Sole proprietorships have one benefit: simplicity. The downsides are numerous, which make operating as a sole proprietorship imprudent. Taking the time to form legally is an investment in your business just like having a website or sending a grand-opening letter.
Before analyzing the negatives, it is important to review what is meant by “sole proprietorship.” A sole proprietorship, according to Black’s Law Dictionary, is “a business in which one person owns all the assets, owes all the liabilities, and operates in his or her personal capacity.” Generally, all you have to do is start offering a good or service for profit and you are a sole proprietor – for better and worse.
Risk of a Sole Prioprietorship
Sole proprietorships create massive risk by exposing business owners to liability. Business owners can be personally liable in both tort and contract law should the business find itself in legal or financial trouble. Let’s take an example.
Joe owns a handyman business. He negligently leaves a power saw sitting around and a child saws his finger off. A jury finds Joe negligent and awards the child $500,000. Joe has to come up with the money to pay it – out of his own pocket. As an aside, insurance is surprisingly little help most of the time, so Joe does not get help paying despite staying current on heavy premiums.
Let’s look at another example. Joe can be found in breach of contract and have to pay personally for debts of the handyman business. If Joe borrows $100,000 to hire a new employee and then finances $50,000 in equipment, then he personally owes on those loans. If Joe’s business fails – because of a market crash or a personal injury that forces him out of work – then he’s on the hook.
Alternatively, Joe could have created a limited liability company (LLC), which would have limited his personal liability. He also could have formed a partnership or corporation.
Inflexible Taxation with Sole Proprietorship
On the tax front, sole proprietorships offer only one alternative: pass-through taxation. Other types of business entities can opt to be taxed at the company level or use an S-Corporation. The pass-through distinction works much of the time, but it also has limitations, especially when trying to raise capital or invite new partners into the business. There can also be ways to reduce taxable income so always consult a tax professional before making a decision regarding taxation.
How to Get Liability Protection
Use a combination of an LLC and good templates to confidently operate your business and minimize your risk while doing so. Don’t leave your personal assets to risk. Use Drafted Legal to start your business the right way.