Sole Proprietorships: What Are They and Should I Form One?
Dec. 3, 2021
This is the second in a series of posts in which I discuss various business entity structures. In the second of this series, we discuss sole proprietorships. The sole proprietorship represents the most basic single-owner business entity type. Despite its flexibility and tax appeals, the sole proprietorship fails to protect its owners in the way many other entities do.
Ease of Formation, Simplicity, and Taxation
As essentially the single-owner version of the general partnership, the sole proprietorship offers the simplicity, flexibility, and tax advantages of the general partnership. The sole proprietorship requires neither any filing with the Texas Secretary of State nor any formal business agreements. Therefore, if one commences business without filing formation documents with the State and without any business partners, one conducts business necessarily as a sole proprietorship. Like the general partnership, the sole proprietorship does not require any formal agreements and offers a simple, flexible management structure. Indeed, the sole proprietor may conduct business however he or she desires. In a sense, because the sole proprietorship features one owner, the owner need not even reach an agreement, verbal or written, regarding division of labor, management duties, capital contributions, etc. because the single owner must accomplish all tasks himself or herself. The law does not require any recordkeeping procedures of this structure, although business logs always constitute a safe, precautionary measure.
Like the general partnership, the sole proprietorship offers pass-through taxation. This means the business does not pay tax at the entity level. Instead, the sole proprietor’s profits and losses pass through to the business owner, who includes the profits and losses in his or her individual tax returns. Without demeaning the benefits of this tax treatment, other business structures offer pass-through taxation in addition to other advantages.
Severe Liability Risks
Despite the ease and speed of establishment and favorable tax treatment, severe weaknesses plague the sole proprietorship. Like the general partnership, the sole proprietorship exposes one’s personal assets. In exchange for filing fees and formation filings, the State of Texas grants most business structures some degree of asset and liability protection. The sole proprietorship, however, does not enjoy any asset or liability protection and exposes one’s personal assets. In fact, the law treats the sole proprietorship business and its owner as one and the same entity. The sole proprietorship’s owner automatically assumes full and personal liability for the conflicts, liabilities, and lawsuits of the business. So severe is this drawback that most attorneys rarely recommend the sole proprietorship structure.
Common Misconceptions and Crucial Distinctions
I will take a moment to correct common misconceptions regarding the sole proprietorship. First, do not conflate sole proprietorships with single-member LLC’s and other single-owner entities. Single-member LLC’s or sole-member LLC’s differ from sole proprietorships and generally limit the liability of the single owner to those assets within the LLC even though a single person or entity owns the LLC. The sole proprietorship does not enjoy this protection. A single-member LLC must also file its formation with the State and pay formation fees. The term “sole proprietorship” does not refer exclusively to the number of owners and does not refer to all entities owned by a single person or entity; rather, a sole proprietorship is specifically a person or entity that commences business without paying any fees and without filing formation documents.
Second, an assumed name certificate, commonly known as a “DBA,” does not grant any asset or liability protection despite the modest filing fee. A business operating under a “DBA” alone is a sole proprietorship and generally suffers from the asset and liability dangers discussed in this article. DBA’s exclusively concern the naming rights of the business and generally do not impart any asset protection or liability limitation. We will discuss DBA’s in greater detail in a separate post.
Diab Law Firm