The number one easiest method of getting into business is to become a Sole Proprietor. You simply obtain a business license and a sales tax number (if required), then comply with any other State regulations, and you are in business. However, we strongly recommend that you form a corporation or LLC instead of operating as a Sole Proprietor.
Disadvantages of A Sole Proprietorship
The major drawback with a Sole Proprietorship is that its sole owner is completely liable for all business debts and claims. If a customer believes you failed to complete a contract, or someone falls on your property and your insurance does not cover it, your personal assets are at risk for the satisfaction of judgment. If, for example, you suddenly have a very disappointing month and cannot pay the bills or the credit line to the bank, then your personal bank account, the equity in your house, your car, and any other personal assets can be attached for the repayment of judgment and debts.
Over the years, many new and aspiring entrepreneurs have asked, “So, if I’m just starting out, why not be a Sole Proprietor? After all it’s simple, easy, and cheap.” The best common sense answer we can supply is, you are never just starting out. Nearly everyone has accumulated assets throughout their life and by using a Sole Proprietorship they are placing everything at serious risk.
In reality, the cost to form and maintain an LLC or Corporation is minimal compared to the risks involved with operating any other form of business. There are two well documented statistics to support this position:
- According to the American Bar Association by the end of 2007 there were over 1,143,000 lawyers in the U.S.
- One-third of all Americans will be sued at least once in their lifetime.
If you have ever been sued, then you have intimate knowledge of how it can be an extremely stressful and costly experience. Even more bizarre, there seem to be economic incentives in the legal system for outrageous frivolous lawsuits. The only way to protect yourself is to remove all your personal assets from risk. Of course, if you have never been sued, it is in your best financial interest to keep it that way by taking the legal and reasonable steps to place all your personal assets out of the reach of predatory foes.
The Risks of a General Partnership
With a General Partnership you are actually using a far less desirable entity for conducting business than a Sole Proprietorship. When two or more people agree to share profits and losses a partnership has been formed. Even if the group never signs a Partnership Agreement (which is not required by law), state law provides that under such circumstances you have formed a General Partnership. The business may have as many partners as they desire, with nothing more than a handshake on an oral agreement. To many this sounds like a blessing, but in reality it is a curse.
The number one disadvantage of a General Partnership is that each partner is liable for the debts and obligations incurred by all the other general partners. Even though you may trust your one partner not to improperly obligate the business, the more general partners you bring aboard, the greater risk you run that someone will eventually make a serious error. The result is, everyone’s personal assets are at risk. Your house and life savings can be lost through the actions of your partner. Even though you had absolutely no connection with the actions, you are still personally responsible for the decisions made and actions taken.
In a General Partnership, any general partner may obligate the business. In contrast, LLCs and Corporations offer much greater protection. Both offer the owners limited personal liability for business debts and the actions of others.
Why Insurance Coverage Isn’t Enough to Protect You
Some people have suggested that good insurance can overcome the risks of unlimited personal liability for the actions of general partners. In reality, many affordable commercial insurance policies contain high deductibles for which the partners are responsible for, and a lengthy list of exclusions designed to limit coverage. When operating a small business it’s impossible to foresee all the possible risks, and full coverage is financially out of reach. In addition, we have never heard of a policy that will cover mismanagement, or the wrongful acts of a general partner, or the inability to pay normal debts and obligations. However, LLCs and Corporations, as a matter of law, will shield their owners from such liability.
One last factor to consider is cost. An attorney will typically charge between $2000 and $5000 to write a General Partnership Agreement because each one must be custom tailored to address the specifics of each business. That is a significant amount of money for an entity document that will not protect the owners from personal liability. Generally, a good attorney will strongly recommend an LLC or Corporation which will better protect their clients at far less cost. After all, why pay more to be put at greater risk?
The Next Step: Deciding Where to Incorporate
When you form a corporation or LLC, you have to consider many different factors. The first thing you should decide is where to incorporate. Learn about the many advantages of forming your business in the state of Delaware: