The Two Disadvantages of A Sole Proprietorship

The benefits of a sole proprietorship are well documented elsewhere–it is the default business characterization assumption that is made when a business springs into existence without filing any paperwork (though the transactions of the business may be subject to paperwork, such as the California business license requirement). The advantages of a sole proprietorship are the limited paperwork that makes it easier for a businessman to get started while lacking the expertise regarding structural formalities.

A sole proprietorship also provides a benefit in the form of reduced taxes (all profits and losses are reported on the sole proprietor’s own return, and therefore, any money extracted from the business only requires the payment of taxes once. This is a sharp contrast to the corporation structure, which can require an initial tax of possibly 35% on the profit earned within the corporation, and then an additional tax that occurs during dividend payment to the shareholders that are taxed at their capital gains rate).

The disadvantages of a sole proprietorship relate to liability and borrowing ability.

The advantage of the corporate form is that contracts and almost all torts can never pierce the corporate veil–and this is especially true if you are a passive shareholder. If the corporation car wash owes $50,000, and the corporation cannot pay it, the worst-case outcome is that the corporation car wash enters bankruptcy and the shareholders in the corporation lose the entirety of their investment that was put into the corporation. But the investors personally don’t have to pay the $50,000–once the corporation’s assets are exhausted, that is it.

A sole proprietorship does not offer this same protection in the event that the assets of the business are exhausted. If a guy running a sole proprietorship owes $50,000, and the bank account for his sole proprietorship cannot make the payments, there is no extinguishment of liability when the bank accounts and assets for the sole proprietorship run dry. If the man running the car wash as a sole proprietorship has $50,000 sitting in Coca-Cola stock in a plain vanilla brokerage account, he may be forced to sell it–at least, he remains legally liable for paying off the $50,000.

The other disadvantage relating to sole proprietorships is financing. If a sole proprietor needs to borrow money, he may visit a bank and took out a loan for the sole proprietorship. But the label is misleading because the debt of the sole proprietorship is also the debt of the individual running the sole proprietorship, making the borrowing virtually indistinguishable from personal debt. It is not incredibly uncommon for banks to be willing to extend a sole proprietor credit that is especially negotiated to apply to the sole proprietorship itself–essentially a waiver of the right to personally collect–but this exception is usually in the context of well established and highly profitable sole proprietorships and not customarily available to sole proprietorships in the early days. This waiver must be especially bargained for–it is always the default assumption that sole proprietorship debt is a personal liability of the sole proprietor.

Running a corporation does not carry this risk–the additional financing of the company can come in the form of securitization of future income streams or the issuance of stock which ties the financing to the risk of the corporation’s success. The financing for a sole proprietor is tied not only to the business, but also attaches to the person himself that runs the business.

Despite these disadvantages, it does not mean that a sole proprietorship should never be chosen. In recent years, courts have been more willing to “pierce the corporate veil” and treat the corporation’s responsibilities as that of an individual when the interests of justice seem to require it–the most egregious of intentional torts. If you are a one-man corporation running a cookie delivery service, and you drive drunk and severely injure someone, the courts are more willing to examine conduct to find an instance in which the formalities associated with a corporation were not followed and thus the court can pierce the corporate veil and hold the tortfeasor personally liable. Also, if you only enter into low-value contracts in your business, the possibility of being personally liable for the debts incurred may not be meaningful when compared against the increased cost of pursuing a corporate form. The disadvantages related to liability and financing for a sole proprietorship are very real, but sometimes the benefits of the corporation form can be exaggerated when suggesting that certain conduct won’t force a one-man operation to be held responsible.

Notice: This article, which I believe may be of interest to readers, is for general information and entertainment purposes only. It only reflects my best understanding of the topic at hand and should not be relied upon as legal or investment advice.