I generally advise solo entrepreneurs and other self-employed folks against operating their businesses as sole proprietorships. There are significant risks and disadvantages that flow from a sole proprietorship, even if it is set up "properly." Although sole proprietorships are commonly used by "solopreneurs" and the self-employed, the personal risk exposure inherent in a sole proprietorship cannot be avoided or mitigated in the same way that can be done by running your business as a corporation or an LLC.
If you are in Los Angeles or Ventura County or elsewhere in California and currently operating a business as a sole proprietor, or if you are thinking about starting your own business as a sole proprietorship, you should talk to an experienced business lawyer. I can help you understand the risks inherent in sole proprietorships, as well as the pros and cons of corporations and limited liability companies (LLC's), advise you on the most advantageous business structure for you, and help you either form a new business entity, or transition from a sole proprietorship into a business entity.
Despite the risks of running a one-person business as a sole proprietor, some people choose to do so. But, at a minimum that decision should be an informed one.
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What is a Sole Proprietorship?
A sole proprietorship, or sole trader, is a business owned and operated by one person who receives all of the business's profits while being personally liable for all of the business's debts and liabilities, including (as contrasted with a corporation or LLC) individual risk exposure that comes from the business being sued.
While it is true that a sole proprietorship is the simplest and quickest way to start a business, there is a trade-off that business lawyers at least want their clients to understand. On the one hand, there is no formation paperwork to file, and there are no continuing obligations to file annual reports and comply with "corporate formalities" (although you may need to apply for state or industry-specific business licenses or permits or to file a trading name if different from your own).
On the other hand, as the tradeoff for this simplicity, you will personally assume all risks associated with the business. Personal assets — your house, your personal bank accounts, your car or boat or other vehicles, your stocks and art collections, your right to receive dividends or royalties from unrelated businesses, etc. — can be used to cover the business's debts and liabilities and any awards rendered against you personally in a business lawsuit or arbitration.
What a Sole Proprietorship is Not
Despite what far too many websites say, a sole proprietorship is not a business entity. It is this primary distinction that differs the sole proprietorship most importantly from corporations and limited liability companies. And, it is this main difference that results in the sole proprietor assuming the potentially damaging risks of personal liability for the business, as well as a potentially greater risk of an IRS audit.
Can You Operate a 501c3 Non-Profit as a Sole Proprietor?
No. Federal tax-exempt status under Section 501(c)(3) of the Internal Revenue Code is reserved only to qualified organizations formed exclusively for a charitable purpose. Although most are corporations, such qualified organizations can also be community chests, funds, foundations, and certain unincorporated associations.
High-Risk and Low-Risk Businesses in California
To be fair, not all industries and businesses have the same liability exposure. For example, some businesses will tend to have higher risk exposure. For example:
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- software developer or SaaS provider
- providing gourmet food products to local restaurants
- carpentry
- personal fitness trainer
- federal firearms licensee
- brewery, winery, or distillery
- web developer
- online aggregator of third-party content
- medical or dental practice
- law practice
- any business with customers that enter business property
Of course, the above list is not exhaustive.
Other businesses, however, may not carry the same risk of being sued, such as:
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- life coach
- career counselor
- tutor
- virtual assistant
- dog walker
- online courses (depending on the subject matter)
- freelance writer (be sure you are completely free of claims of plagiarism)
- running an Etsy shop or Fiverr business (depending on the nature of the goods and services)
But, beware: not only is there no guarantee that a "low risk" business won't be sued, but regardless of the business or industry, as a general matter sole proprietorships may tend to be subject to IRS audits at a higher rate than self-employed people who operate their businesses under a small corporation structure.
Before deciding whether a sole proprietorship is the best structure for your business, it is very important to weight the possible advantages against the risks.
Possible Advantages of a Sole Proprietorship in California
Some advantages to a sole proprietorship include the following:
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- Lower Setup Costs. The paperwork to start business as a sole proprietor is limited, meaning there are minimal costs and filing obligations involved. In some circumstances, you will only need to apply for relevant licenses or permits and register your business name. The setup costs will reflect the fees associated with licensing and registration. (This does not consider federal trademark filings, which will be essentially the same for sole proprietors.)
