Sole Proprietorship

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Terms:


Commingling Funds:
In the context of a small, privately held company, such as a sole proprietorship, there may be occasions when the owner finds it necessary to transfer funds between her own account and that of the company. The best approach that an owner can take is to keep her bank account separate from that of the company. When an exchange of money between the two accounts occurs, as it most likely will, any such transaction should be properly accounted for and documented.

Accounts Receivable / Payable:
Accounting deals with the flow of dollars and goods/services provided by and to a company. In calculating its balance sheet, one of the statements of the company’s financial status, these flows of payments to suppliers (accounts payable) and dollars owed by customers (accounts receivable) need to be properly handled to accurately reflect such transactions.

Introduction

There is not much to say about sole proprietorships. That is not because the sole proprietorship is unimportant as a business form. On the contrary, sole proprietorships constitute the vast bulk of companies in the United States. The reason that there is little to say on this business form is that there is no legal distinction between the people who own sole proprietorships and the companies themselves.

Businesses that might be sole proprietorships:

  • Your corner deli or convenience store
  • The local pizza parlor
  • An auto mechanic

Characteristics

As stated above, there is no distinction between a sole proprietorship and the person who runs and owns the company. Thus, the individual who owns the company and the company itself are subject to the same set of legal obligations. 

Formation
The main benefit of a sole proprietorship is its ease of formation. There are no requirements mandated by the government for the creation of the business. While there are still certain filings that will need to be completed - such as permits for building or sales - there are no filings required for creating the business entity itself. See: IRS - Do you need an EIN

Anyone can create a sole proprietorship, and while the name of the form (i.e., "sole") seems to indicate that the business can only be created by one person, some states do allow for multiple owners. The people who run the company, however, need to be particularly cognizant of their actions as both the IRS and many states will imply a partnership or other business form if the owners of a sole proprietorship hold themselves out as something other than independent. See Unif. Partnership Act § 202(c)(3). In such a situation, the owners of the company may unwittingly find themselves subject to certain business and tax requirements they had not anticipated.

Finally, it is worth noting that an increasing number of states have chosen to do away with the sole proprietorship form. In these states, any individual conducting a business for profit is required to register that business with the state. 

Ownership and Operation
Ownership and operation of a sole proprietorship is generally vested in the individual who is running the business. While a sole proprietorship may hire employees, the owner should keep in mind that as the business grows, so does its complexity and exposure to potential liabilities. Thus, while a business remains small and its operations simple, a sole proprietorship is relatively easy to manage. However, as the company grows, the proprietor may wish to evaluate the form of the company and choose one of the other business forms as most appropriate for the firm's changing needs.

EXAMPLE: Harold’s golf club business, which he has always run on his own, is booming. To take advantage of the market opportunity, he decides to bring on two other people to invest in the company and help manage it. This is a great time for Harold to consider incorporating the company or forming a partnership or LLC (discussed in this chapter).

Taxation
As there is no independence of the company from the individual owner, taxation of the sole proprietorship occurs at the same rate and in the same manner as taxation of the individual owner. Typically, a proprietor will simply pay all of the firm's operating expenses directly out of the company's gross revenues and then will claim anything left over as his/her individual income.

By electing to remain a sole proprietorship, the individual owner manages to keep his/her taxation a simple and straightforward process. However, the commingling of personal and business funds, along with the loss of potential benefits that may attach to being taxed as a business, are issues that need to be considered.

EXAMPLE: Tara has been running her company as a sole proprietorship for the last three years. The company needs $5,000 to buy some new equipment and Tara pays it out of her own bank account. (Alternatively, the company might have had a stellar month so the owner simply puts some of the company’s money in her own dwindling account.) While these transactions may seem harmless, and often have no impact, they can become dangerous down the road. What if the company begins to falter economically and a bank calls in a loan? Is the owner still owed the $5,000 she put in? Probably not unless the loan was properly documented as a loan. On the other hand, what if a potential buyer looks at the books of the firm and sees a monthly deposit in an account held by the owner and not the company? It is possible that he may not want to buy the company as the balance sheet is a mess, and the exact state of the company's financial health is unclear.


