29 Jul The Consequences of Being a Sole Proprietor
When starting a new business, there are many forms of business entities to choose from: corporation, limited liability company, limited partnership, professional association, and many more. Choosing an entity form and filing the corresponding formation documents with your state’s Secretary of State means you have officially “incorporated” your business. So, what happens when a new business owner chooses not to incorporate their business and instead operate as a sole proprietor? Simply put, it means the business owner and the business are indistinguishable, the consequences of which can be substantial.
Incorporating a business means that a new, legally distinct entity is created. For example, if a business owner creates a corporation, that corporation has its own separate existence from the business owner: the corporation will have its own identifying number (an “employer identification number”), it can own assets and enter into contracts with third parties, it can (and should) have its own bank accounts, and it will potentially file its own tax returns. There are administrative costs in separating your business out into a legally distinct entity, but the main reason business owners do this is for the all-important limited liability protection.
Limited liability protection is a shield or wall between the legally distinct entity’s assets and the business owner’s personal assets. If you properly create and maintain the entity and continuously treat it as separate and distinct from the business owner, creditors and claimants typically can only go after the entity’s assets, and not the business owner’s personal assets (with certain exceptions, including if the business owner participated in tortious conduct towards another person). This gives a business owner the peace of mind that if the worst-case scenario happens and the business fails, they can still fall back on their personal assets and can have a “fresh start” with a new business venture.
This leads to the biggest risk of not incorporating a business and choosing to be a sole proprietor – that the business owner has no liability protection because the business and the business owner are one in the same. The shield that protects a business owner’s personal assets only arises when a business incorporates (filing a DBA or assumed name certificate does not qualify as incorporating a business) and maintains its separate status. Since a sole proprietorship by definition has not incorporated, it therefore has no limited liability protections. The allure of a sole proprietorship can be enticing at first – for example, there are much less administration costs to being a sole proprietor. But the potential consequence of having your personal assets subject to litigation should undoubtedly outweigh those administrative costs.
While liability protection is by far the biggest reason to not be a sole proprietor, there are many other reasons to incorporate, including the difficulty in raising capital without an entity in place, the difficulty of succession planning when you have personal and business assets comingled, hesitation from lenders to lend capital to a sole proprietor, potential tax advantages to incorporating, how third parties view your business, and many others.
Incorporation may seem daunting at first, but the protections derived from incorporating and the mitigation of risks associated in incorporating cannot be overstated. All in all, the risks of being a sole proprietor, especially putting a business owner’s personal assets at risk, do not outweigh the perceived benefits.
Copyright © 2021 by Drew Erickson. All rights reserved.