Hopefully, by now you have read through one of my many past articles so you have seen me discuss things like business entities, why they are important, and even how to take the first steps to set something up for yourself.
But, I don’t doubt that there are still so many questions regarding entity formation and what entity is the right one for you. In fact, just this last week I was asked by a fitness online coach about staying a sole proprietor. It’s easy, he is already doing it, and it doesn’t require he make any changes to the way his business works! And while all that is true, it doesn’t make me feel any better about someone operating as a sole proprietor. Of course, there is always a time and a place for organizing your business this way but for me, it’s too risky. Even if you utilize amazing contracts, and have excellent insurance-it’s too risky.
So, while I understand that when you’re first starting out in your business you may not have the resources to form a business entity right away, but I want to ensure you have an understanding of the risks of being a sole proprietor so that you can get a plan of action in place to grow out of that business formation asap.
What is a Sole Proprietorship (SP)?
In the simplest terms, it means that all of your business and personal assets are mixed. There is no separation and there is no liability protection for your personal assets. SP’s are super easy to “form” because all you have to do is start doing business and bam, you’re an SP. It is the legal default formation when you start that new business venture whether it be full time, part-time, or only some of the time. State laws do vary on formation requirements but it is the most commonly found since it doesn’t typically require action or overt filings and payments to the State.
What are these reasons I don’t recommend a Sole Proprietorship?
#1 The Unending Liability.
There are practically no benefits to operating as an SP aside from ease of formation, and it isn’t expensive to set up. So fine, you’re working and filing your taxes, and everything is going smoothly. Until it isn’t. And when the time comes to separate your personal assets from the business assets you will have one long uphill battle to fight. When someone decides to sue you, those personal assets are practically up for grabs. All other entity types provide two separate and distinct piles- business assets and personal assets. And when that one customer decides to take you to court, the personal asset pile stays at home, because this is business not personal.
#2 Terminating the Business
If you die or become incapacitated, the business does too. Because again, your business and your personal piles aren’t separated. An SP is tied to you the individual business owner, and “if you go I go Jack” in this case you’re Rose, the business is Jack, and you’re both going down in this version. If you have another entity formed, this is avoided.
#3 Raising Capital
It is a lot more difficult to raise capital when you are operating as an SP. If you need to acquire funds through loans or investors you will have a more difficult time proving the value of this investment. Not many investors are interested in giving their money to someone that has unending liability, and let’s be honest, hasn’t taken the steps to set up a more formal business entity. Also, keep in mind you cannot bring in any business partners because that would require a change in business formation.
#4 Bankruptcy and Credit Risks.
Ok let me repeat myself, all business credit will go under you the individual owner of the SP. When an SP goes under and must file bankruptcy all of your personal assets are going to get involved in that bankruptcy. Also if a business expense goes into collections, a creditor can collect their judgment from either business or personal assets because they are one in the same!
#5 You Lose out on some Tax Benefits.
Honestly, benefits and taxes are not two words that most people put together, but having a formal business entity does provide some tax benefits that can help your business and you save money. SP’s do not get any of those same tax benefits, and you may actually end up paying out more than you needed.
I hope you can tell that while a sole proprietor is easier, it isn’t always better. If you run a very low-risk business, then maybe just maybe operating this way is fine. But, for the majority of businesses out there, it will pay off tremendously if you take the time to set up a formal business entity. Not sure what entity is right for your business? Send me an email and we can discuss it- Shannon@montgomerypllc.com.
Please note that this is not meant to be legal advice for you or your situation, this is merely some legal research and knowledge on the given topic.