by Richard Keyt, Arizona LLC Attorney
This article is part of a series of nine related articles I wrote about the seven types of entities used in Arizona to operate a business and to hold business assets and investment real estate. The articles are: (1) the “Best” Arizona Entity, (2) limited liability companies, (3) sole proprietorships, (4) general partnerships, (5) limited partnerships, (6) C corporations, (7) S corporations, (8) business trusts, , and (9) the entity comparison table. The type of entity can have significant income tax and asset protection consequences. The articles discuss the entities in terms of ease and cost of formation, number of owners & restrictions on ownership, privacy, control and management, owners protection from liabilities of the entity, and federal income taxation issues.
Arizona Sole Proprietorship
Warning: Never, never, never, never own or operate a business as a sole proprietorship because the owner is 100 percent liable for everything that goes wrong and his or her life savings is at risk.
Ease of Formation & Cost
The sole proprietorship is the simplest form of business structure and the cheapest to create. However,it is actually not an entity. An individual operates a business as a sole proprietorship simply by engaging in business without forming an entity.
To operate as a sole proprietorship in Arizona, the owner does not have to file any formation documents with any Arizona governmental agency or pay any filing fees. Although not legally required, the owner of a sole proprietorship should consider registering the trade name of the business with the Arizona Secretary of State. The trade name of a business is the name under which the business operates, which is sometimes referred to as a “dba” or “doing business as” name. One reason to register your trade name is that the Arizona Corporation Commission and the Arizona Secretary of State will not allow another person or entity to register an identical trade name or allow a corporation, limited partnership or limited liability company to use a name that is identical to a registered trade name.
To register a trade name in Arizona, the trade name must not be deceptively similar to any trade name, corporate name, limited liability company name, or other name previously registered with the State of Arizona. The Arizona Secretary of State has an Application for Registration of Trade Name. For more information about registering a trade name read the Secretary of State’s Trade Name Handbook. To search to see if a trade name was previously registered, go the Arizona Secretary of State’s trade name search page.
Number of Owners & Restrictions
This method of business ownership is available only to a sole owner (an individual) who does not adopt any type of entity. The Internal Revenue Service defines a sole proprietorship as “someone who owns an unincorporated business by himself or herself.” The definition should actually state a sole proprietorship is “a person who owns a business and who does not operate the business using any type of entity.”
The term includes the word “sole” because it may exist only if the business is owned by one person. The IRS says “If you and your spouse jointly own and operate a business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement.”
Control & Management
The sole proprietor has total control of his or her proprietorship. There are no annual meetings, reports to be filed with the Arizona Corporation Commission or other state agency or any annual fees to be paid.
Because a sole proprietorship operating in Arizona is not required to file any documents with any Arizona government agency, the owner of an Arizona sole proprietorship is generally not a matter of public record. If, however, a sole proprietorship registers a trade name with the Arizona Secretary of State, the owner of the trade name will become a matter of public record.
Owner’s Protection from Liabilities
The biggest disadvantage associated with operating as a sole proprietorship is that the owner has unlimited liability to creditors for obligations and liabilities of the business. For example, if the sole proprietor sends a secretary to the store to purchase paper and the secretary causes an auto accident in which somebody is killed or injured or property is damaged, the sole proprietor may be personally liable for the damages. If the sole proprietor had operated the business through a corporation or a limited liability company, the sole proprietor probably would not be personally liable for any damages arising from the accident.
Caution: Because the sole proprietorship does not protect the sole proprietor from obligations and liabilities of the business, the sole proprietorship should never be used to operate a business.
Federal Income Taxation
The owner of a sole proprietorship and the business are treated as a single entity for federal income tax purposes. All income and losses of the sole proprietorship are reported on Schedule C or Schedule C-EZ on the owner’s individual federal tax return. In general, losses from the business may offset other income of the business owner.
Because the sole proprietorship is not a separate entity that pays taxes, there is no potential for double taxation that can exist with some entities that pay federal income taxes at the entity level (such as C corporations) before distributing profits to the owners.
Several CPAs have told me and I have also read that of all the types of business entities, the sole proprietor has the highest risk of being audited by the IRS. The IRS seems to target sole proprietors for excessive deductions of home office expenses, travel and entertainment, meals and automobile expenses. One way to reduce the risk of IRS audit is to operate the business using an entity such as a corporation or a limited liability company.