Every entrepreneur must decide under what business form the venture will operate. For those small business owners that do not decide, the state will decide on their behalf. There are five major business forms from which to choose: sole proprietorship, general partnership, corporation, limited liability company, and limited partnership.
Simplicity of formation characterize the first two forms but that simplicity comes at the price of unlimited personal liability, a potentially dangerous characteristic for any business owner but particularly for the budding entrepreneur. This post will cover the business forms I believe business owners should almost always avoid: sole proprietorships and general partnerships. (If you own a business but are unsure under what business form you operate, you likely operate as one of these two forms.)
Subsequent posts will address the more desirable business forms available: the corporation (both C and S), the limited liability company (LLC), and the limited partnership (LP).
A sole proprietorship is owned and operated by a single individual. There is no legal distinction between the owner and the business, and so consequently, the debts and obligations of the business are the debts and obligations of the business owner. This means that the business’s creditors may pursue the owner’s personal assets to satisfy the debts of the business.
In addition, any legal liability that the business incurs the sole proprietor incurs as well. So, for example, if a customer slips and falls in the parking lot, that customer may be able to sue the business owner personally for any injuries sustained. Consequently, the sole proprietor’s home, car, bank accounts, and other personal assets are at risk. While the business owner may have insurance to cover such incidents, a claim in excess of policy limits or a simple denial of coverage could spell financial ruin for the entrepreneur.
This aspect of unlimited liability becomes particularly concerning in light of the legal doctrine of respondeat superior, which states that a business is liable for the actions of its employees. So if an employee injures someone in the course of his or her duties—even while performing those duties negligently or in violation of the company’s rules and policies—the business could potentially be held liable for the resulting damages.
Since a sole proprietorship comes with unlimited liability, the business’s liability for the employee’s actions can easily become the small business owner’s personal liability. While it may seem inherently unfair that a business owner could lose his or her home on account of an employee’s negligent or malicious behavior, that is the nature of operating as a sole proprietor.
While there are some advantages to operating as a sole proprietor, almost all of them may be obtained through another business form with limited liability protections. The ease of setup and lack of continuing formalities that characterize sole proprietorships are greatly outweighed by the inherent risks. I therefore generally recommend that business owners avoid operating as sole proprietors, particularly since operating under a limited liability entity, such as an LLC, is relatively inexpensive and quite manageable.
Entrepreneurs operating as the sole owner of a business venture should recognize that a failure to choose a business entity will result in the entity’s classification as a sole proprietor.
A general partnership exists where two or more individuals run a for-profit business together and no other business form has been selected. Like a sole proprietorship, a general partnership subjects the partners to unlimited personal liability. In a general partnership, however, not only are the partners personally liable for the debts and obligations of the business and its employees, but they are also personally liable for the actions of the other partners.
So, if one partner incurs a large debt on behalf of the business without the consent of the other partners, the non-consenting partner could still be held personally liable for that debt. Worse yet, if the partner incurring the debt then abandons the business and disappears, the remaining partner could be left holding the bag. For this reason, general partnerships may be even more dangerous than sole proprietorship.
Because of the unlimited liability associated with sole proprietorships and general partnerships, small business owners should consider operating as either a corporation or a limited liability company. (Limited partnerships may also be a good choice, but they are best utilized in conjunction with a corporation or LLC.) Future posts will further explain these types of business entities and the protections they provide.