Many people who go into business for themselves will decide to work as sole proprietors. This business structure, which allows people to report business income and expenses on their individual tax returns, is attractive because it is simple, from a legal perspective, to get up and running. The potential danger to operating as a sole proprietor is that you are personally responsible for any debts that your business incurs.
Financial Liability
Although it is easy, from a legal perspective, to operate a sole proprietorship, there is a significant downside to this business structure: there is no legal distinction between your personal and professional assets and liabilities. For example, if there were a judgment against your business, you would be personally responsible for paying the entire judgment using not just your business assets, but also your personal assets. Similarly, if you face substantial debt in your personal life, you might be forced to use professional assets to pay down the debt.
Because a sole proprietorship makes no legal distinction between business assets and personal assets, and between business debts and personal debts, you could be legally required to use personal assets to pay professional debts and vice versa. For example, if you decided to stop operating your business, you would be personally responsible for paying off any business debts, such as unpaid bills or loans. If your business misses payments or defaults on loans, it will negatively reflect on your personal credit report and negatively affect your credit score.
In the worst-case scenario, you could be forced into personal bankruptcy if you don't have personal and professional assets to pay a debt. Or, you could lose your business if you had to liquidate professional assets to pay a personal debt.
Other business structures, such as a limited liability company and a corporation, legally allow you to separate your professional and personal assets, thus protecting them if you incur a substantial debt.
Bankruptcy
If you have insufficient assets to cover your personal or professional debts, you could be forced to file for bankruptcy. Sole proprietors may be eligible for the following types of bankruptcy:
- Chapter 7 personal bankruptcy requires you to liquidate or sell your assets to pay your personal and professional creditors. You'll be able to retain ownership of certain exempt property. Certain debts will survive bankruptcy, including personal and professional liens against you, income tax obligations less than 3 years old and certain debts incurred within 90 days of filing for bankruptcy.
- Chapter 11 reorganization provides partial or complete relief from some debts and contracts. Chapter 11 reorganization is subject to approval court approval with input from your creditors.
- Chapter 13 personal bankruptcy allows you to propose a 3- to 5-year plan to repay creditors. Eligibility for Chapter 13 is limited to individuals with debt that is less than certain limits.
Death of the Sole Proprietor
It's difficult to contemplate your own death, but as a sole proprietor, it is important to understand what happens to your business when you die.
As a sole proprietor, your business ceases to exist when you die. Your business's assets and liabilities become part of your estate. The executor or administrator of your estate will be responsible for liquidating these assets and paying your business debts; money that's left over will become part of your estate to be distributed according to your will, or if you did not have a will, to your heirs as provided by state intestacy law.
Questions for Your Attorney
- What is the best way to legally structure my business to protect my personal assets?
- What are the potential liabilities I face if my sole proprietorship incurs significant debt?
- If a sole proprietorship is not the best form for my business, can I change it to another form?