Starting and running your own business is exciting and rewarding; part of that is the risks and learning curves you’ll need to go through. As an entrepreneur, it’s up to you to make calculated decisions to avoid risk where possible. Let’s look at one of the biggest ways business owners can avoid risking their personal assets by carefully considering the type of business they set up.
One of the most significant decisions you’ll face is deciding upon your legal business structure. LLCs are becoming the most popular, but the sole proprietorship also represents America’s simplest business identity. Any individual may form one, and no formal formation process is required.
A sole proprietorship is a simple business entity in which there is no legal distinction between the business owner and the business; business income is treated like personal income and business assets and personal assets have no distinction. On the flip side, business debts can be treated like personal debts and sole proprietorships have more risks. Small business owners often start as a sole proprietorship and graduate into an LLC.
But despite being simple, forming a sole proprietorship isn’t the right choice for every single-person business. One risk you’ll run is the lack of protection legally, which is particularly true of sole proprietorships.
What legal protection do sole proprietorships offer?
To clarify, legal protection usually means liability, or personal asset protection, as a result of the corporate veil. The corporate veil separates the assets of the owner from the business’s assets; in a sole proprietorship, there’s no corporate veil (and, therefore, no liability protection). In the eyes of the law, the sole proprietorship is the owner, and there’s no separation between personal and business finances. The biggest disadvantage of sole proprietorships is how catastrophic it is to manage a business without proper liability protection.
Doing business without legal protections
Suppose you don’t have any legal protection; you have unlimited personal liability which means you’ll be held personally liable for all of the business’s financial obligations, which may include license fees, debts, taxes, and lawsuits against the business.
If your business can’t pay for a debt or settlement, you’ll need to make up the difference. This can be taken from your personal accounts; your real estate, car, or other assets may be taken to pay for the difference. It’s a risky move; starting a business is risky enough, but using a business structure that offers no protection isn’t a wise move.
Self-employment taxes are identical regardless of whether you’re operating a sole proprietorship or LLC. The IRS allows the income to be ‘‘passed-through’’ onto the personal tax return, meaning that you’ll pay income tax at the same rate.
As a sole proprietor, you won’t have any business name per se. Your business will be named after you; if your name is John Doe, your business will be named John Doe. While you can obtain a DBA (doing business as) name, there’s no exclusivity associated with that.
If you’re going to operate under a sole proprietorship, you can’t shield yourself very much. You’ll have a business and personal liability for everything you do. The only way to get full liability protection is by forming a different business entity, such as an LLC.
You can’t really mitigate risk if you’re operating as a sole proprietor, but you can go some way towards that by taking out insurance policies. Most crucially, you’ll want a general liability insurance policy designed to cover an unexpected expense. You can also reduce your liability by hiring contractors; you can’t be held liable for a contractor’s subpar work.
Regardless, you’ll be best placed considering other business formation types such as a Limited Liability Company or LLP (Limited Liability Partnership).
LLC vs Sole Proprietorship
LLCs are one of the most popular business entities; millions of Americans have formed LLCs. They are cheap and easy to set up by yourself, and some business formation services can help you set up an LLC for less than $50.
One of the key benefits of the LLC is the personal liability protection offered; aside from a few key circumstances, as long as you’ve maintained your business and personal finances separately, your liability is well assured. If your business is sued, only your business can be held liable for any outcome unless you’ve behaved fraudulently or otherwise criminally.
If you’re unsure which structure to choose, it’s wise to take your time and perhaps get professional advice. If you really want to, you can trade as a sole proprietorship for a limited time, but by the time your business has grown large enough to have a steady stream of customers and/or income, you should really consider converting to an LLC.
LLCs offer greater potential for growth, including being able to expand and bring other people into the fold if you need to.
Your business is unique, so what works for one may not work for another, but a business lawyer or other advisor can explain the differences to you. Still, forming an LLC rather than a sole proprietorship is usually advisable as you’ll avoid taking unacceptable risks. If you’re worried about the paperwork involved in creating an LLC, you can use a business formation service.
Plus, creating an LLC is quick and easy with business formation services. They’ll handle the paperwork for you.
LLCs also give you a stronger impression of legitimacy compared to a sole proprietorship, and your business name is just your legal name. An LLC requires correct business name registration, giving you a legitimate trading name.
Sole proprietorships and LLCs are prevalent ways to operate your startup, but sole proprietorships have substantial issues. You won’t have any real legal protection under the “corporate veil” with the sole proprietorship. There are some steps you can take to remedy this, such as working with contractors and looking into business insurance policies to carry the risk of expensive liability issues, but the protection is in no way close to what a simple LLC can offer you. If you want to be protected, consider a single-member LLC to be a great alternative.