Business Forms to Avoid

Every entrepreneur must decide under what business form the venture will operate. For those small business owners that do not decide, the state will decide on their behalf. There are five major business forms from which to choose: sole proprietorship, general partnership, corporation, limited liability company, and limited partnership. (A sixth form, the limited liability partnership (LLP), is available in most states but is most commonly used by—and in some states restricted to—licensed professional service firms such as law firms, accounting firms, and medical practices.)

Simplicity of formation characterizes the first two forms, but that simplicity comes at the price of unlimited personal liability, a potentially dangerous characteristic for any business owner but particularly for the budding entrepreneur. This post will cover the business forms I believe business owners should almost always avoid: sole proprietorships and general partnerships. (If you own a business but are unsure under what business form you operate, you likely operate as one of these two forms.)

For a deeper look at the more desirable business forms, see my posts on the corporation (both C and S), the limited liability company (LLC), and the limited partnership (LP).

Sole Proprietorship

A sole proprietorship is owned and operated by a single individual. There is no legal distinction between the owner and the business, and so consequently, the debts and obligations of the business are the debts and obligations of the business owner. This means that the business’s creditors may pursue the owner’s personal assets to satisfy the debts of the business.

In addition, any legal liability that the business incurs the sole proprietor incurs as well. So, for example, if a customer slips and falls in the parking lot, that customer may be able to sue the business owner personally for any injuries sustained. Consequently, the sole proprietor’s home, car, bank accounts, and other personal assets are at risk. While the business owner may have insurance to cover such incidents, a claim in excess of policy limits or a simple denial of coverage could spell financial ruin for the entrepreneur.

This aspect of unlimited liability becomes particularly concerning in light of the legal doctrine of respondeat superior, which states that a business is liable for the actions of its employees. So if an employee injures someone in the course of his or her duties—even while performing those duties negligently or in violation of the company’s rules and policies—the business could potentially be held liable for the resulting damages.

Since a sole proprietorship comes with unlimited liability, the business’s liability for the employee’s actions can easily become the small business owner’s personal liability. While it may seem inherently unfair that a business owner could lose his or her home on account of an employee’s negligent or malicious behavior, that is the nature of operating as a sole proprietor.

While there are some advantages to operating as a sole proprietor, almost all of them may be obtained through another business form with limited liability protections. The ease of setup and lack of continuing formalities that characterize sole proprietorships are greatly outweighed by the inherent risks. I therefore generally recommend that business owners avoid operating as sole proprietors, particularly since operating under a limited liability entity, such as an LLC, is relatively inexpensive and quite manageable. In Arkansas, for example, filing Articles of Organization for an LLC costs just $45 online.

Entrepreneurs operating as the sole owner of a business venture should recognize that a failure to choose a business entity will result in the entity’s classification as a sole proprietor. It is also worth noting that filing a “doing business as” (DBA) name—sometimes called a trade name or fictitious name—does not create a separate legal entity and provides no liability protection whatsoever. A DBA simply allows the sole proprietor to operate under a different name; the owner remains personally liable for all business debts and obligations.

General Partnership

A general partnership exists where two or more individuals run a for-profit business together and no other business form has been selected. Like a sole proprietorship, a general partnership subjects the partners to unlimited personal liability. In a general partnership, however, not only are the partners personally liable for the debts and obligations of the business and its employees, but they are also personally liable for the actions of the other partners.

So, if one partner incurs a large debt on behalf of the business without the consent of the other partners, the non-consenting partner could still be held personally liable for that debt. Worse yet, if the partner incurring the debt then abandons the business and disappears, the remaining partner could be left holding the bag. For this reason, general partnerships may be even more dangerous than sole proprietorships.

Because of the unlimited liability associated with sole proprietorships and general partnerships, small business owners should consider operating as either a corporation or a limited liability company. (Limited partnerships may also be a good choice, but because they require at least one general partner with unlimited liability, they are best utilized in conjunction with a corporation or LLC serving as the general partner—and they are generally not a good fit when all partners want to be actively involved in managing the business.) See my other posts for a deeper look at these business entities and the protections they provide.

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Quick Comparison: Sole Proprietorship vs. General Partnership vs. LLC

	Sole Proprietorship	General Partnership	LLC
Personal liability	Unlimited	Unlimited (joint and several)	Generally limited to investment*
Asset protection	None	None	Personal assets shielded
Formation required	None (default)	None (default for 2+ owners)	State filing required
Respondeat superior risk	Owner personally liable	All partners personally liable	Business liable, not owners
Cost to form	Free	Free	Low (varies by state)
Ongoing formalities	Minimal	Minimal	Minimal to moderate
Tax treatment	Pass-through (Schedule C)	Pass-through (Form 1065)	Flexible (pass-through default)
Recommended?	No	No	Yes

*LLC liability protection can be lost if owners commingle personal and business funds, ignore corporate formalities, or personally guarantee business debts. See piercing the corporate veil for details.

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LLC vs. Sole Proprietorship: Video Overview

For a helpful visual walkthrough of the differences between an LLC and a sole proprietorship, see this video from LYFE Accounting:

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Frequently Asked Questions

What is a sole proprietorship?

A sole proprietorship is an unincorporated business owned and operated by a single individual. There is no legal distinction between the owner and the business, which means the owner is personally responsible for all business debts and legal liabilities.

What is a general partnership?

A general partnership is formed when two or more people run a for-profit business together without selecting another business form. Each partner shares unlimited personal liability for the business’s debts and for the actions of every other partner.

Why should I avoid a sole proprietorship?

Sole proprietorships expose your personal assets—your home, car, and bank accounts—to business debts and lawsuits. Under the doctrine of respondeat superior, you can even be held liable for injuries caused by your employees. An LLC provides the same simplicity of operation with the added protection of limited liability.

What is respondeat superior?

Respondeat superior is a legal doctrine holding that a business is liable for the actions of its employees performed within the scope of their duties. For sole proprietors and general partners, this means personal liability for employee conduct—even if the employee acted negligently or violated company policies.

How is a general partnership more dangerous than a sole proprietorship?

In a general partnership, each partner is personally liable not only for business debts and employee actions but also for the actions of every other partner. If one partner incurs a large debt or commits a wrongful act on behalf of the business, the other partners can be held personally liable even without their knowledge or consent.

How much does it cost to form an LLC?

LLC formation costs vary by state but are generally low—typically between $35 and $520 for the initial filing fee, with most states charging under $150. Arkansas, for example, charges $45 for online filing. Some states also require an annual report or franchise tax. Compared to the unlimited personal liability of a sole proprietorship or general partnership, the cost of forming an LLC is a modest investment in protecting your personal assets.

Does filing a DBA protect me from liability?

No. A “doing business as” (DBA) filing—also called a trade name or fictitious name—simply allows you to operate under a name other than your legal name. It does not create a separate legal entity and provides no liability protection. If you are a sole proprietor with a DBA, you are still personally liable for all business debts and obligations. To obtain liability protection, you need to form an LLC or corporation.

What business form should I choose instead?

Most small business owners should consider forming a limited liability company (LLC) or a corporation. Both forms create a legal separation between the owner’s personal assets and the business’s liabilities. An LLC is generally the most accessible option: it is relatively inexpensive to form and does not require the extensive formalities of a corporation.

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This article provides general legal information for educational purposes. It does not constitute legal advice and should not be relied upon as such. Business formation laws vary by state, and entrepreneurs should consult a licensed attorney in their jurisdiction before making decisions about business structure.