Operating a business as a sole proprietorship- why do it?
Risk of personal assets:
I had a client who wanted to start operating under his own name immediately and did not want to wait for the incorporation process to finish. She wanted to operate her 12 employee business and begin entering contracts even though she had personal assets with value. She stated she did not need to worry because she had a One Million Dollar umbrella policy.
I advised against her operating as a sole proprietorship (also called a “dba”) for several reasons:
Any employee claim would be a claim against her, personally. Even if the employee claim was frivolous. The defense cost are staggering.
It is unlikely that an umbrella policy covering her home and cars would cover a business activity.
Further, even if the One Million Dollar policy covered the activity, often lawyers will amend their lawsuit to increase their damages over the policy limits. The purpose for this tactic is to scare the defendant into a position where the defendant does indeed have something at risk.
Operating as a dba will result in the filing a Schedule C tax return. As you know Schedule C tax returns are the most audited Returns. That is reason enough to not operate as a dba.
All of these risk are avoided if the client operates under a corporation (or LLC as the case may be).
By operating under a Corporation:
The client files a corporate tax return, the least audited Returns. Further, if the client did not have a significant history of social security earnings (many sole proprietors do not) operating under a corporation would allow her to take a salary and build her social security account. (The issue of the existence of the future of the social security fund is not the point here).
Further, by taking a salary the client no longer has to make estimated tax payments, which she often forgot to do.
Another benefit of operating under a corporation, the client will be eligible make greater deposits into a fully protected retirement account. I explained to her I was recently defending a client’s retirement account that a creditor was seeking collection against. IRAs and other non employer retirement accounts are not fully protected. Creditors can at times get to those accounts. Yet, a retirement account set up by an employer are 100% protected.
Even if that employer is the client’s own corporation where she is the sole owner and employee of that corporation. I advised her that there is a California law that states, for retirement purposes a small corporation is treated the same as a larger corporation employing several employees. As such her retirement accounts would be 100% protected from creditors.
The above reasons are just some of the reasons not to operate as a sole proprietorship. The yearly state fee and accounting expenses are worth the added protection. I always view the state franchise fee more as an insurance policy for the protection of assets. It is money well spent. Further, the accounting fee may not be that much more in cost, as Schedule C Returns can be quite expensive in their own right.