11.1 Sole Proprietorships

Figure 11.2

Entrepreneurs like Lily must decide what form to conduct business in.

© Thinkstock

Lily, a college sophomore, is home for the summer. Unable to find even part-time work in a tough economy, she begins to help her parents by cleaning up their overgrown garden. After a few days of this work, Lily discovers that she enjoys doing this and is good at it. The neighbors see the work Lily is doing, and they ask her to help their gardens too. Within a week, Lily has scheduled appointments and jobs throughout the neighborhood. Using the money she has earned, she places orders for additional landscaping equipment and materials with a local retailer. Within a month, she is so busy that she has to hire workers to do some of the more routine tasks, such as mulching and lawn mowing, for her. By the middle of summer, Lily has applied knowledge she picked up in her business classes by developing a name for her business (Lily’s Landscaping) and developing marketing materials such as a Facebook fan page, flyers to be posted at local stores, business cards, and a YouTube video showing her projects. By the end of the summer, Lily has earned a healthy profit for all her work and developed valuable know-how on how to run her business. She has to stop working when the weather gets cooler and she returns to school, but promises herself to restart the business next summer.

Lily is a sole proprietorA type of business where there is no legal distinction between the business and its owner., the most common form of doing business in the United States. From a legal perspective, there is absolutely no difference between Lily and Lily’s Landscaping—they are one and the same, and completely interchangeable with each other. If Lily’s Landscaping makes a profit, that money belongs exclusively to Lily. If Lily’s Landscaping needs to pay a bill to a supplier or creditor, and Lily’s Landscaping doesn’t have the money, then Lily has to pay the bill. When Lily’s Landscaping enters into a contract to plant a new flower garden, it is actually Lily that is entering into the contract. If Lily’s Landscaping wants to open a bank account to accept customer payments or to pay bills, then Lily will actually own the account. When Lily’s Landscaping enters into a contract promising to pay a worker to mow lawns or lay mulch, it is actually Lily that is entering into that contract. Lily can even apply for a “doing business as” or d.b.a. filing in her state, so that her business can carry on under the fictitious name “Lily’s Landscaping.” Note, however, that legally Lily’s Landscaping is still no different from Lily herself. Any fictitious name therefore cannot have any words in it that suggest a separate entity, such as “Corp.” or “Inc.”

There are many advantages to doing business as a sole proprietor, advantages that make this form of doing business extremely popular. First, it’s easy to create a sole proprietorship. In effect, there is no creation cost or time, since there is nothing to create. The entrepreneurA person who organizes a business and carries the risk of loss and reward of profit with it. in charge of the business simply starts doing business, charging money, and providing goods or services. Depending on the business, some sole proprietors may need to obtain permits or licenses before they can begin operating. A pizza restaurant, for example, may need to obtain a food service license, while a bar or tavern may need to obtain a liquor license. A small grocery store may need a license to collect sales tax. Do not confuse these governmental permits with legal approval for a business organization; in a sole proprietorship, the license is granted to the individual owner.

Another key advantage to sole proprietorships is autonomy. Since the owner is the business, Lily can decide for herself what she wants to do to Lily’s Landscaping. She could set her own hours, grow as quickly or slowly as she wants, expand into new lines of businesses, take a vacation, or wind down the business, all at her own whim and direction. That autonomy also comes with total ownership of the business’s finances. All the money that Lily’s Landscaping takes in, even if it is in a separate bank account, belongs to Lily, and she can do with that money whatever she wants.

These advantages must be weighed against some very important disadvantages. First, since a sole proprietorship can have only one owner, it is impossible to bring in others to the business. Lily cannot bring in her college roommate to work on Web site design as a partner in the business, for example. In addition, since the business and the owner are identical, it is impossible to pass on the business from Lily. If Lily dies, the business dies with her. Of course, she can always sell or give away the business assets (equipment, inventory, as well as intangible assets such as customer lists and goodwill).

Raising working capital can be a problem for sole proprietors, especially those early in their business ventures. Many entrepreneurial ventures are built on great ideas but need capital to flourish and develop. If the entrepreneur lacks individual wealth, then he or she must seek those funds from other sources. For example, if Lily decides to expand her business and asks her wealthy uncle to invest money in Lily’s Landscaping, there is no way for her uncle to participate as a profit-sharing owner in the business. He can make a loan to her, or enter into a profit-sharing contract with her, but there is no way for him to own any part of Lily’s Landscaping. Traditionally, most sole proprietors seek funding from banks. Banks approach these loans just like any other personal loan to an individual, such as a car loan or mortgage. Down payment requirements may be high, and typically the banks require some form of personal collateral to guarantee the loan, even though the loan is to be used to grow the business. Many sole proprietors resort to running their personal credit cards to the maximum limit, or transferring balances between credit cards, in the early stage of their business.

In certain industries, entrepreneurs may be able to find financing through venture capitalMoney invested in an unproven or new start-up business.. Venture capital firms combine funds from institutional investors and high net-worth individuals (known as angel investorsAffluent individuals (or groups of individuals) who provide capital to start-up and early-stage businesses.) to identify promising start-ups, and to fund them in a private placementA nonpublic offering in which a business sells securities to a few chosen and qualified investors to raise capital. offering until the start-up has developed its technology to a commercially feasible stage. At that point the venture capital firm seeks an exit strategy, typically through offering sale of the business to the public in an initial public offering (IPO)The first time a corporation sells its shares to members of the public..

Tax planning can also be challenging for the sole proprietor. Since there is no legal distinction between the owner and the business, all the income generated by the business is treated as ordinary personal income to the owner. The United States has several income tax rates depending on the type of income being taxed, and ordinary personal income typically suffers the highest rate of taxation. Being able to plan effectively to take advantage of lower income tax rates is very difficult for the sole proprietor.

Finally, sole proprietors suffer from one hugely unattractive feature: unlimited liabilityAn undesirable situation where if the debts of the business exceed its ability to pay, creditors may reach the personal assets of the business owners.. Since there is no difference between the owner and the business, the owner is personally liable for all the business’s debts and obligations. For example, let’s say that Lily’s Landscaping runs into some financial trouble and is unable to generate planned revenue in a given month due to unexpectedly bad weather. Creditors of the business include landscaping supply stores, employees, and outside contractors such as the company that prints business cards and maintains the business Web site. Lily is personally liable to pay these bills, and if she doesn’t she can be sued for breach of contract. Some proprietors are very successful and can generate many hundreds of thousands of dollars in profit every year. Unlimited liability puts all the personal assets of the sole proprietor reachable by creditors. Personal homes, automobiles, boats, bank accounts, retirement accounts, and college funds—all are within reach of creditors. With unlimited liability, all it takes is one successful personal injury lawsuit, not covered by insurance or exceeding insurance limits, to wipe out years of hard work by an individual business owner.

For these reasons, while sole proprietors are still the most common way of doing business in the United States, they are in many ways the most unattractive. Thankfully, modern business law creates real and viable alternatives for sole proprietors, as we’ll discuss shortly.