SHOULD I OPERATE AS A SOLE PROPRIETOR?
© 2001 By Douglas E. LoMonte
Many of the nation’s largest corporations were launched by a single entrepreneur, long on vision but short on cash. Henry Ford started Ford Motor Company in a small shed, alone with some tools and spare parts. Many a successful entrepreneur began operations without a formal business structure. Today, the law provides entrepreneurs with a variety of business structures from which to choose. See What form of business entity should I establish? Still, not all businesses require a formal business structure. If you’re just starting a business of your own or wondering whether it’s time to establish something formal, read on.
Legally, a business without a formal legal structure is classified as a sole proprietorship. With the possible exception of a trade name certificate, no forms are required to form a sole proprietorship in Connecticut.
For tax and liability purposes, sole proprietorships have no separate identity from that of their sole owners. For example, a plumber operating as a sole proprietor reports all items of income and expense on his/her Form 1040, personal income tax return. The cost of a new wrench is a deductible business expense. The customer’s payment for a new kitchen installation is ordinary income.
With respect to liability, there are two classifications with which the sole proprietor should be concerned: tort liability and contractual liability. The most applicable form of tort liability in this context is professional negligence (e.g., an electrician incorrectly wires a building, causing a fire). Often professional negligence is covered under the sole proprietor’s business insurance policy. If the insurance policy coverage limit is insufficient to cover the damage or the event is outside the coverage of the policy, the sole proprietor’s personal assets (i.e., residence, motor vehicle, bank accounts and wages) are exposed. Contractual liability arises when an individual fails to meet the obligations of a contract. Contractual liability most commonly occurs when there is a breach of:
• a lease (office space or equipment);
• an employment agreement (written or implied);
• an agreement for the performance of services; or
• a commercial loan.
Business insurance policies typically do not cover contractual liability. Therefore, the sole proprietor must generally satisfy contractual liabilities out of personal assets.
As indicated above, the danger inherent in sole proprietorships is the exposure of personal assets. That is why, in most cases, we recommend that a new business be organized as a formal business entity (i.e., a limited liability company or corporation). When a business is organized as a formal business entity, a statutory shield protects the personal assets of the owners. Connecticut statutes permit limited liability companies and corporations to be organized by a single individual. No other officers, directors or members are required.
A limited liability company or corporation is not appropriate for all entrepreneurs. There are circumstances under which there is no practical advantage to organizing a formal business entity. For example, under certain circumstances, a limited liability company or corporation may be of little value to a consultant who works from home and has no plans of ever sharing ownership or hiring employees.
To discuss whether you should operate as a sole proprietor or establish a formal business entity, please contact us for a free initial consultation. If you have any questions about this article, please email to dlomonte@wsdb.com. We look forward to hearing from you.
