The following is taken from chapter 5 of the book “Selecting and Forming Business Entities” published by Continuing Education of the Bar. Copyright held by The Regents of the University of California. This page is not updated regularly and may not be current.
Chapter 5 was written by Richard G. Burt
I. INTRODUCTION §5.1
A. Ease of Formation §5.2
B. No Documents or Fees §5.3
C. Avoids Entity-Related Issues §5.4
III. DISADVANTAGES §5.5
A. No Shield for Employee Wrongdoing §5.6
B. Contract Creditors §5.7
IV. CONCLUSION §5.8
I. INTRODUCTION §5.1
A sole proprietorship is the simplest form of business organization. Anyone who goes into business without co-owners and without forming a legal entity is a sole proprietor. Whether the business is a lemonade stand, a clothing shop, or a factory employing hundreds or thousands of workers, the principles are the same.
§5.2 A. Ease of Formation
A sole proprietorship is one form of business organization that anyone can establish without the assistance of counsel. No formalities at all must be followed in setting up such a business. The simplicity and lack of expense of a sole proprietorship are its major advantages.
§5.3 B. No Documents or Fees
To establish a sole proprietorship as a form of business, the prospective business owner need not prepare any documents for filing with any government agency. No legal and accounting fees are typically incurred in establishing a sole proprietorship. In addition, there are no annual tax returns (although a Schedule C must be attached to the sole proprietor’s federal tax return), no filing fees, and no minimum annual tax or user fee (e.g., the minimum annual tax currently imposed in California on corporations and other limited liability entities).
As with every business, a sole proprietorship must meet certain legal requirements, including obtaining the necessary licenses and permits, filing payroll and other tax returns, obtaining workers’ compensation insurance, and filing and publishing a fictitious business name statement under certain circumstances. These tasks ordinarily apply to all forms of business organization, however, and are not usually based on how the business is organized.
§5.4 C. Avoids Entity-Related Issues
Because the business’s income is reported individually by the sole proprietor on his or her own tax returns, there is no need to file a form in a timely fashion with a taxing agency to ensure that the business’s income or loss will flow through to the tax return of the owner. There is also no risk that the business will be subjected to an unexpected entity-level tax because the owner failed to meet some requirement of the Internal Revenue Code. In addition, there are no legal restrictions on a sole proprietor’s taking money out of the business, and there is no risk that, when a sole proprietor draws money out of the business, the draw itself will be subject to tax.
III. DISADVANTAGES §5.5
The principal disadvantage of the sole proprietorship is that the owner’s liability for the obligations of the business is not limited by law to the assets of the business. For certain types of one-owner businesses, however, this disadvantage may not be significant. Some businesses do not create much exposure to liability, and some liabilities (principally tort liabilities) are not always avoided by forming a limited liability entity.
§5.6 A. No Shield for Employee Wrongdoing
A sole proprietor is subject to liability for injuries caused by the negligence of employees. Although organizing as a corporation or an LLC (see chap 11) ordinarily protects the owner against liability for employee wrongdoing, a corporation, like a sole proprietorship, offers no shield for a business owner’s personal negligence or other tortious wrongdoing. Consequently, insurance may be a better solution for liability exposure than incorporation.
Even if a business owner is insulated from personal liability as a result of incorporating, the assets of the business are still exposed to the claims of tort creditors, and the business must bear the expense of defending itself against such claims. Insurance transfers these risks to the insurance carrier. If all likely tort risks are insured against, the lack of a shield against tort liabilities may be insignificant.
§5.7 B. Contract Creditors
For commercial enterprises, the biggest exposure to liability may come from contract creditors. In many cases, a sole proprietor may avoid liability simply by not entering into contracts that he or she cannot perform (e.g., not ordering goods when the ability to pay for them is in doubt). In some cases, the other party to a contract may be willing to limit the sole proprietor’s liability on the contract to the assets of the business or to exclude certain assets of the sole proprietor (e.g., a personal residence) from any claims for breach of contract.
In most cases, however, limiting the liability of the owner for the business’s contractual obligations will not be feasible, which suggests that the sole proprietorship is at a significant disadvantage to a corporation or an LLC as a form of business organization. This disadvantage may be illusory in many cases, because lenders, landlords, and other sophisticated creditors often demand personal guaranties by business owners if their businesses are incorporated. Furthermore, because a business is typically the owner’s most significant asset, failure of the business (even if it is incorporated) may result in the owner’s insolvency or personal bankruptcy—particularly if the owner provided a personal guaranty or pledged personal assets to secure financing for the business.
§5.8 IV. CONCLUSION
For many sole proprietors, their form of business organization is the result of not choosing any other form of business organization: a decision by default, but often a correct one. The simplicity and lack of expense of the sole proprietorship make it worthy of consideration by many new businesses once liability concerns have been addressed.