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The Dangers of Being a Sole Proprietor

You know that operating as a sole proprietorship has a lot of risk from audit, liability and paying the most in taxes. Let's address more specifical issues from court cases. As you know partners in a partnership face a significant risk of personal liability. The same holds true for sole proprietors. As stated by an Illinois appellate court, "[t]he universal rule is that the sole proprietor is personally responsible for the activities of the business." Georsantas v. Country Mutual Ins. Co., 212 Ill.App.3d 1, 570 N.E.2d 870, 873 (1991). If a lawsuit is brought against such a business, the suit generally must be brought against the owner individually and not against the business enterprise. This is so, since a sole proprietorship has no legal existence apart from its owner. See Cashco Oil Co. v. Moses, 605 F. Supp. 70 (N.D. Ill. 1985). These rules often leads to harsh results for the owners of sole proprietorships.

This proved to be the case in Holberg & Co. v. Citizens National Assurance Co., 856 S.W.2d 515 (Tx, App. 1993). Here, Holberg & Co., a sole proprietorship owned by Robert Holberg, had an agency relationship with Citizens National, wherein it sold insurance on a commission basis. Citizens National brought a breach of contract action against the business, and received a judgment against it for $94,304.79 plus costs and expenses. After trial, the trial judge granted Citizens National's motion to modify the judgment to include Holberg individually. The appellate court approved this and affirmed the trial court's judgment.

The court stated:

When an individual is doing business under an assumed name, a judgment rendered against the unincorporated association is binding on the individual.

Id. at 517 (citing Mustang Tractor & Equip. v. Cornett, 747 S.W.2d 33 (Tex. App. 1988). This is the case since unincorporated associations have no legal existence apart from their members, Cox v. Thee Evergreen Church, 836 S.W.2d 167 (Tex. 1992), and:

[B]ecause a sole proprietorship has a legal existence only in the identity of the sole proprietor.

Holberg, 856 S.W.2d at 518 (quoting Ideal Lease Service, Inc. v. Amoco Production Co., 662 S.W.2d 951, 952 (Tex. 1984).

This is not the case with corporations, which are deemed in the law to have a separate legal existence apart from their owners. Because of this, corporate owners are not personally liable for the corporation's debts or liabilities absent a "piercing" of the "corporate veil." A sole proprietorship, on the other hand, does not provide a "veil" at all. Instead, the business debts and liabilities are those of the owner.

This rule of sole proprietorships is inherent in the form of the business organization. Some might believe that a business name such as "X, d.b.a. (doing business as) Y" will relieve them of personal liability. This is not so:

The designation 'd/b/a' means 'doing business as' but is merely descriptive of the person or corporation who does business under some other name. Doing business under another name does not create an entity distinct from the person operating the business.

Dural v. Midwest Auto City, Inc., 425 F. Supp. 1381, 1387 (D. Neb. 1977), aff'd, 578 F.2d 721 (8th Cir. 1978). This rule is universally applied throughout the country. See, e.g., Pinkerton's, Inc. v. Superior Court, 49 Cal. App.4th 1342, 57 Cal. Rptr.2d 356 (1996); Southern Ins. Co. v. Consumer Ins. Agency, Inc., 442 F. Supp. 30 (E.D. La. 1977); Wood Manufacturing Co. v. Schultz, 613 F. Supp. 878 (W.D. Ark. 1985); American Express Travel Related Services Co. v. Berlye, 202 Ga. App. 358, 414 S.E.2d 499 (1992); Krawfish

Kitchen Restaurant, Inc. v. Ardoin, 396 So.2d 990 (La. App. 1981); Jaffe v. Nocera, 493 A.2d 1003 (D.C. App. 1985); Arizona v. Ivanhoe, 165 Ariz. 272, 798 P.2d 410 (1990); Patterson v. V & M Autobody, 63 Ohio St.3d 573, 589 N.E.2d 1306 (1992); Rink v. NPN, Inc., 419 N.W.2d 194 (N.D. 1988); Thomas v. Colyin, 592 P.2d 982 (Okla. App. 1979); Vernon v. Schuster, 179 Ill.2d 338, 688 N.E.2d 1172 (1997). Thus, to operate a sole proprietorship, under any name, is to be personally liable for the debts of the business.

