Running your own small business is a rewarding experience.
Part of what makes it so fulfilling is the fact that you have to overcome certain risks in order to succeed. As an entrepreneur, it’s your job to understand those risks and avoid them as much as possible.
One of the toughest decisions of any company’s business life cycle is deciding which type of business entity to form and operate. The sole proprietorship is the simplest business structure in America, as any individual may form one at any time, and there is no formal formation process to follow.
But this doesn’t necessarily mean that forming a sole proprietorship is the right choice for every one-person business. One risk some businesses run into is a lack of legal protection, which is especially true of sole proprietorships.
In this guide, we’ll cover what that means for your business and what steps you can take to protect yourself.
First off, we have to clear the air on what we mean by “legal protection.” Basically, a business with legal protection has personal asset protection as a result of what’s known as the corporate veil, which separates the finances and assets of each owner from the assets of the business itself.
But in a sole proprietorship, there is no corporate veil, and as a result, no legal protection. In fact, in the eyes of the law, the sole proprietorship is indistinguishable from the owner ― there is no separation between the business finances and personal finances.
In our opinion, this is the biggest disadvantage of sole proprietorships. It’s difficult to overstate how catastrophic even one liability claim against your business could be if you remain a sole proprietor instead of forming a formal business entity, like a limited liability company or a corporation.
Since a sole proprietorship has no legal protection, you are held personally liable for any and all financial obligations for the business. This includes any taxes, license fees, and debts, and it also applies to lawsuits against your business.
If you cannot pay for a debt or a settlement from your business finances, then you’ll be expected to shell out from your personal accounts. This means your house, your car, your personal finances, and more could be taken to pay the difference.
While it may sound like we’re exaggerating for effect, we truly believe that this is one of the biggest risks you can possibly take as an entrepreneur. Starting a business by yourself is risky enough, but to do so using a business structure that offers you no protection from creditors is another level of peril.
This is why we consistently tell our readers that they should form limited liability companies instead of operating as sole proprietors ― the value of your personal assets is far greater than the small amount of money it costs to form an LLC.
The only way to get complete liability protection for your business is to form an LLC, a corporation, or another formal business entity. Thankfully, you can start out as a sole proprietorship and convert into one of these entities if you determine that you need your personal assets protected.
As we’ve already indicated, the best way to protect your personal assets as a sole proprietor is to form a single-member limited liability company. While there are some expenses involved with the formation and maintenance of an LLC, the personal asset protection offered by this business structure is well worth this small expense.
If you want more information on how these two entity types compare, take a look at our “LLC vs Sole Proprietor” article. In addition to limiting your personal liability, the LLC also provides a level of legitimacy to your business venture that a sole proprietorship simply can’t compete with.
Unlike a sole proprietorship, which has no exclusive rights to a unique business name, an LLC registers its name with the state government. Therefore, your business name is yours and yours alone, and all other businesses are prevented from using it or any other name that is deemed to be too similar.
As a sole proprietor, your legal business name is actually just your personal name, so if your name is James Johnson, your business is also named “James Johnson.” While you can obtain a doing business as (DBA) name that allows you to operate your business under an assumed name, there is no exclusivity associated with this filing.
If you still want to remain a sole proprietor, then there is no way to access this level of legal protection. However, there are a few steps you can take. First, you can get a general liability insurance policy for your business. With this policy, if you encounter an unexpected expense because of a mistake made while operating your business, the policy will help cover part of your costs.
You can also reduce your company’s liability by hiring independent contractors whenever possible. If a lawsuit occurs because a contractor did shoddy work, then you cannot be held liable for that damage, but if your employees do poor work, then you are held responsible.
The lack of legal protection is probably one of the biggest drawbacks to owning a sole proprietorship.
While there are some steps you can take to overcome that, if you want your personal assets to be protected, the sole proprietorship is not the right business structure for you ― forming an LLC or corporation would be a much better idea.
If you still want to continue operating as a sole proprietorship, and forfeit the legal protections of a formal business structure, we at least urge you to look into insurance policies that can help carry the load of an expensive liability issue.
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
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