Liabilities of a Sole Proprietorship

Evaluate your potential liability before choosing a sole proprietorship.
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The sole proprietorship is the most common and simplest form of business in the U.S. If you're starting a company, deciding which structure to use is one of the most important decisions you face. The tax and liability issues associated with each type of business must be considered before you select one. A sole proprietorship has the fewest requirements in terms of establishing and running your business, but do your homework before deciding if it's the right choice for you.

Definition of Sole Proprietorship and the Advantages & Disadvantages

A sole proprietorship is owned and managed by a single person, though in some cases a couple also can be considered a single entity and hence a sole proprietor. Tax codes treat sole proprietorships differently from corporations and partnerships. Any taxable income is reported on the owner's personal tax return.

The advantages of a sole proprietorship include the simplicity, low cost and minimal formal requirements to establish the business; control over all decisions; the ability to sell, transfer or close the business at the owner's discretion; and avoidance of corporate tax payments. On the other hand, the owner faces potentially serious disadvantages with a sole proprietorship. Yes, she gets to make all of the decisions herself, but she is also responsible for all the business's debts and financial obligations as well as any liabilities incurred by the business. Additionally, sole proprietorships are seldom attractive to investors, meaning the owner typically must come up with her own start-up and operating funds.

Can Insurance Protect a Sole Proprietorship?

Depending on the nature of your business, you might want insurance to protect yourself against potential legal claims. Sole proprietorships do not enjoy the protection provided by other business forms, such as corporations or partnerships. In those cases, the business entity might be sued or held liable for debts, but only the business's assets are at risk. In a sole proprietorship, if financial or legal claims are made against your business, you personally are liable because, in the eyes of the law, a sole proprietorship is not legally distinct from its owner. Your personal assets are therefore at risk. Consult your insurance professional to find out exactly what type of insurance you need to protect yourself from claims against your business. Be aware that some policies exclude personal property. This definition could conceivably extend to your business equipment since there is no distinction between the business and its owner.

How Long to Keep Returns for a Sole Proprietorship?

The Internal Revenue Service expects businesses to keep tax returns and supporting records "as long as they may be needed for the administration of any provision of the Internal Revenue Code." This means you need to keep any documents or records that support an item of income or deduction on a return until the period of limitations for that return runs out. The period of limitations for most common income tax situations that might require you to refile or amend a tax form ranges from three to seven years from the time the return is filed. Any documents related to acquisition or disposition of property related to your business should also be retained until limitations periods have expired. Although it is generally recommended that you retain copies of your filed tax returns to help with future returns or amended returns, theoretically you could discard materials older than seven years, based on IRS guidelines. Before you discard any tax documents or supporting materials, however, ensure you do not need to keep them for other reasons, such as meeting insurance company or creditor requirements.

Statistics of Sole Proprietorship

The IRS reports that just over 23 million income tax returns included nonfarm sole proprietorship activity for tax year 2010, the most recent statistics available at the time of publication. This represents an increase of 1.5 percent over 2009. Profits for such businesses increased by 9.1 percent over 2009, reversing a four-year trend of declining numbers. The sector that experienced the largest increase in new business entities during this period was the health care and social assistance sector. According to the IRS, this sector increased by 5.3 percent and recorded an increase in profits of 18.2 percent from 2009 to 2010. Other sectors reflecting increased profits included the professional, scientific and technical services sector and the finance and insurance sector, with the latter enjoying a 54 percent gain in 2010. In other statistics, the percentage of sole proprietorships owned by women has grown consistently since the mid-1980s, in most years at a rate almost double that of their male counterparts' businesses. However, women traditionally are in lower-profit businesses, such as child care and personal services, and their profits remain far below those of their male peers.

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