L I A B I L I T Y (screaming caps locks intended)…that’s the single most important difference between an LLC and sole proprietorship. The following story will illustrate why sole proprietorships are inadequate for most businesses.
Jack studied as an engineer and diligently paid his student loans. He paid his loans and saved enough to buy a wedding ring, start a family, and even buy a home. He felt he was in a good place to pursue his dream of owning a tackle shop at the beach. Jack’s wife was a nurse who loved her job, but wanted to slow down and focus on her own hobbies and family. So, they took the leap, Jack opened up his shop and his wife stayed home. Everything was amazing!
Scenario 1: Who Pays for Debts in a Sole Proprietorship?
Soon after opening “Jack’s Tackle and Supply Shop,” an industrious young man convinced Jack to broaden his horizons and sell offshore fishing boats out of the large parking lot in the back of the store. Jack quickly sold several boats, so he decided to place a large order of 10 boats valued at $50,000 each and agreed to pay the boat company $500,000 by the end of the year – and of course Jack would mark the price up which is where he would make a little money on each boat sold. One week after delivery of the fleet, a hurricane devastated the area destroying all the docks and shutting down businesses. All the new boats were damaged, but not totaled. Still the value of the boats dropped 25%. The boat company did not care, they wanted full payment. Because the docks were gone and the depreciation in the value of the boats, all Jack could do was sell 5 boats for a total of $187,500, leaving $312,500 outstanding. Where does that money come from?
You guessed it, Jack’s store, and Jack, personally. The value of the store is $50,000 – merchandise, website, logo, goodwill. Jack and his wife got $50,000 for the new cars they had purchase which they promptly paid to the debt. They still owed $212,500. They sold their home to pay the bulk of the debt (albeit there are some homestead protections) and found the remaining money by robbing their 401k (and of course were hit with fees and penalties). All said, Jack and his wife were doing well one week and the next week set them back more than 15 years.
Alternatively, had Jack set up his business as an LLC, only the business would have been on the hook. The store, the cars, the home, and 401k would have been safe. Moreover, the boat company may have been more willing to give him time to make payments if they were faced with more limited recovery options.
Scenario 2: Who Pays If Someone Is Injured?
The day before Jack’s Tackle and Supply Shop” opened, a boy stopped by to purchase bait. The boy didn’t realize the store was not yet open. When he entered the shop, the boy slipped on wet paint and hit his head on a stack of bricks. The fall caused serious brain damage. A personal injury lawyer sued. Unfortunately, Jack’s general liability insurance coverage had not yet begun. If a jury returns a multimillion-dollar verdict, how will Jack and his wife pay? The businesses and cars will be the first to go, then who knows maybe a lien on the house or potentially foreclosure.
The only way to avoid this kind of unfortunate event is to limit liability by setting a business up for success, and that means carefully considering the proper entity formation. There are many options including a limited liability company, various forms of partnerships, and corporations. The taxation of the entities can matter too. Some can be S-Corps or pass through or the business can be taxed.
This story isn’t one of being afraid to start a business, but rather empowerment. Now that you know the difference between an LLC and Sole Proprietorship is massive, none of the stories apply to you. In other words, don’t be a Jack and default to a sole proprietorship. You owe yourself and your business liability protection.
Put your mind at ease and use Drafted Legal’s LLC Setup and Templates to start the right way. Take is a step further with the legal education you need to protect your business in the Business Law 101 Course.