- May Be Easier to Operate. When it comes to sole proprietorships, there is much less government regulation compared to other business structures. Unlike a corporation, for example, sole proprietorships don't require a board of directors or annual meetings or other "corporate formalities." You will also (likely) not have employees, so you manage only yourself and no one else unless you enter into a contract with a third party.
- Simpler Taxation (Maybe). Sole proprietors report their business income on their personal tax returns (even if they have a separate "W-2" job as an employee for a traditional employer), which is then taxed at the personal income tax rate. Whether you are running a sidewalk lemonade stand or developing incredible and highly sophisticated websites, there is no legal distinction between you as the owner of the sole proprietorship and the sole proprietorship itself; you are one and the same.
- Sole Ownership & Control. The owner of a sole proprietorship makes all the decisions about the business, without needing to consult other owners or members or answer to shareholders. They have complete control over the business.
Of course, these advantages only benefit your business if they are aligned with your business mission, your business income, your personal tax situation, and your risk exposure and personal level of risk aversion.
Dangers of Sole Proprietorships in California
Understanding the disadvantages of a sole proprietorship will help you proactively strategize and plan your business.
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- Unlimited Personal Liability. Since the owner and business are treated as one, an owner is personally liable for the debts, liabilities, and obligations of the business including loans, rent, utilities, lawsuits and taxes. This means your personal assets can be seized to pay any liabilities.
- Full Ownership and Control. While the owner of a sole proprietorship has full control over the business and can freely make business decisions, the success and failure of the business also rests entirely on you. This can be stressful and create a heavy workload.
- Limited Funding Options. Attracting outside investment in a sole proprietorship is difficult. Due to the unlimited liability of the owner, there's no protection against creditors. Investors and banks, therefore, often view sole proprietorships at a greater risk of business failure than other structures.
- Taxation. While the profits of a sole proprietorship are passed to the owner and taxed at the personal rate, the owner has to pay both income tax and self-employment tax, which can add up.
- Risk of IRS Audit. Sole proprietors may tend to be selected for audit by the Internal Revenue Service more often (at a higher rate) than corporations. (It is also worth noting here than in some cases a single-owner LLC might carry the same risk of an IRS audit as a sole proprietor, making the corporation possibly more attractive for some self-employed business people.) Of course, operating a business as a corporation or LLC does not guarantee you will not be subject to an audit, but the likelihood may tend to be higher for you as a sole proprietor. You should speak to an experienced certified public accountant for more information.
When deciding on your business structure, you should weigh these factors in light of your circumstances.
When Should You Convert a Sole Proprietorship to a Corporation or LLC in California (or Delaware)?
My answer to that question is often: "as soon as possible." That said, sole proprietors sometimes wait until a time when they think their businesses have grown "enough" before they even begin to think about transitioning their business structures to that of a limited liability company or an S-corporation or C-corporation. If you are a sole proprietor, you should consider the risks and benefits before deciding whether to continue your sole proprietorship.
While a sole proprietorship is a great starting point for your small business, once it begins conducting higher-risk business activities, or making more money, or having customers enter their owned or leased property, or using vehicles for any part of their business, or hiring employees or independent contractors, then incorporating or forming an LLC limits the business owner's liability and may reduce the risks of having to go through the trauma, expense, frustration and uncertainty of an IRS audit.
In addition to reducing certain risks, corporations and LLCs are more heavily regulated business structures. Rather than being a negative, this makes them a more attractive investment choice for investors and lenders. You might consider forming an LLC or incorporating if you ever expect to seek third-party capital investment (including from friends and family) to expand your business.
Changing your business structure to a limited liability company, S-corporation or C-corporation as your profits increase may also unlock potential tax advantages. Regarding this, I always advise small business owners to have a good relationship with a certified public accountant (not just a bookkeeper); very often, the "best friend" of a small business is its accountant.
If you are considering incorporating your sole proprietorship or forming an LLC in Los Angeles or Ventura County or elsewhere in California, you should speak to a business lawyer for advice based on your specific circumstances and your goals for your business.
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