There are a few things that can be quite emotionally rewarding as seeing that business that had been just a sketch on paper for years morphing into reality. When your business gets very tangible in that you are almost fully set up, one of the most important decisions you ought to make at this point is what legal form the business will take.
If you are just starting the business alone or with a group of friend on a small scale, the easiest legal entity that can come to mind is the sole proprietorship. You will find that a lot of individuals running small businesses subscribe to this model.
A sole proprietorship is essentially just an individual doing business without the benefit of forming a legal entity such as a partnership or corporation. If you are operating a business yourself and have not formed a corporation or any of the various entities within the realm of corporations, then you have a sole proprietorship.
When it comes to forming a sole proprietorship, you don’t need formal legal documents. This is one of the lures of the sole proprietorship business model and why it’s perfect for small businesses. You can choose to just register the company name with the secretary of state and obtain a separate tax identification number for the business, and you are good to go.
When it comes to setting up your business as a sole proprietorship, the benefits are numerous. A sole proprietorship requires very little capital to start in most of the cases as there are no legal fees or formal legal maneuvers required.
In addition, a sole proprietorship allows the owner to avoid the often high tax rate at which corporations are taxed. If you operate as a sole proprietor, you also have complete control and management of the business without having to consult with, or answer to anyone else such as a partner or shareholders.
5 Types of Liabilities Sole Proprietors are Subjected to
Any sole proprietorship business will come with unlimited liability. This is a fact no matter how you try to maneuver it. Unlimited liability refers to the full legal responsibility that business owners and partners assume for all business debts. This liability is not capped, and obligations can be paid through the seizure and sale of owners’ personal assets, which is different from the popular limited liability business structure known to most businesses.
In this business model, there is practically no legal distinction between the owner and the business, meaning that anybody and everybody who has has something to do with the business credit wise, as well as any other entity or individual who has any claim against the owner, can reach both the business and the owner’s personal assets.
Being the bearers of unlimited personal liability, sole proprietors are subject to all kinds of liabilities. They must be fully and personally responsible for all their business debts, like loans used to purchase physical capital and equipment.
As an entrepreneur, you need to know that the biggest downside to operating a business as a sole proprietor is the liability you are subject to. If your business incurs debts that it cannot pay from the profits, you are personally responsible for the payment. Creditors may sue you personally to satisfy the debt, and this is legal. The opposite is also true. If you have personal debts that are unpaid, a creditor may go after your business profits or assets to satisfy the debt.
Along with liability for debts, as a sole proprietor you also have personal liability for any torts, or injuries, that occur as a result of any acts or omissions of your business. You may, however, be able to purchase liability insurance for your business that can help eliminate tortious liability.
In a sole proprietorship, the liability issue is a potentially major structural flaw that is not correctable. Legally, the sole proprietor and the business are one, so every business liability is also a personal liability of the single owner. Listed below are a few other liabilities a sole proprietor is subject to;
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Sole Liability Ownership
When it comes to the structure of the business model, a sole proprietorship can have only one owner, and this is good news as well as bad news. The good news is that the sole proprietor will receive all the company profits. The bad news is that you run the business alone, so there can be no shared or allocated liabilities among the owners. All liabilities of the business must all come to you the sole proprietor.
2. All Credit and Loans Come Back to the Sole Proprietor
Your ability to take on debt and other obligations is a function more of your personal credit than of your company’s credit standing. Since banks usually will only loan to sole proprietorships upon getting the owner’s signature and personal guarantee, a sole proprietor’s credit score is critical to business financing. Your business’s borrowing ability is typically dependent on your personal credit rating.
3. Liabilities Can Outlive the Company
This is a very ugly side to the sole proprietor business model. In this regard, should a sole proprietor create liabilities or debts and subsequently decide to close the business for one reason or the other, the obligations will last until paid. Should the business idea be flawed and the owner cease operations, an existing loan will not disappear, because it is the owner’s loan. The owner will still be obligated to pay up this loan.
4. The Kind of Liability Involved
The issue of liability is what puts a clog in the wheel of the sole proprietor business model. Most sole proprietor liabilities fall into two categories: Loans and vendor or supplier obligations. Loans obtained for financing the business usually come with the sole proprietor’s personal guarantee. Vendors might provide product (inventory), computer services, telephone or electricity. Even if all goods and services were for the business only, sole proprietors are liable for paying outstanding bills.
4 Ways to Protect from Liability in Sole Proprietorship
Being that the sole proprietorship business model carries with it a lot of liabilities that carry a lot of implications for a business, entrepreneurs who have this business model should start thinking of what to do to avoid falling victim. Here are ways you can protect yourself from such liabilities.
Make Sure You Are Adequately Insured
Your first recourse if you are a sole proprietor that wants to protect yourself and your business from legal issues is to get insurance. There is business liability insurance that can perfectly protect a sole proprietor from liabilities such as lawsuits that would derail the business and deplete personal assets.
While it may be an expensive option, especially for small business owners, it can protect sole proprietors from many events that would be financially devastating to the business. Another way to protect your business from lawsuits is to have your customers sign a liability waiver in case they sustain injuries from a risky activity that is part of the services you offer.
2. Shield Your Home from Liability
In many cases, a person’s home is his/her most prized asset, but this would be targeted if a massive liability claim arises. With this in mind, protecting your home from liability that revolves around operating a sole proprietorship business should be your first priority. For married individuals, it may be wise to consider changing the title of the house so that it includes you and your spouse as tenants by entirety.
It would mean that the property is shared on a 50-50 basis. It would then effectively hinder creditors from placing a lien on the property because the debts owed only relate to you individually as the sole proprietor of the business and not your spouse.
On the other hand, unmarried sole proprietors can consider owning the home with someone else other than a spouse, say with your parent. Remember that this provision always differs depending on the laws of each state.
3. Bring in Independent Contractors
According to most business laws, a sole proprietor is not responsible for damages or negligent acts caused by independent contractors. In this regard, a sole proprietor can consider hiring the services of an independent contractor for all the staffing needs, instead of employees.
Anyway, keep in mind that this provision may vary from state to state, especially where negligent acts are involved. For example, sole proprietors in California can be responsible for a contractor’s negligence if the job for which he/she hires the contractor is inherently dangerous.
4. Decide to Incorporate the Business
While all the above ways can protect a sole proprietor and his/her business from liability, the most effective and inexpensive way of liability protection is to effectively change the business from a sole proprietorship to a Limited Liability Company (LLC).
An LLC comes with numerous benefits not only to the business but to you as the business owner. It gives you the chance of separating your business entity from personal activities, meaning that creditors cannot target your personal assets to satisfy liabilities of the business.