This rule of liability applies even if a business begins as a sole proprietorship, then converts to a corporation. For the period of time the sole proprietorship existed, personally liability attaches to the owner. Normally, if one business entity succeeds another, the purchasing entity is not liable for the debts or liabilities of the transferor business. See, e.g. , Vernon, supra; Leannais v. Cincinnati, Inc., 565 F.2d 437 (7th Cir. 1977). There are four exceptions to the general rule, however. The important one for our purposes is that the new business entity is merely a continuation of the previous one. That is, the new business has the same ownership but merely "wears different clothes." See, e.g. , Vernon, supra; Bud Antle, Inc. v. Eastern Foods, Inc., 758 F.2d 1451 (llth Cir. 1985); Welco Indus., Inc. v. Applied Cos., 67 Ohio St.3d 344, 617 N.E.2d 1129 (1993); Baltimore LuggaRe Co. v. Holtzman, 80 Md.App. 282, 562 A.2d 1286 (1989). In such a situation:

To allow the predecessor to escape liability by merely changing hats would amount to fraud. Thus, the underlying theory of the exception is that, if a [business] goes through a mere change in form without a significant change in substance, it should not be allowed to escape liability.

Vernon, supra, 688 N.E.2d at 1176 (quoting Baltimore LagRaRe, supra, 80 Md. App. at 297, 562 A.2d at 1293). Because of this exception, it would be quite dangerous for someone to begin their business as a sole proprietorship, with the thought of converting the business into a corporation at a later time. If in the interim a liability of the business arises, the owner will be personally liable. The only way to avoid personal liability is to incorporate at the outset.

One last downside of sole proprietorships is found in the area of insurance coverage. This was demonstrated in Providence Washington Ins. Co. vs. Valley Forge. Ins. Co. , 42 Cal.App.4th 1194, 50 Cal. Rptr.2d 192 (1996). Here, sole proprietor Paul Hifai operated A-1 Rent-A-Car, and also two gasoline service stations under the name Tennyson Mobil Service. The service stations routinely provided maintenance for the rental vehicles. One of the rental vehicles was involved in an accident, injuring nine people. Several lawsuits were brought upon claims that the vehicle owner negligently maintained and rented the vehicle.

Hifai tendered the action to his insurers, but two of the three denied coverage. The trial court and the appellate court sided with the insurance companies.

One of the insurance companies had issued a commercial general liability (CGL) policy to Hifai, "doing business as Tennyson Mobil Service." The other issued a garage operations policy (GOP) to Hifai, also "doing business as Tennyson Mobil Service." The CGL policy covered bodily injury caused by an accident and the GOP policy had the same general coverage, if the injury resulted from "garage operations." Importantly, both policies limited coverage for an insured's "owned-autos." The CGL policy excluded coverage for bodily injury "arising out of the ownership, maintenance, [or] use" of any auto owned by any insured. The GOP policy excluded coverage for bodily injury arising out of "an auto owned or sublet by an insured while rented, leased or loaned to another."

The business being a sole proprietorship was the key to the decision. Since such a business has no legal existence apart from the owner, the court found that Hifai, and not the business, owned the vehicle involved in the accident was also was the named insured. Thus, the vehicle was subject to the exclusions in the CGL and GOP policies, and Hifai had no coverage under these policies.

Many courts have held that the named insured under insurance policies listing the insured by a trade name or as a "dba" is the individual owner, not the business enterprise. See, e.g., Allstate Ina. Co. v. Willison, 885 P.2d 342 (Colo. App. 1994); Carlson v. Doekson Gross, Inc., 372 N.W.2d 902 (N.D. 1985); Purcell v. Allstate Ins. Co., 168 Ga. App. 863, 310 S.E.2d 530 (lg83); O’Hanlon v. Raftford Accident & Tndem. Ch., 639 F.2d 1019 (3d Cir. 1981).

Thus, a sole proprietor must exercise extreme caution in obtaining insurance for his or her business, since the business has no legal existence apart from the owner. This is not the case for corporations, which have a separate legal existence.

From all of the above, it can be seen that being a sole proprietor can present a real danger to your pocketbook. Every debt or liability of the business is the personal responsibility of the owner of the business. This liability is inherent in the form of the business, and cannot be avoided. Operating your business through an entity that provides limited liability can alleviate the problem of personal liability.


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Avoid Costly Incorporating Mistakes!

 

Why Incorporate?


The Risk of Personal Liability by not Incorporating -Read real cases when partners lose time and money by not operating through an entity.

Who Needs Asset Protection? -Read a checklist of criteria and find out why you may need more than just insurance to protect your financial net worth.

The State Rules on Exempt Assets - Discover what assets are already protected by the state.

The Limited Protection for Personal Assets Provided by Liability Insurance Policies - If you think your insurance will always protect your assets you must read this!

The Dangers of Being a Sole Proprietor! Discover how you can lose everything you worked to accumulate!

Will Insurance Protect Your Assets? - Learn critical loopholes and when insurance will not cover you!

The Notice Requirements of Business Entities Operating as D/B/A's - What are the requirements for putting the public on notice about your DBA?

State Personal Property Exemption Laws for Stoc - If you get sued, is your stock porfolio protected by state law?


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