A sole proprietorship is a type of business that is owned and operated by one person, with no legal distinction between the owner and the business entity. This is a common choice for many small business owners or merchants when they establish their own business because it is the least expensive option. However, sole proprietors need to be cautious. The potential liabilities that can emerge due to a lawsuit, trademark infringement, or worse, can be crippling for a business owner.

You may be asking “Why should I, as a sole proprietor, be worried?” Simply put, because there isn’t a legal division between the business and the business owner, your personal assets would be at as much risk as your business assets if the business suffers. There is no difference between the belongings of the business, and those of the owner.

To help paint a better picture of what this could mean for a sole proprietor, meet Diane.

Diane is the owner of AAA Widgets, a sole proprietorship. She has had this business for a few years, and things are going well. Suddenly, a lawsuit pops up from one of her customers, Joe Schmoe, for damages due to a product defect. The judge rules that Diane’s business, AAA Widgets, is liable and now owes Joe Schmoe $20,000 for those damages. Because AAA Widgets is a fairly new business, the funds aren’t there to pay for the judgment.
Joe Schmoe got himself a savvy lawyer, and she took Joe’s case with the chance that the outcome would be positive for both Joe’s pocketbook, and her own. After a little digging, she finds that Diane and her husband have a joint bank account with $50,000. This is an account that they have both been adding to with their separate incomes, PLUS an inheritance that Diane recently received through a family estate.

Joe’s lawyer attaches the account to the lawsuit claim to ensure the judgment is enforced. This means that the $20,000 from the lawsuit against AAA Widgets just came out of DIANE’S personal bank account! Needless to say, Diane’s husband isn’t very happy with the situation either, as they both share the account. He had told her over and over again that operating as a sole proprietor was riskier, and repeatedly urged her to incorporate the business as an LLC.

As a result of the lawsuit, AAA Widgets has now lost a significant amount of revenue for the year. This is horrible for Diane, especially because the new van and equipment she purchased for the business still needs to be paid off. The bills are piling up, and without that $20,000 in the bank, she can’t make those payments. Consequently, Diane is forced to declare bankruptcy and close the doors of AAA Widgets.

Let’s break this story down. As a sole proprietor, Diane was not protected by an extra layer or “veil” that an established LLC or C-Corporation would have. The veil is critical to split liability of the business from the personal liability of the owner.
In terms of the lawsuit, if AAA Widgets had been set up as an LLC or C-Corporation, the only assets that Joe Schmoe could have leveraged against would be those held by the business. Diane’s personal property and real estate would have been shielded from liability, as they would be separate from AAA Widget property.

This scenario is incredibly important to consider when starting your business. Let this be a lesson to learn from.