02 / 10 / 2014

Avoiding The Crosshairs of Sole Proprietorships

Every business has a story. The beginning of their story is often humble with nothing but a novel idea and a steely determination. Sitting in a garage, spare bedroom, or booth of a diner an entrepreneur may create the next Apple, Google, or Amazon for the world. That is the American Dream; to create something truly from the “ground up.” Initially most of these businesses operate as a sole proprietorship, meaning that there is no distinction between the business owner and the business itself.  This seems like a logical choice, as many business owners, especially those in specialized or technical areas, market their personal reputation and skills to grow their business. However, problems arise when that business evolves from a part-time home-based hobby to a growing and profitable venture.

You started a business to build something for yourself, to be independent, and let your success be determined by your skills and determination, while doing something you love to do. Most business people want to build an enterprise that someday will outgrow them. At some point, it is normal for a business to transition away from the owner working in the trenches, to hiring young guns or bringing in business partners to take the company to the next level.

So, why should a business owner transition from a very comfortable sole proprietorship to a more formal legal entity, such as a corporation or limited liability company? The answer, is the same as why your business is a success in the first place. It is because of you. Sole proprietorships do not draw a practical distinction between the activities of the business and its owner. So, while many professionals and service providers are successful because their business promotes the owner’s skill and expertise, the obligations and liabilities of a sole proprietorship are also the liabilities and obligations of the business owner.

When your business is large enough to hire employees or look for additional capital or skill sets through employees, partners, or investors the rationale for a sole proprietorship or a general partnership are typically long gone.

With the increased expansion of the business comes the increased risk of liability. Liabilities may include contract debts and potential lawsuits you may face as a result of something that happens in the normal course of your business. It is axiomatic that the more successful your business becomes, the greater the likelihood you will be sued. Unfortunately, if you are unable to dismiss a lawsuit early in the litigation process, there is a chance that a jury may find against the sole proprietorship or a general partnership, which is essentially a judgment against you. A plaintiff may then try to satisfy the judgment by going after your non-exempt personal assets.

Sometimes, a business will diversify by bringing in partners, but not transitioning to a legal entity, with the hope that a co-owner will share some of the business and financial load. If you decide to make the sole proprietorship a general partnership – where two or more partners agree to operate the business, and share in the profits and losses – you have essentially “doubled down” on your exposure. Not only do you have to worry about yourself but, in a general partnership, you also have to worry about your business partners and their conduct because every general partner is both a principal and an agent of his or her partnership, and is able to bind the partnership to obligations, regardless of whether the other partners know about it or not. Every general partner is personally liable to an unlimited extent for any conduct (act) or omission of any other general partner.

The only downside to setting up a separate stand-alone legal entity is the slightly more formal requirement of the operating business entity. Yes, you have to file separate tax return, and yes, you should consult with business attorneys, at least on a quarterly basis, to ensure company documents are periodically updated and that the company is operating and functioning appropriately.

Business and corporate attorneys, such as the Dallas business attorneys at the Vethan Law Firm, routinely assist businesses and business people with issues regarding corporate governance, employment law matters, and assist in implementing policies to protect its intellectual property rights. Our attorneys are experienced and enjoy working with business people. We look forward to working with you and your management team to address your business and corporate concerns.

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