What Can Happen if You Run a Business Without Forming an Entity?

In fact, Sole Proprietorships and General Partnerships – enterprises that are not registered with the state and thereby not formal business entities – make up a sizable share of all the companies operating within the United States.

A big problem with a Sole Proprietorship or General Partnership, though, is that there are no legal protections in place for the owner or owners, which can put their personal assets at risk.

If an entrepreneur running a Sole Proprietorship or a General Partnership is sued or can’t repay business debt, creditors can go after their personal bank accounts, homes, vehicles, and any other personal assets.

In my experience, many people who run Sole Proprietorships or General Partnerships aren’t aware of this risk until something happens and they find themselves facing a perilous situation.

Let’s take a closer look at the differences between a company that’s registered with the state and one that is not, and what can happen to a company operating without the benefits and protections of a formal business entity.

Unregistered Business vs. Formal Business Entity

Starting a business can be easier than you might expect. As soon as someone begins getting paid to provide a product or service, they have a business. So, if Ron cuts grass and trims shrubbery at eight of his neighbor’s properties and gets paid to do so, Ron is a Sole Proprietor operating a Sole Proprietorship.

If Juana and Julia work together to create wedding cakes and have built a clientele that keeps them busy baking and selling, they have a General Partnership. There’s no need to inform the state of what they’re doing, as they’ve started a business simply by selling the cakes they make.

These entrepreneurs are likely to need business licenses and permits, which can be issued by a local, state, or federal government. They don’t need to fill out any paperwork or pay any fees to start their businesses, however, and they don’t have to file annual reports or pay yearly fees to operate.

Sole Proprietors and General Partners are subject to pass-through taxation, which means all business income and losses flow through to their personal tax returns. The owners of an unregistered business simply file tax returns using their Social Security numbers – no Federal Tax Identification Number is required.

It’s likely that owners will have to pay quarterly taxes and they are responsible for self-employment tax, which is a combination of Social Security and Medicare taxes. While employers pay one half of those taxes for employees, people who are considered self-employed, such as Sole Proprietors and General Partners, must pay both halves.

Someone who does register a business with the state as a Corporation, LLC, or other type of business entity, on the other hand, must submit paperwork and pay fees to get the business started, and must take steps to remain in compliance with all state rules and regulations.

Those rules and regulations vary from state to state, but normally include such tasks as filing annual reports, maintaining a registered agent to accept and process important paperwork, filing timely tax returns, obtaining licenses and permits, and complying with labor laws and health and safety standards.

An LLC is taxed the same way as a Sole Proprietorship unless members choose to be taxed as a Corporation, which pays taxes on its profits at the corporate tax rate. In addition, the shareholders of a Corporation are taxed on any dividends they received, a system known as double taxation.

At this point, you might be questioning why anyone would bother to register a business instead of simply operating as a Sole Proprietorship or General Partnership, which doesn’t require paying fees or worrying about compliance issues. As you’ll soon read, however, there are some compelling reasons to do just that.

The Downside of Operating a Business Without Registering it With the State

As you’ve already read, the most significant risk of running a business without registering it with the state is the lack of liability protection you are exposed to.

While being registered as a C Corporation or LLC protects owners from personal liability if the business is sued or unable to repay business debt, the assets of entrepreneurs operating a Sole Proprietorship or General Partnership are left exposed.

If 100 wedding guests get sick after eating Juana and Julia’s cake, or Ron cuts through electric wires while trimming bushes, resulting in power outages and a fire sparked by the damaged wires, it’s likely they could be facing some serious legal consequences.

Without the personal liability protection afforded by a Corporation or LLC, Juana and Julia and Ron could be facing very serious financial issues.

Lack of personal liability protection is the biggest drawback of operating a business without the benefits of a formal business entity, but not the only one. Consider these other factors:

• Difficult to raise capital. Sole Proprietorships and General Partnerships often find it difficult to raise capital to cover startup costs or other expenses. While a Corporation can generate capital by offering ownership in exchange for money, a Sole Proprietorship or General Partnership has no shareholders and can’t sell shares, limiting the ability to generate funds. And many lenders view these types of business as risks because they may lack regular income, significant savings, or insurance to protect them against lawsuits.
• Limited opportunity for growth. A Sole Proprietorship is by definition a business owned and run by one person. If that person takes on a partner, the business becomes a General Partnership, which carries many of the same disadvantages as a Sole Proprietorship. If either of these types of businesses want to hire employees, owners will need to obtain an employer identification number for tax identification, deal with worker compensation insurance, and handle other paperwork when hiring. Also, hiring employees can be difficult if you’re not able to offer competitive salaries and perks.
• Sole responsibility. Very few people are skilled in every aspect of operating a business, but that is what Sole Proprietors and General Partners are called to do. That increases the possibility that mistakes could be made, further exposing the business to risk.
• There’s no employer backup. Sole Proprietors and General Partners don’t have the luxury of an employer who pays them a set amount of money at regular intervals. Instead, they take money out of the business to cover personal expenses – income that is transferred from a business bank account to a personal account and known as a “draw.” If the business is struggling to get customers and generate income, however, there may not be sufficient money available to transfer to the personal bank accounts of owners, making it difficult for them to cover costs of living.
• Difficult to sell the business. Because a Sole Proprietorship or General Partnership is not separate from its owner or owners, the business cannot be sold. Assets of the business, such as the name, licenses and permits, inventory, real estate, supplies and equipment, and raw materials can be offered for sale, but not the business itself. So, while owners can divest themselves of property and other assets, they remain burdened with any business liabilities a buyer doesn’t want, such as outstanding loans or unfinished contracts.
• The business dies with the owner. Again, because there is no legal distinction between an unregistered business and its owner, the business normally will cease to exist after the owner dies.
• Viewed as less legitimate. It may not be warranted, but a business such as a Sole Proprietorship or General Partnership that is not registered with the state is often viewed as less professional or legitimate than a Corporation or LLC.

The Case for Forming a Corporation or LLC

Many entrepreneurs run businesses without taking the time and effort to register them as a Corporation, LLC, or other type of formal business entity. And while I recognize the ease and attractiveness of doing so, I strongly recommend against that strategy.

Registering a business with the state does require that you file paperwork, pay fees, hire a Registered Agent, and be diligent about following all rules and regulations to remain in compliance.

When you consider, however, that running your company as a recognized business entity can protect your personal assets and ultimately increase your chances for success, completing those tasks becomes well worth the effort and expense. If you’re uncertain about how to proceed with registering a business and protecting your personal assets, consult a professional who can help.