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Why Sole Proprietorships Are Accidents Waiting To Happen

Most businesses in the United States are operated as sole proprietorships.  This means that the individual who operates the business owns the business personally.  Sole proprietorships have really only one advantage….they are very easy to get started.  There is no separate entity to set up.  All you need to do is open up a bank account under a separate tax identification number and you are in business.  If you operate under a name other than your personal legal name, you must obtain a fictitious name registration in most states.  Depending on the activity you are engaging in, you may need to obtain licenses from the state or federal government.  But ease of starting the business is the ONLY benefit of a sole proprietorship.

Sole proprietorships provide absolutely no protection of personal assets from liabilities that may occur in the business.   If you operate your business as a sole proprietorship, your house, your investments, your bank accounts, and all of your personal assets are subject to attachment and are vulnerable to the liabilities that may occur in your business.

This is because there is no separate and distinct legal entity between your personal assets and your business assets.  In a sole proprietorship all business assets are owned individually.  All liability from the business runs to you individually.

One example taken from an actual case illustrates the devastating results of operating as a sole proprietorship.  The names have been changed to protect the identity of the person that this happened to.

 Jim owned a lawn service as a sole proprietorship.  Jim’s Lawn Service obtained a fictitious name registration, but never registered as a corporation.  After working hard for other people for many years, Jim had managed to buy his own home and had accumulated a nice little savings account of around $50,000.00.  having tired of working for other people, he started his lawn care service.  He purchased lawn care equipment from a company that was going out of business.  Between his truck, trailer, and lawn equipment,  he had approximately $50,000 worth of assets in his business.  He obtained a loan from the bank to purchase these items.  After about a year, he had managed to pay down the loan so that he had around $25,000 in equity in his business assets.  Jim also loved toys.  He owned a jet ski, a camper, a ski boat and motor. 

One day, while water skiing, Jim took a very bad fall.  He did severe damage to his neck and back and suffered a severe concussion.  Jim was unable to work after the accident.  His business came to a screeching halt.  He tired to have employees take over much of the responsibility, but this lead to more problems, customer complaints and headaches.  After four months, Jim’s business was run into the ground.  He was 2 months late on his payment to the bank for his business loan. 

 Jim tried to explain to the bank.  At first the bank was willing to try to work with him.  But after four months of no payment had gone by and there was no real indication of when Jim would be able to return to the business, the bank called the loan, repossessed the equipment, had the equipment sold at auction, and then began collection action against Jim on the deficiency.  At auction, Jim’s equipment had only brought $10,000.  The bank obtained a judgment against Jim personally for the $40,000 deficiency.

 There was nothing that Jim could do about this.  He had spent much of his $50,000 in savings to support his household expenses during his period of recovery.  He was down to around $20,000 in the bank.  And he needed this money to keep his house going in the foreseeable future.  He couldn’t afford to spend that money to hire and attorney.  And he felt that he couldn’t risk spending that money to keep his business going.  It was time for Jim to realize that his business was finished.

 Jim felt that he had some time.  He could keep his house and family going, if they pinched pennies, for another six to eight months.  In the meantime, his wife would go back to work and hopefully by the end of that time, he would be recovered to the extent that he could get a job somewhere.  So Jim convinced himself that everything would be alright.

But then Jim received certified mail from the bank that they would be attaching his bank account to satisfy the deficiency judgment.  Around the same time, Jim received another certified mail.  He was being sued by one of his employees.  Apparently, one of the persons that Jim had hired to take over his business while he was recovering, had an accident and done some damage to his leg while on the job.  He was now seeking compensation fro his injuries from Jim.

So Jim was now facing having his personal savings taken to satisfy the bank loan.  Additionally, the rest of his personal assets were vulnerable to the employee lawsuit.  And on top of this, Jim had trade creditors that were breathing down his back for another $15,000.

Jim finally went to see an attorney.  The attorney advised him that he had no choice at this point than to take a personal bankruptcy.  This would stop all the collection efforts against him.  The downside was that he would have to liquidate his personal assets.

Jim would never had been in this situation if he had operated his business through a corporation.  The bank loan would have been in the name of the Corporation.  The employee lawsuit would have been against the Corporation and the Corporation’s assets; not against Jim individually.  The trade creditors would have had claims against the corporation; not against Jim individually.  When Jim went to see the attorney, had he been incorporated, the attorney’s answer would have been completely different.  Jim’s personal assets would not have been vulnerable and Jim would not have had to face personal bankruptcy.

Jim learned a very expensive lesson  with this case.  His friend had told him that it didn’t pay to incorporate unless his business was making over $50,000 per year.  This is a common myth that is heard time after time.  This is a myth.  Regardless of the level of revenues of your business, you should incorporate.  This is because the potential liabilities from operating your business are the relevant factor; not the level of revenues achieved through your business.  If you are not incorporated, all of these potential liabilities present risk to your personal assets.  Jim’s life would be much different today if he would have incorporated his business.

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