Liability
Because there is no distinction between the acts of the firm and those of the individual owner, liability of the owner is inseparable from that of the company. The result of this situation is that the proprietor is potentially subject to liability for debts run up by the company, torts committed by the company, crimes committed by the company, and many acts that would otherwise be ascribed to the firm or its employees. The sole proprietor of a business is personallyliable, as is the business he or she owns, in all cases of liability. See Herman v. Galvin, 40 F. Supp. 2d 27 (D. Mass. 1999).

Often, if there is any single reason driving a shift away from a sole proprietorship, it is the issue of liability. The owner of a sole proprietorship needs to recognize the potential dangers associated with leaving a firm unincorporated or otherwise informal. Many owners do not consider the fact that dealings in their business could cost them their personal home or their child's college savings account.

Furthermore, as a business grows, so does its potential liability. Thus, while a sole proprietorship may be appropriate for the first years of a company's operation, the benefit of flexibility may ultimately be outweighed by the danger of liability that stems from leaving the business in an unincorporated form. 

EXAMPLE: Frank runs an auto mechanic shop and has six employees working for him. Frank is worried about keeping his business a sole proprietorship because, if something should happen to the business, he might lose the savings that he has accumulated with the intent of putting his kids through school. As such, he decides to elect another business form that limits his liability exposure.


Capitalization and Fund Raising
As sole proprietorships are generally small organizations, they often require relatively small amounts of initial and follow-up capital. In most cases, funding for a sole proprietorship may originate from the proprietor or his/her friends and family, in combination with loans from wealthy individuals and/or the local bank. 

Normally, if the business stays small, then these sources of funding (along with credit extended by suppliers in the form of delayed accounts receivable) should be sufficient for the company's operations. However, if these sources of capital become insufficient, or as is often the case, a bank requires incorporation as an element of completing a more sizeable loan, then altering the business form may become necessary.

EXAMPLE: Nigel’s Bowtie Palace has been doing blockbuster business. Nigel, as the sole owner, decides that it is time for the business to expand into other areas like frilly lace cravats and cummerbunds. He approaches the local Savings & Loan, where he has banked for years, and asks for a business loan to expand. The bank, though willing to make the loan, asks that as a condition of the loan, Nigel incorporate the business and keep his personal account wholly separate from the business account so that it can monitor the viability of the loan and the strength of the business. 


Liquidity
Liquidity in a sole proprietorship is simultaneously both high and low. On the one hand, the ability of a sole proprietorship to sell itself is easy given the fact that it is likely a small firm with a relatively simple capital and ownership structure. The decision to sell the company rests in the hands of one individual, the proprietor, and approval for the sale, if required of anyone else, will only be required of a creditor (e.g., a bank or supplier), who is likely to approve. 

At the same time, true liquidity in a sole proprietorship is limited in the sense that finding a buyer, particularly one that is willing to completely release the owner, is somewhat unlikely. Often, a sole proprietorship IS the individual who owns it and if that person leaves the business as a result of the sale, the goodwill that the company has and that person’s knowledge may be leaving with her. 

EXAMPLE: People buy their pizza from Dave's Pizza Shop because they like both the pizza and Dave. Thus, if Dave sells the shop to someone else, people may be less inclined to buy there. As such, the company buying Dave’s business creates a complex solution that provides limited liquidity - perhaps the sale of the company with a condition that Dave stay on for six months - prior to completion of the sale.

In the end, sale of a sole proprietorship is sometimes a complicated process depending on the history of the business, the nature of the business, and the extent to which the buyer is willing to go to purchase the company as it exists in the hands of the seller. In many cases, the sale of a sole proprietorship, or its transformation into another business shortly before sale, is a simple, hassle-free business/legal transaction. However, just as frequently, the sole proprietor may find herself in a situation where she is selling off the company's assets piecemeal, prior to liquidating the remaining interests of the firm.