Sole proprietorships and partnerships work well for small businesses that are just getting started and have few risks. However, there are some serious drawbacks to these business structures that business owners should consider as the company grows. If you have a small business that has few assets, then a sole proprietorship or partnership may make sense, but if you want asset protection and limited liability, another business structure may work better.
Concerns About Liability for Sole Proprietorships and Partnerships
A sole proprietorship is really just an extension of a single person. It is not a separate legal entity, and income and costs are submitted directly on the individual’s tax return on Schedule C. Because a sole proprietorship is not a separate legal entity, it offers no asset protection or protection from liabilities.
Everything you own as a sole proprietorship essentially merges with you as an individual. That also means that you put your own assets at risk, including things like your home, vehicle, and non-business-related funds. There is no way to legally separate what you own as a business and what you own as an individual in a sole proprietorship.
A partnership is similar, but it has more than one owner. In terms of legal distinction and asset protection, a partnership is merely a sole proprietorship that involves more than one person. A partnership may seem like a separate legal entity because the “partnership” can be liable for debts and hold assets. It also has a separate reporting requirement for tax purposes. However, it is taxed at the same level as the individual partners, and any liabilities or assets that the partnership holds actually legally belong to the partners.
Like a sole proprietorship, then, partnerships offer no asset protection. That means that any creditor of the partnership has access to all of the property that every partner holds, whether or not those assets have anything to do with the partnership.
Do Partnerships and Sole Proprietorships Offer Any Protection?
The short answer is: No. Literally, everything you own is at risk when you operate your business under a partnership or sole proprietorship. In fact, it can affect a spouse or anyone else that you hold property jointly with as well.
Consider an example. Imagine that you and a friend are going into a side business to provide essential services for cars, such as oil changes, rotating tires, and other routine maintenance items. You dub your partnership “Jim and Dale’s Maintenance Services” and use that name to order supplies and open a bank account.
One day, you leave the radiator cap off of a car, and the car owner is upset because the mistake caused damage to his vehicle. If he brings and wins a lawsuit, he could levy on property that you and your spouse own, including your house, car, and personal bank account. That means that the mistake not only affects you, it also affects your entire family and your future. The same can be said about your partner, even though he did not do anything wrong – all of his assets are at risk as well. It does not matter that you were performing services as “Jim and Dale’s.”
There are situations where sole proprietorships and partnerships will work well for a small business. If you provide a service that has virtually no potential for liability, such as writing, tutoring, or providing translating services, this type of structure might work well. For anyone that offers a product or a riskier service, incorporating or creating a limited liability company is likely a better option.
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