Understanding Sole Proprietorships
The simplest business structure is what's known as a "sole proprietorship," and it is the default business structure for an individual who runs a business with only one owner. When starting your business, if you do not choose to form a corporation, limited liability company (LLC), or other type of separate entity, your business will by default be treated as a sole proprietorship.
With a sole proprietorship a single individual personally owns the business, and he or she is fully responsible for the debts and liabilities of the business. This means that, should the business owner be unable to pay his or her business debts, creditors can go after the assets of the individual proprietor for payment.
Example: Julie is an artisan who starts her own small business designing and creating beautiful beaded necklaces and earrings. She creates several dozen pieces and convinces Al's Jewelry Shop to buy them from her for resale. Julie has become a sole proprietor, even though she has never registered with any government entity as such.
Sole Proprietorship vs. Other Business Structures
While a sole proprietorship is the simplest business structure, many businesses choose a corporate or LLC form based largely on the protection from personal liability these forms offer.
With a corporate or LLC company structure, the personal assets of the business owners are generally not at risk. Instead, the risk for the business owner is limited to his or her investment in the corporation or LLC.
Thus, sole proprietorship can be more appropriate for a business that does not risk a lot of capital, such as a personal service business. Contrast this with a type of business that risks capital, such as a retail business that holds a depreciating inventory or a manufacturing business that requires a large investment in equipment in order to make its products.
Example: Julie's necklaces and earrings sell well and she decides to produce designs made from precious metals and gems. She purchases $50,000 in raw materials she needs to make the jewelry from dealers who give her 90 days before payment is due. Unfortunately, Julie's upscale line does not sell well, and after the 90 days is up she does not have the money to pay her suppliers. Several suppliers sue Julie and obtain judgments, and because Julie's business is a sole proprietorship, these creditors can seize her personal assets and possibly force the sale of her personal residence to satisfy the judgment. If Julie were doing business as a corporation or LLC, creditors would generally be able to look only to the assets of her jewelry company, and her personal assets and residence would not be at risk.
Mitigating Risk with Insurance
The risk of liability for any business can be mitigated under some circumstances with the appropriate insurance coverage. Insurance to cover risks such as business premise injuries are common; policies to cover other business risks, such as declining inventory value, are less common and more expensive.
Example: Stacy falls and injures herself on a decaying piece of flooring while shopping at Al's Jewelry Shop. Because Al has been negligent in not timely fixing the dangerous condition, Stacy has a valid personal injury claim. The defense of the claim and the settlement payment are covered by Al's general business insurance policy, and Al's assets are not at risk (up to the amount of the policy).
Tax Obligations for Sole Proprietorships
Just as a sole proprietor's creditors look to the sole proprietor to pay the business debts, income taxing authorities look to the sole proprietor to satisfy the business tax obligations. Thus a sole proprietor reports to the taxing authorities on his or her individual tax return. This can be contrasted again with a corporation or LLC, where generally a separate tax return is required for the business entity.
While sole proprietorship is the default structure for a business owned by an individual, this does not mean the sole proprietorship is free from other local municipal and state business registration, reporting, permit, and zoning requirements. In many municipalities, all businesses of any size must get a business license.
Partnerships
If the business is owned by more than one individual, the default structure is a partnership. Like a sole proprietorship, the partners in a partnership are individually liable for business debts and liabilities, and report their share of the partnership assets and debts on their personal tax return.
Michael Casey Walker is an attorney and founder of the Walker Law Firm, based in San Francisco, California. The Walker Law Firm was founded in 1988 and specializes in serving small and medium-size business clients with a variety of business issues, including business formations and dissolutions, contract review and preparation, and business disputes and litigation. Walker Law Firm also has a Trust and Probate department. You can reach the law firm via e-mail at Walker@WalkerLawFirm.com or by phone at (415) 337-7864.
Note: This article does not constitute legal advice and should not be relied upon as legal advice. If you have a legal issue or wish to obtain legal advice, you should consult an attorney in your area concerning your particular situation and facts. Nothing presented on this site or in this article establishes or should be construed as establishing an attorney-client or confidential relationship between you and Michael Casey Walker. This article is provided only as general information, which may or may not reflect the most current legal developments or be complete.
