Is your sole proprietorship at risk?

A sole proprietorship is attractive to the average entrepreneur, you get to reap all of the profits and to have full control of the business; however, it does come with some risk, namely unlimited liability for the owner.

by Stephanie Morrow
updated May 11, 2023 ·  3min read

A sole proprietorship is probably the simplest and most prevalent form of business organization. It is the least regulated of all other forms of business and provides numerous tax benefits for the owner. A sole proprietorship is available to companies owned by one person and gives the owner the ability to hire other employees, including his or her own minor children, without being liable for payroll withholding.

A sole proprietorship however is not without risk. At first glance, it appears attractive to the average entrepreneur—you get to reap all of the profits and to have full control of the business. On the flip side, sole proprietors may find it difficult to obtain loans for the business start-up. Many times the owner must use his or her own personal assets, mortgaging a home, for example, to obtain a loan.

What's even riskier is that a sole proprietor has unlimited liability. In other words, all of your personal and business assets are at risk. If the business debt begins to exceed the assets, creditors may obtain the personal assets of the owner to cover the outstanding debt. Another drawback is that a sole proprietorship cannot exist without the owner. Upon death, the business dies.

The protection of incorporating

A sole proprietor can avoid the pitfalls of unlimited liability by simply electing to incorporate. Although standard corporations can be more complex than necessary, there is the option of the S corporation. A sole proprietor may also choose to form a limited liability company (LLC).

Both S corporations and LLCs have incredible advantages. These business forms give limited liability to their owners, meaning your personal assets are not in jeopardy as they are with a sole proprietorship.

They also have the benefit of being taxed as a partnership. All income, deductions, credits, etc. "passes through" to the individual shareholders or members and are reported on their individual tax returns. This allows the two entities to avoid the double tax on income that is inflicted upon regular corporations.

It is also an attractive method to raise much-needed capital. While a corporation requires you to take on shareholders, the S corp and LLC allow you to simply sell shares to raise capital.

In many ways, S corporations are particularly ideal for small businesses. To even qualify for S corp status, the business must have fewer than 75 shareholders who are all either U.S citizens or resident aliens and only one class of stock.

LLCs allow a bit more leeway when it comes to business formation. For example, unlike S corporations, LLCs allow any entity including individuals, partnerships, trusts, estates, corporations, or other LLCs, to be owners. They offer greater flexibility than S corporations, such as not having any limits on the number of members. In addition, with the IRS "check-the-box" regulations, a business that is currently a sole proprietorship can change to an LLC with no tax consequences.

It is important to note that since LLCs are a relatively new type of business entity, their track record with the courts and the IRS is not as well established as an S corp. There is a narrow body of court cases that limit the LLC's member liability protection to withstand certain court challenges. Additionally, all 50 states are not uniform in their tax treatment of LLCs. Until a nationally uniform set of rules is agreed upon, confusion may arise when LLCs engage directly or indirectly in multi-state operations

If your company is thinking about bringing on another owner, or if the unlimited liability is too intimidating, an S corp or LLC could be very beneficial choice for your business. However, be sure to investigate all of your business formation options with your legal and tax professionals before venturing into business as a different entity.

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Stephanie Morrow

About the Author

Stephanie Morrow

Stephanie Morrow has been a contributor to LegalZoom since 2005 and has written about nearly all aspects of law, from ta… Read more

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of the author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.