Sole proprietorships are popular business entities: they're easy to set up and you include the income on your personal tax return. However, unlike some of the more formal entity types, like limited liability companies and corporations, sole proprietorships have unlimited personal liability because the business isn't a separate legal entity. You're personally liable for all your business debts.
Any time you buy something on business credit, such as inventory or machinery, you're on the hook if the business can't come up with the cash. For example, say that you order $5,000 worth of tools for your body shop and the supplier puts the expense on the company's balance. If your body shop goes under before paying off the $5,000 for the tools, the supplier can sue you for payment.
Any time your sole proprietorship takes out a loan, you're personally liable for the debt as well because the business isn't a separate entity. If the business can't pay back the loan, the lender can come after you, so borrow carefully. For example, say your sole proprietorship takes out a $150,000 mortgage to buy a shop to sell your inventory. If the business isn't able to make enough money to cover the monthly payments, the lender can demand that you repay the loan.
As a sole proprietor, you're also personally liable for paying any judgments against the business. For example, say a customer sues your bakery because she got sick after eating one of your cookies. If a court awards $25,000 in damages against the business, you're on the hook if the business doesn't have the money. Similarly, if one of your employees hits a pedestrian while out making deliveries, and the business is found liable, you're liable, too.
Violation of Regulations
There's a mass of regulations and statutes that govern how businesses must conduct themselves. If your business runs afoul of one of these statutes, the company could be assessed fines or be forced to pay for other damages, such as clean-up costs for improper waste disposal. Again, since there's no limited liability for a sole proprietorship, the government agency issuing the fines could demand payment from you if the business doesn't have the money to cover the fees.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."