Sole Proprietorships are the simplest form of business, but not always the best. From a legal standpoint, a sole proprietorship is a “business in which one person owns all the assets, owes all the liabilities, and operates in his or her personal capacity.” Black’s Law Dictionary, Third Pocket Edition 663 (7th ed. 2006).
Simple enough, right? Well, maybe not. Let’s take a look into the good, the bad, and the ugly when it comes to operating your business as a sole proprietorship.
Sole proprietorships are easy to operate. You can wake up one day and start running your business. There are no corporate formalities or hoops to jump. It’s just you working hard to pursue your dreams.
Let’s take Ted the boat detailer for example. Ted no longer wanted to work as a fishing guide because he was a little too OCD and always cleaning his boat. He decided to take his clean boat obsession and make it a business, so one day he put together flyers and sent out an email to his fishing buddies. Suddenly, he was slammed with work because every boat owner needs a good detail from time to time.
It’s literally that easy to start a business as a sole proprietor. Ted did not need to sign anything or file reports or create a board of advisors. He just had to get to work. As we’ll see, however, Ted may have unanticipated exposure on several fronts.
Ted has a great business. He’s detailing two boats a day, then fishing in the afternoon for fun. His wife is happy because Ted has flexible hours. Life is good. Until it’s not…
Sometime during the first few months of business, Ted promised Will, the dock master of a local marina, that he would clean all the boats at the marina – a new service Will’s marina offered. Will paid Ted $50,000 (50% of the total) upfront so Ted could buy supplies. The oral agreement was memorialized by Will in an email to Ted. It read in part: “Thanks for agreeing to detail all the boats by June 1. This is going to make the owners so happy to have clean boats for boating season. I mailed a check for $50,000 to your house.” Ted deposited the check into his personal account.
On July 30, Ted had not detailed a single boat, so Will hired a lawyer to collect the money. Sure enough, the lawyer was able to secure a judgment against Ted for $50,000, another $10,000 in legal fees, and an additional $20,000 in other general damages. The total amount Ted and his wife owed was now $80,000. Ted had to sell his boat and his new cleaning van to satisfy the debt. Ted’s wife had to trade in her new SUV for a 7-year-old sedan.
If Ted had set up an LLC and a separate business account, he would have shielded his personal assets from exposure. He could have set up a payment plan through the business or found another option through the business.
In addition to owing money for Ted’s breach of contract, he had bigger problems. One day while detailing a boat, Ted spilt a highly flammable cleaning solution through the bilge and engine. When the owner cranked his boat, the engine exploded. The explosion caused a fire through the stern of the boat, causing it to sink – and a nearby boat was lightly charred. In addition, the boat owner sustained serious burns and a part of the engine hit a little girl standing on the dock.
The cost of the boat damage was $200,000, the boat owner’s injury claim was another $200,000, and the girl’s injury claim was $500,000 because she had to have shrapnel removed from her leg and was left with a limp. In total, Ted owed $900,000 – before interest and his own legal expenses.
Ted and his wife ended up with an enormous lien against their house, her wages were garnished, and they had to deplete all the money they had saved. Ted lost his business, but fortunately found an entry-level position in the service department of a local boat dealership.
By Ted’s estimate, it would take them 30 years to pay the debt. Ted assumed some insurance would pay, which it did, but the boat property insurance and health insurance carriers maintained subrogation claims directly against Ted. In addition, Ted ended up hiring a lawyer to help negotiate a payment plan and prevent further liability, which cost him another $5,000.
Were Ted’s Problems Preventable?
For the most part, Ted’s problems were preventable. A work accident and a breach of contract still would have badly damaged Ted’s business, but it would not have ruined him financially. All he needed was liability protection and a little legal training on how to operate a business. Use Drafted Legal to set up your LLC, educate yourself, and put into place the right documents for your business!
Read the following article for further explanation on how to limit liability. Liability Advantages of an LLC vs. Sole Proprietorship.
Every business owner has a list a mile long of things he or she needs to do. From a legal perspective, there are two essential steps to ensure your business operates smoothly:
- Entity Formation. Don’t default to a sole proprietorship. Take the time to set up an LLC, liability shielding partnership, or corporation. It really does not cost much money or time.
- Maintain the Liability Shield. Don’t commingle funds. Operate your business out of one account and your home out of another account. This helps reduce liability and presents a clean tax presentation so you are not flagged by the IRS.
If you need assistance getting started, use a trusted lawyer or visit draftedlegal.com for further assistance. The Drafted Legal products are tailored specifically to help small businesses and entrepreneurs receive quality legal services at a fraction of the cost lawyers charge. Don’t zoom through your legal, get Drafted.