1st edition Inventor’s Guide to Law, Business & Taxes by Attorney Stephen Fishman FIRST EDITION MAY 2003 Editors RICHARD STIM AMY DELPO Cover Design TERRI HEARSH Book Design TERRI HEARSH CD-ROM Preparation JENYA CHERNOFF ANDRÉ ZIVKOVICH Illustrations SASHA STIM-VOGEL Indexer PATRICIA DEMINNA Proofreading SUSAN CARLSON GREENE Printing CONSOLIDATED PRINTERS, INC. Fishman, Stephen. Inventor’s Guide to Law, Business & Taxes / by Stephen Fishman p. cm. Includes index. ISBN 0-87337-925-X 1. Inventions United States. 2. Inventions Taxation United States I. Title. KF3131.Z9F57 2003 346.73'065 dc21 2003042247 Copyright © 2003 by Stephen Fishman ALL RIGHTS RESERVED. Printed in the USA. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or other- wise without the prior written permission of the publisher and the author. Reproduction prohibitions do not apply to the forms contained in this product when reproduced for personal use. For information on bulk purchases or corporate premium sales, please contact the Special Sales Department. For academic sales or textbook adoptions, ask for Academic Sales. Call 800-955-4775 or write to Nolo, 950 Parker Street, Berkeley, CA 94710 . 1 Why Inventors Need to Know About Law, Business and Taxes A. Business, Tax or Law? 1/2 B. What’s Not in This Book 1/3 2 Choosing the Legal Form for Your Inventing Business A. Your Business Entity Choices 2/2 B. Expense and Complexity 2/4 C. Tax Treatment 2/7 D. Liability Concerns 2/12 E. Recommended Business Forms 2/18 3 Setting Up Shop A. Choosing a Name for Your Business 3/3 B. Working at Home 3/6 C. Leasing a Workplace 3/12 D. Business Licenses and Permits 3/14 E. Federal Employer Identification Number 3/16 F. Insurance 3/17 Table of Contents Table of Contents 4 Bookkeeping and Accounting A. Simple Bookkeeping for Inventors 4/2 B. Length of Time for Keeping Records and Logs 4/12 C. Accounting Methods and TaxYears 4/13 D. Creating Financial Statements 4/14 E. Other Inventing Business Records 4/14 5 Tax Basics A. Inventors Who Earn Profits 5/2 B. Inventors Who Incur Losses 5/6 C. Inventors Who Hire Employees 5/7 D. How To Handle Your Taxes 5/7 E. IRS Audits 5/10 6 How to Prove to the IRS You’re in Business A. Qualifying as a Business 6/2 B. Passing the 3-of-5 Profit Test 6/4 C. Passing the Behavior Test 6/5 7 Inventor Tax Deductions A. Tax Deductions: The Basics 7/2 B. Tax Deduction Road Map 7/8 C. Inventing Expenses You May Currently Deduct 7/10 D. Inventing Expenses You Must Deduct Over Time 7/27 E. Special Deduction Rules 7/33 8 Taxation of Inventing Income A. Capital Gains vs. Ordinary Income 8/2 B. Capital Gains Treatment for Patents Under IRC § 1235 8/3 C. Paying Self-Employment Taxes 8/6 D. Paying Estimated Taxes 8/10 9 Your Inventor’s Notebook A. Why Keep an Inventor’s Notebook? 9/2 B. How to Keep Your Notebook 9/5 C. Witnessing Your Notebook 9/7 D. Alternatives to the Inventor’s Notebook 9/8 10 Hiring Employees and Independent Contractors Part I: Determining Workers’ Legal Status 10/3 A. ICs Are Business Owners, Employees Are Not 10/3 B. Pros and Cons of Hiring Employees or ICs 10/5 Part II. Hiring Employees 10/7 C. Drafting an Employment Agreement 10/9 D. Tax Concerns When Hiring Employees 10/22 Part III. Hiring Independent Contractors 10/26 E. Drafting an Independent Contractor Agreement 10/26 F. Tax Reporting for Independent Contractors 10/37 11 Who Owns Your Invention? A. Patent Ownership 11/2 B. Are You an Inventor? 11/3 C. Are You a Solo Inventor? 11/4 D. Are You a Joint Inventor? 11/5 E. Are You an Employee/Contractor Inventor? 11/13 F. Have You Transferred Your Ownership? 11/26 G. Trade Secret Ownership 11/29 12 Introduction to Intellectual Property A. What Is Intellectual Property and Why Is It Important to Inventors? 12/2 B. Doing the Work of Obtaining IP Protection 12/8 13 Ten Things Inventors Should Know About Trade Secrets 1. All Inventions Begin As Trade Secrets 13/2 2. Any Valuable Information Can Be aTrade Secret 13/2 3. Trade Secrets Are the Do-It-Yourself Intellectual Property 13/3 4. You Can Make Money From Trade Secrets 13/3 5. Trade Secret Protection Is Weak 13/4 6. Trade Secret Laws Don’t Protect Against Independent Discovery or Reverse Engineering 13/5 7. Trade Secret Protection Has No Definite Term 13/6 8. You Must Choose Between Trade Secret and Patent Protection 13/6 9. You Must Keep Your Trade Secrets Secret 13/9 10. When In Doubt, Use a Nondisclosure Agreement 13/11 14 Fifteen Things Inventors Should Know About Patents 1. Patents Are the Most Powerful IP Protection 14/2 2. A Patent—By Itself—Won’t Make You Rich 14/2 3. You Can Profit From Your Invention Without a Patent 14/3 4. Patents Don’t Work Well for Inventions With Short Commercial Lives 14/4 5. Patents Are Expensive and Difficult to Obtain 14/5 6. Most Inventions Are Not Patentable 14/7 7. Do a Patent Search Before Anything Else 14/9 8. You