Would you like to save $500? Of course you would. What if to save that $500, there was a 1% chance you lost your home, car, savings, jewelry, and everything else you owned? That’s what you are choosing when you choose the sole proprietorship route instead of an LLC. That may seem dramatic, but your decision (or non-decision) to operate a sole proprietorship could end badly, very badly. And the amount you save for being in a sole proprietorship instead of an LLC is not worth it. While a sole proprietorship offers ease and low cost, it comes at a massive risk (especially compared to how easy and inexpensive an LLC is to set up. Nothing exposes business owners to more risk than operating as a sole proprietor. The sole proprietorship advantages are heavily outweighed by the numerous problems that could arise. Additionally, most states have reduced the cost of establishing a limited liability company dramatically so that it is more accessible than business owners may think.
If you are reading this, you will likely make a smart decision to avoid the sole proprietorship. Most of the time, people who end up in a sole proprietorship think the sole proprietorship advantages are more significant than they are and they don’t fully understand the risks.
What is a Sole Proprietorship?
Sole proprietorship is the easiest way to form a business, but certainly not the best. A sole proprietorship is a single owner business with no codified organizational formalities. that the owner must follow in conducting business and on documents must be filed in most states. Black’s Law Dictionary defines sole proprietorship like this: “A business in which one person owns all the assets, owes all the liabilities, and operates in his or her personal capacity.”
How Do Sole Proprietorships Work
Individual owners of sole proprietorship are not considered legally distinct from the business. Usually the income, gains, losses, and deductions are accounted for on the owner’s individual tax return. Because the business owners have no separate legal identity from the owner and no statutory protection, the owner is subject to unlimited personal liability for all business debts and financial obligations. The only shield from liability sole proprietors have is insurance, which may or may not provide coverage (an issue most of us have experienced when dealing with insurance companies).
People usually end up with a sole proprietorship accidentally or because they are too busy in the early phases of starting a business. All you have to do is start operating a business – that’s it. There are no rules or corporate formalities. The biggest issue with operating a sole proprietorship is the massive exposure to liability. Let’s review an example.
Harry started a business called “We’ve Got Worms” to supply fishermen with an abundance of bait. He dreamed up the company with his buddy Lloyd, but after a fall out over a girl, Harry moved forward with the plan. He prudently acquired liability insurance, but failed to consider entity formation so ended up operating as a sole proprietorship. Harry used money he inherited from his uber-wealthy grandmother to start the business.
When Lloyd found out about the business, he was angry. Lloyd’s grievances were extensive: Lloyd created the name, the entire idea was his, the website uses images of him so he claims misappropriation of identity, and he loaned money to get the business started. He sued to recover his share of the business.
Unfortunately for Harry, if Lloyd prevails with a large verdict, then Harry will have to pay not only from the company but also his personal assets (the money inherited from his grandmother). Because Harry keeps so little money in the operating account, he might end up having to sell assets to satisfy the verdict.
This story can be told many different ways. Any sole proprietor that owes money (actually or allegedly) can expose their personal assets. For example, the same is true of a consultant providing services to a business. Let’s say a disgruntled client argues your advice was negligent and caused harm to the business. Or a virtual assistant that is blamed for dropping the ball on something that caused the client money. Any disgruntled client has amplified leverage when you are a sole proprietor because personal assets could be at risk.
Another example of how a sole proprietorship could expose personal assets is when a product injuries someone. Let’s say you are operating a pet walking business and a pet you are walking mauls a child causing significant injuries. What if insurance denies the claim or the medical bills exceed your coverage. That’s right, you and your personal assets (even those inherited from the wealthy grandmother) are now in jeopardy.
If you want to see how it plays out in court, there are thousands of examples. Here is just one, Garden City Boxing Club, Inc. vs. Dominguez. As stated in this article (and similarly by thousands of court opinions): “Because Antenas was legally a sole proprietorship, its owner was found to be legally responsible for the payment of damages.” Take Away: The sole proprietorship advantages of low cost and effort are never worth it! Get into an LLC or other liability protection entity.
What are the Alternatives to Sole Proprietorship?
Fortunately, there are several liability shielding forms of business. Limited Liability Companies (LLC), Corporations, and certain types of partnerships each shield owners from liability. If the business is sued, in other words, only the business is responsible, not the owners personally. Most of the time, an LLC does everything a business needs.
It’s something we business owners take for granted but the ability to invest in a business and keep that separate from our personal lives is amazing. It encourages people to invest in new services and products without having to risk their own nest egg.
A Final Point
As mentioned above, aside from liability exposure, corporate formalities might actually be a good thing. One reason people like sole proprietorships is because they don’t have to obey rules or corporate formalities. It’s easy to assume a side business does not need an LLC and an operating agreement, but in reality, there is good reason to treat any business professionally. And, it doesn’t have to be complicated – Drafted Legal has changed online legal documents from their one-size-fits-all legalese to understandable and straightforward documents that you can be proud to hand to a client or a business partner.
Business ownership is awesome, but don’t fumble on the goaline by failing to consider entity formation.
Put your mind at ease and use Drafted Legal’s LLC Setup and Templates to start the right way.
P.S. There’s also an added bonus when you set up your LLC and get your documents up to speed, it elevates your business and signals to your customers that you are professional and ready for their business. More likely than not, that messaging to your clients, alone, will earn back the money spent on your business.