporation owners try to take any profits out of the business in the form of employee salaries, benefits and bonuses. These items are deductible expenses for corporate income tax purposes; thus, income tax will only be paid once on such employee compensation.

S corporations

When you incorporate, you have the option of having your corporation taxed as an S corporation for federal income tax purposes. An S corporation is taxed like a sole proprietorship or partnership. Unlike a C corporation, it is not a separate taxpaying entity. Instead, the corporate income and losses are passed through directly to the shareholders -- that is, you and anyone else who owns your business along with you. The shareholders must split the S corporation’s profit or loss according to their shares of stock ownership and report it on their individual tax returns. This means that if your business has a loss, you can deduct it from income from other sources including your spouse’s income if you’re married and file a joint return.

An S corporation normally pays no taxes, but must file an information return with the IRS on Form 1120S telling the IRS how much the business earned or lost and indicating each shareholder’s portion of the corporate income or loss.

To establish an S corporation, you first form a regular corporation under your state law. Then you file Form 2553 with the IRS. If you want your corporation to start off as an S corporation, you must file the form within 75 days of the start of the tax year of your business.

Liability Concerns

In theory, forming a corporation provides its owners (the shareholders) with “limited liability.” This means that the shareholders are not personally liable for corporate debts or lawsuits. The main reason most small business people go to the trouble of forming corporations is to obtain such limited liability. However, limited liability is more a myth than a reality for many small business people. Thus, for many inventors, the limited liability afforded by the corporate form does not justify going to the time, trouble and expense of incorporating.

Business debts

Corporations  were created to enable people to invest in a business without risking all their personal assets if the business fails or is unable to pay its debts. That is, they can lose what they invested in the corporation, but corporate creditors can’t go after their personal assets such as their personal bank accounts or homes.

This theory holds true where large corporations are concerned. If you buy stock in Microsoft, for example, you don’t have to worry about Microsoft’s creditors suing you. But it usually doesn’t work that way for small corporations -- especially newly established ones without a track record of profits and a good credit history.

Major creditors, such as banks, don’t want to be left holding the bag if your business goes under. To help ensure payment, they will want to be able to go after your personal assets as well as your business assets. As a result, if you’ve formed a corporation, these creditors will demand that you personally guarantee business loans, credit cards or other extensions of credit -- that is, sign a legally enforceable document pledging your personal assets to pay the debt if your business assets fall short. This means that you will be personally liable for the debt, just as if you were a sole proprietor or partner.

You can avoid having to pledge a personal guarantee for some business debts. These will most likely be routine and small debts. But, of course, once a creditor gets wise to the fact that your business is not paying its bills, it won’t extend you any more credit. If you don’t pay your bills and obtain a bad credit rating, no one may be willing to let you buy things for your business on credit.

Lawsuits

If forming a corporation could shield you from personal liability for business-related lawsuits, doing so would be worthwhile. However, the small business owner obtains little or no protection from most lawsuits by incorporating. Corporation owners are personally liable for their own negligence. The people who own a corporation (the shareholders)  are personally liable for any damages caused by their own personal negligence or intentional wrongdoing in carrying out corporation business. Lawyers are well aware of this rule and will take advantage of it if it’s in their client’s interest. If you form a corporation, and it doesn’t have the money or insurance to pay a claim, you can be almost certain that the plaintiff’s lawyer will seek a way to sue you personally to collect against your personal assets.

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