Must Document Your Inventing Activities 14/10 9. You’ll Lose Your Right to Patent If You Violate the One-Year Rule 14/10 10. Filing a Provisional Patent Application Can Save You Money 14/11 11. Patents Last 17–18 Years 14/12 12. Enforcing a Patent Can Be Difficult and Expensive 14/13 13. U.S. Patents Only Work in the United States 14/13 14. Filing for Patents Helps Show You’re in Business 14/13 15. Design Patents Can Protect the Way Your Invention Looks 14/14 15 Ten Things Inventors Should Know About Trademarks 1. Trademarks Can Earn Billions 15/2 2. Trademarks Identify Products and Services 15/2 3. You Must Have Trade to Have a Trademark 15/3 4. You Don’t Need a Trademark to License Your Invention (But It Can Help) 15/3 5. Trademarks Are Not All Created Equal 15/4 6. Registering a Trademark Is Not Mandatory, But Provides Important Benefits 15/4 7. Intent to Use Registration Can Protect Your Mark Before You Use It in Trade 15/5 8. Do a Trademark Search Before Selecting Your Mark 15/5 9. Trademark Rights Are Limited 15/6 10. Only Federally Registered Marks Can Use the ® Symbol 15/7 16 Ten Things Inventors Should Know About Copyright 1. Copyright Protects Works of Authorship, Not Inventions 16/2 2. Copyright Can Protect Invention Design 16/3 3. You Can Make Money From Copyrights 16/5 4. Copyright Protection Is Limited 16/5 5. You Get A Copyright Whether or Not You Want It 16/6 6. Copyright Protection Lasts a Long Time 16/6 7. Register Valuable Copyrights 16/6 8. Use a Copyright Notice When You Publish Valuable Works 16/7 9. Copyright Isn’t the Only Law That Protects Designs 16/8 10. Watch Out If You Hire an Independent Contractor to Create a Copyrighted Work 16/8 17 Ten Things Every Inventor Should Know About Licensing 1. No License Is Better Than a Bad License 17/4 2. You’re Licensing Your Rights, Not Your Invention 17/4 3. Sublicensing and Assignments Allow Strangers to Sell Your Invention 17/5 4. You Can License Away the World and Get It Back 17/6 5. A Short Term Is Usually Better Than a Longer Term 17/7 6. Royalties Come in All Shapes and Sizes 17/8 7. Sometimes a Lump Sum Payment Is Better Than a Royalty 17/10 8. GMARs Guarantee Annual Payments 17/12 9. Deductions Can Make Your Royalties Disappear 17/13 10. Audit Provisions Permit You to Check the Books 17/15 18 Help Beyond the Book A. Patent Websites 18/2 B. Finding and Using a Lawyer 18/5 C. Help From Other Experts 18/8 D. Doing Your Own Legal Research 18/9 E. Online Small Business Resources 18/11 F. State Offices Providing Small Business Help 18/13 Appendix A How to Use the CD-ROM A. Installing the Form Files Onto Your Computer A/2 B. Using the Word Processing Files to Create Documents A/3 C. Using PDF Forms A/5 D. Files Included on the Forms CD A/7 Index Chapter 1 Why Inventors Need to Know About Law, Business and Taxes A. Business, Tax or Law? 1/2 B. What’s Not in This Book 1/3 1/2 INVENTOR’S GUIDE TO LAW, BUSINESS & TAXES G enius is not always rewarded. Hungry for cash, John “Doc” Pemberton sold the world’s most famous trade secret—the formula for Coca- Cola, for less than $900. Charles Goodyear had a brilliant innovation—rubber that could be used year-round. But Goodyear made many bad deals, failed to protect his patent rights and died in 1860 owing over $200,000. Charles Stahlberg woke the world up with his alarm-clock invention but then, because of business debts, was forced to sell all rights cheaply to the Westclox company. George Ferris had two brilliant ideas—the Ferris wheel and the amusement park—but debts forced him to auction his wheel and eventually he was driven to bankruptcy. Adolph Sax patented his saxophone but died penniless after spend- ing all his money on attorneys to fight patent battles. From Gutenberg (yes, he died penniless as well) to today, developing a great invention has never been a guarantee of financial success. There are many reasons for these financial failures—bad luck, bad timing, the world’s indifference to innovation—but one of the most significant causes is the inventor’s lack of basic knowledge in three areas: • law—the array of laws, such as patent law, that protect inventions and thereby enable inventors to make money from them • business—the knowledge of how to properly organize and run inventing activities like a real business, and • taxes—the ability to take advantage of the tax laws to help underwrite inventing efforts. This book is intended to help the indepen- dent inventor fill this knowledge gap. Whether you’re a full- or part-time inventor, just starting out or highly experienced with many patents to your name, reading this book will enable you to answer such crucial questions as: • If I invent something on the job, who owns it—my employer or me? (See Chapter 11.) • Can I deduct my home-workshop expenses from my taxes? (See Chapter 7.) • Should I incorporate my inventing business? (See Chapter 