When you choose to run your business as a sole proprietorship rather than creating a separate entity for it, the principal disadvantage is that you’re personally liable for all debts you incur through the business. This is because state governments and the IRS don’t consider your business activities as being separate from your personal transactions. However, there are ways to protect yourself from liability.
Protecting Your Home
Since it’s common for a person’s home to be his most valuable asset, it’s likely to be the first personal asset you want to protect as a sole proprietor. If you are married, protecting your home can be as simple as changing the title so that you and your spouse own it as tenants by the entirety. This type of ownership implies that you and your spouse each have a property interest in the entire home rather than 50 percent each. This is effective because business creditors cannot place a lien on the home if the debts you owe through the sole proprietorship don’t relate to your spouse. And even if you’re not married, you may be able to own the home with someone other than your spouse, but this always depends on the laws of your state.
The last thing you want is for a lawsuit to bankrupt your business and deplete your personal assets. One way to eliminate this risk is by obtaining business liability insurance policy. This is an expensive option, but it can protect you from events that may be financially devastating and put you out of business. The amount of insurance coverage necessary will depend on the type of business you operate. For example, if you work in the construction industry, one little mistake can be rather costly if you are sued. In this case, choosing a policy that provides sufficient coverage is critical since you’re still personally liable for any lawsuit judgment that exceeds the amount that your insurance company will pay on your behalf. But if your sole proprietorship provides services, such as interior design consulting, a much smaller amount of insurance coverage is usually sufficient.
Since a sole proprietor is generally not responsible for the negligent acts of an independent contractor, you should attempt to use contractors rather than employees for all of your staffing needs. However, one thing of which you should be aware is that each state has different laws regarding your personal liability for the negligence of contractors. In California, for example, a sole proprietor is not responsible for a contractor’s negligence unless the job for which he hires the contractor is inherently dangerous.
Create an LLC
The most effective and inexpensive way to protect yourself from liability is to change your sole proprietorship into a limited liability company, or LLC. A LLC provides the best of both worlds. By filing a simple formation document with your state, you can separate your business and personal debts, which means that your business creditors are unable to go after your personal assets to satisfy debts and judgments of the business. However, for tax purposes, as a single- member LLC, you can continue to file your taxes as a sole proprietor.