When you start up your business, one of the first decisions you will have to make is what legal structure the company will take. The three main forms of business organization are sole proprietorship, partnership and corporation. Each has its own tax rules and filing requirements, and each allows different levels of protection to the owner from liability claims. However, if you want limited personal liability, sole proprietorship is not the way to go.
What is a Sole Proprietorship?
A sole proprietorship is the most basic form of business, represented by a single owner. Everyone who is self-employed is a sole proprietor. Each state has its own rules for business registration and name registration, but in general, a sole proprietorship has to register a doing business as, or DBA, name if using a name other than the owner's. Income and expenses of the sole proprietorship are reported on the owner's personal income tax return, and the net income is taxed at the owner's marginal tax rate.
Read More: An LLC Vs. Sole Proprietorship
Without legal protection, business owners are legally responsible for all debts and actions of their company. This means that a bank can go after the owner's house to satisfy a delinquent company loan, or customers could sue for damages if the company's product injured them. Regardless of the form of business chosen, there is no way to protect an owner from personal liability for negligence or harm caused that is directly related to the owner's actions. Some forms of business structure can protect owner's assets from seizure for company debt or from actions of other owners. A sole proprietorship, however, is not such a structure, and the owner is completely exposed to all types of liability.
The best way for a sole proprietor to limit his liability is to operate the company with due care and to ensure that all company debt is paid on time. The owner can also protect personal assets in some cases by transferring title to other family members. Each state has rules, however, about this type of liability avoidance, so plan with a corporate lawyer before moving any assets. Liability insurance is always a good idea to cover some of the business risks, but it may not be enough. A sole proprietor should also consider incorporating if his personal liability is extensive.
Alternative Business Structures
There are two main alternate business forms that sole proprietors can choose to limit liability: the single-shareholder S corporation and the single-member LLC. The single-shareholder S corporation treats the company as a separate entity for liability purposes, but the net income flows directly to the shareholder and is reported as business income, much like a sole proprietorship. There is no tax benefit over a sole proprietorship, but it protects the owner's personal assets from seizure for company debt. The single-member LLC also automatically treats the company's income as personal income to the business owner but allows him to choose to have the business be taxed as a corporation. The caveat to both of these business forms is that banks and other lenders often require the business owner to provide personal guarantees on corporate debt, especially if the company is small or new. This nullifies the benefit of the limited liability.
Angie Mohr is a syndicated finance columnist who has been writing professionally since 1987. She is the author of the bestselling "Numbers 101 for Small Business" books and "Piggy Banks to Paychecks: Helping Kids Understand the Value of a Dollar." She is a chartered accountant, certified management accountant and certified public accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.