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Guest post by Jennifer K. Halford, Esq.
Many of the small business owners that I have worked with are sole proprietors. This is not surprising given that setting up a sole proprietorship is a simple process. And completing the sole proprietorship's taxes is fairly simple as well. All business income and losses are simply reported on the business owner's personal income tax return.
Yet, I am careful when speaking with small business owners to point out that there are serious risks of a sole proprietor to watch out for.
The most serious risk of a sole proprietor is unlimited personal liability for the business' debts. This means that if the business is unable to pay its debts, your house, assets, and bank accounts are in jeopardy. If you are married, your spouse's interest may also be at risk.
But there are more risk to watch out for.
Another risk is that the business ends with the death of the business owner. The sole proprietor is the business. When the sole proprietor dies, the business does too.
So how do you avoid the risks of a sole proprietor?
1. Follow prudent business policies: A small business can be ruined by the financial and emotional cost of a lawsuit. One of the best ways to protect your business is to have and follow good employment policies that will protect you from employee lawsuits.
2. Invest in a good insurance policy: Insurance is vital to protecting your personal and business assets. Familiarize yourself with the types of insurance available to sole proprietors. Find an insurance agent who has experience with your type of business. Then have your agent visit your place of business and tailor a policy to the risks common to your business.
3. Protect your spouse: By definition, a sole proprietorship only has one owner. If your spouse has any involvement in your business, you must be careful that your actions do not result in the IRS classifying your business as a partnership. Talk to your accountant to make sure you are in compliance.
4. Know when to change to a corporation or LLC: The question I am asked most often by a sole proprietor is, "when should I switch to a corporation or an LLC?" The answer is unique to each business owner. Generally, if liability is a concern, a corporation or LLC can offer better protection for your personal assets. Also, if continuity or leaving your business to your family is important, you should talk with your attorney about changing into a business entity that will not end with your death.
Jennifer K. Halford is an attorney whose practice focuses on business law and estate planning. She is also a professor at California State University, Chico, where she teaches Entrepreneurial Law.