2.) • How can I pay the low 20% capital gains tax rate on my inventing income? (See Chapter 8.) Reading this book won’t guarantee you’ll get rich from inventing, but at least you’ll be able to avoid some of the mistakes other inventors have made. A. Business, Tax or Law? This book is divided into three conceptual parts: Starting and Running Your Business. Chapters 2 through 4, 9 and 10 cover starting and running your inventing business, including choosing your form of business, record keep- ing and hiring employees and contractors. Taxes. Chapters 5 through 8 cover the tax aspects of inventing, including such issues as showing the IRS that your inventing is not a hobby, deducting your inventing expenses and paying taxes on inventing income. Ownership and Exploitation. Chapters 11 through 17 cover laws regarding ownership [...]... and perform other business functions In theory, every corporation consists of three groups: • those who direct the overall business, called directors • those who run the business day to day, called officers, and • those who just invest in the business, called shareholders 2/4 INVENTOR’S GUIDE TO LAW, BUSINESS & TAXES However, in the case of a small business corporation, these three groups can be and. .. direct and run the corporation and own all the corporate stock So, if you incorporate your one-person inventing business, you don’t have to go out and recruit and pay a board of directors or officers B Expense and Complexity Some business forms are more expensive to set up and more difficult to run than others If you’d prefer to spend your time inventing rather than dealing with corporate minutes and. .. have to pay any selfemployment taxes 2 Partnership Partnerships receive much the same tax treatment as sole proprietorships Like proprietorships, partnerships do not pay taxes Instead, 2/8 INVENTOR’S GUIDE TO LAW, BUSINESS & TAXES 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, ... in the business Rich and Andrea could make Bill another partner in their partnership, but Bill doesn’t want this because he doesn’t want to be personally liable for the partnership’s debts or lawsuits All Bill wants to risk is his $100,000 So Rich and Andrea form a corporation and give Bill one-third of the corporate stock Rich and Andrea continue to run the business and Bill is a passive investor 2... issuing corporate stock options is a good way to motivate and keep key employees CHOOSING THE LEGAL FORM FOR YOUR INVENTING BUSINESS EXAMPLE: Rich and Andrea have formed a partnership to invent a new type of folding bicycle Having reached the point where they want to create a prototype, they conclude they need to find an investor to provide some development money Andrea’s father Bill agrees to invest $100,000... INVENTING BUSINESS C Tax Treatment 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 1 Sole Proprietorship When you’re a sole proprietor, you and your inventing business are one and the same for tax purposes Sole proprietorships... 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...WHY INVENTORS NEED TO KNOW ABOUT LAW, BUSINESS AND TAXES and exploitation of your invention These laws include intellectual property laws for inventors such as patents, trademarks, trade secrets and copyrights, as well the law relating to invention licensing Chapter 18, Help Beyond the Book, tells you how to do further research on your own, and, if necessary, hire an attorney If you need... Ashok Gadgil Inventor of an inexpensive way to purify water using ultraviolet light 2/12 INVENTOR’S GUIDE TO LAW, BUSINESS & TAXES allocation of profits, losses, credits and deductions passed through to the members The LLC must also prepare and distribute to each member a Schedule K-1 form showing the member’s allocations Although LLCs are ordinarily taxed the same as a sole proprietorship or partnership,... Stephen Elias, Albin Renauer & Robin Leonard, and • Chapter 13 Bankruptcy: Repay Your Debts, by Robin Leonard (Both are published by Nolo.) 2/14 INVENTOR’S GUIDE TO LAW, BUSINESS & TAXES EXAMPLE: Arnie, a sole proprietor inventor, fails to pay $5,000 to a supplier The supplier sues him in small claims court and obtains a $5,000 judgment As a sole proprietor, Arnie is personally liable for this judgment . overall business, called directors • those who run the business day to day, called officers, and • those who just invest in the business, called shareholders. 2/4 INVENTOR’S GUIDE TO LAW, BUSINESS. profits and manage the business any way they want. A partnership automatically comes into existence whenever two or more people enter into business together to earn a profit and don’t choose to incorporate. expenses and paying taxes on inventing income. Ownership and Exploitation. Chapters 11 through 17 cover laws regarding ownership WHY INVENTORS NEED TO KNOW ABOUT LAW, BUSINESS AND TAXES 1/3 and exploitation