A. Tax Income Issues:

The IRS taxes income as either ordinary income or capital gains.  Ordinary Income is produced by salaries or wages associated with employment while capital gains pertains to incomes produced by profits or appreciated of a capital asset held for more than one year.   Because capital gains are taxed at a flat rate of either 10% or  20%, inventors should try to characterize money they receive as a long term capital gain rather than ordinary income.

 IRS Section 1235:  Capital gain treatment for patents.  1 yr. requirement for capital gain treatment is NOT required.  The person using the treatment must be the holder of the patent, transfer all substantial rights to the patent, can not transfer rights to a related person,

 

Payment for Self-Employment Taxes still required.

 

Important IRS Publications to review:  IRS Publication 533, Self-Employment Tax.; 544, Sales and Other Dispositions of Assets    

 

 B. Tax Deduction Issues

          If you make money with an invention, you must pay federal taxes on the amount.  If you are an individual, you must file an IRS Form 1040,  and Schedule C to report Profit and Losses. If you form an LLC, or a partnership, you must file a partnership return, IRS Form 1065 (also known as a Schedule K-1) to report Profit and Losses.  Both the Schedule C and Form 1065 with your IRS 1040 Form.

 

If you are incorporated, and elect to operate as an S corporation, the entity must file an information formed called a Schedule K-1 Form along with a IRS 1120S Form.  The K-1 Form lists the Profits and Losses of the shareholder and is filed with the individual’s IRS Form 1040.

 

            If you are incorporation and elect to operate as a C corporation, then the corporation files it own tax return

 

In order to deduct the cost of research and development for an invention, the cost of a patent search, a trademark search or a copyright search, or the cost of filing a patent application, a trademark application, or a copyright registration, the IRS requires the following:

 

1.      That your activities constituted a business and not a hobby;

2.      Show that the deduction was related to the business; and

3.      Keep accurate records.

 

Business vs. Hobby Requirement:   In order to qualify as a business, you must prove (1) that your main objective for the activity is to earn a profit; and (2) that you were involved with the inventing business continuously and regularly. 

 

            Did you earn a profit three years over the last five years?   If you can show you earned a profit, the IRS will treat the venture as a business.

 

If you did not earn a profit, you can still qualify as a business if you operated as one.  You must do most of the following tasks:  register with the Department of Revenue, open a checking account, have business cards and stationary printed, create a separate telephone number and P.O. Box for the business, etc..  You should also keep track of the amount of time you spend in the business., ie. 16 hrs. per week.   The IRS also considers whether  you have some background or expertise in this type of business.  If you do not, it is recommended that you attend seminars or classes to learn more about the business, and keep records of these activities.

 

You must keep track of the expense.  Keep copies of the receipts. 

 

You must have a legal basis for the deduction.   This means that you must determine if the expense is currently deductible (research and experimentation, ordinary and necessary business expenses, Section 162 of IRS Statute) or over time (called depreciation or amortization). Review Section 174 of IRS Statute to learn more about deducting expenses currently vs. amortization. Review Section 179 of IRS Statute to learn more about deducting the cost of long-term property tangible personal property (currently up to $25,000).

 

Note regarding Start-up Expenses:  (Section 195 of IRS Statute)  Expenses you incur before you begin the business are NOT currently deductible. They must be amortized over 5 yrs.  (See IRS Publication 535, Business Expenses)

 

Home Office Deductions:  (See IRS Publication 587, Business Use of Your Home);

Car, Travel, Meals and Entertainment:  (See IRS Publication 463 Travel, Entertainment, Gift and Car Expenses)