The Top 5 Reasons to Avoid Sole Proprietorship

Nina L. Kaufman, Esq.

Nina L. Kaufman, Esq.

Nina L. Kaufman, Esq., owner of Ask The Business Lawyer, is an award-winning business attorney, speaker, and Entrepreneur Magazine online contributor. She saves consulting and professional services companies time, money, and aggravation by serving as their outsourced legal counsel.

Posted on February 2, 2014 in Form a Company

“Life is trouble; only death is not,” comments Zorba the Greek in the novel by Nikos Katzanzakis. I’ve heard many a business owner brag about the lack of complication that their sole proprietor status affords them. No messy ownership agreements, no separate filings or taxes, complete freedom and flexibility to do what you want when you want. And if it’s “just me” working as a contractor/consultant to other companies, why get so involved in structure and meeting minutes?

Well, it’s a law of nature and balance that for every yin, there’s a yang; every action breeds a reaction; every silver lining has a cloud. And the “clouds ” hanging over a sole proprietor can create a deluge of catastrophic proportions.

Cloud #1: You risk the whole ball of wax.
One of the benefits of doing business as a limited liability entity (such as a corporation or limited liability company) is that the structure (that’s so unwieldy to the sole proprietor) acts as a protective fortress against personal liability. Sole proprietors don’t have that shield of protection. As a result, all of their personal assets are at risk in the event of a lawsuit or judgment. Personal assets, like your home, bank accounts, savings, car, jewelry (which can be sold to pay off a judgment). How remote is a judgment against you? For the computer consultant whose network configuration inadvertently crashes the server? The graphic designer whose design may have infringed on someone else’s? The independent sales rep accused of misusing a company contact list? The marketing consultant whose plan did not produce the promised results? In a suit-happy society, sole proprietors often don’t have the “war chest” to fund a lawsuit – or pay off a judgment. So why put Grandma’s engagement ring, or your life savings, at risk? It’s like jumping into a pool of hungry sharks: you may not get eaten, but why would you want to put yourself in that danger in the first place?

Cloud #2: A house of cards crumbles easily.
Erratic economies, slow- (or non-) paying clients, or lawsuit judgments noted in Cloud #1 can all contribute to the demise of a business. Limited liability entities have the option to take the business through a bankruptcy proceeding, without it having to affect the business owners. But with sole proprietors, the business is the owner. The two are inseparable – nay, identical. Therefore, harm to the business equals harm to the sole proprietor. If a sole proprietor is seeking a way out through bankruptcy, she must declare personal bankruptcy. Bankruptcies can stay on your credit record for 10 years and even longer, so the fresh start that the bankruptcy process is supposed to provide may turn into a millstone around your neck . . . for over a decade.

Cloud #3: You may lose business opportunities.
Larger companies like to use independent contractors because they do not have to pay Social Security and Medicare taxes on their behalf. Yet, consulting assignments, although temporary positions, can last for months or even years! If that happens, a consultant/contractor could look dangerously like a part time (or even full-time) employee. As a result, an increasing number of companies will only do business with consultants who operate their businesses as limited liability entities, for the limited liability form lends a certain presumption that the business truly is independent. Is this form over substance? Not if sole proprietors are missing out on attracting larger and more prosperous clients.

[UPDATE:  Another significant reason for an entity is that thousands of small businesses across the U.S. are looking for a way to escape the fines and expenses of ObamaCare by keeping their core workforce to under 50 employees. See Paul Christiansen's WSJ online Op-Ed piece, "To Outsmart ObamaCare, Go Protean." Even more reason to think--and operate--as an independent business!]

 

Cloud #4: You curtail business expansion opportunities.
One of the most significant ways for a small business to expand is to bring in other business owners because they can contribute capital, contacts, and cheap labor. But you cannot have more than one owner in a sole proprietorship: by definition, it’s “just you.” Therefore, bringing in a business owner essentially means that you must create a new business . . . literally, as a new entity will have to be established. However, if you already have a limited liability entity, you can control who joins you and on what terms. In short, it can remain your business, only bigger and better.

Cloud #5: You risk thinking small.
There’s no law that says your have to want to be a millionaire if you go into business for yourself. You may be quite content with remaining a one-person operation. But just as putting on a suit to go to that important client meeting (or special date) makes you feel and act differently, so too can having a limited liability entity help formalize your thinking and enable you to run the business smoothly, instead of running from pillar to post. There’s a lot to know about running a business well – much of which has to do with understanding financial statements and what makes your business profitable. For the same 168 hours per week, wouldn’t you rather make more money than less?

As you can see, there are lots of significant factors that can cloud the life of a sole proprietor. But you also have options to hedge against their risks. Don’t make this decision alone – be smart and find the right people (such as a small business attorney and accountant.) to help you. Avoiding sole proprietorship may be just the smart move to bring your business to Cloud 9!

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