The sole proprietor

• Pages: 5-50
• Author: William A. Klein,John C. Coffee Jr.,Frank Partnoy

5

Chapter 1

THE SOLE PROPRIETOR

I. OWNERSHIP ATTRIBUTES

A. PROPRIETORSHIPS AS ORGANIZATIONS

Our objective is to understand the nature and functions of business

organizations or entities. It is useful, however, to begin with an exami-

nation of the sole proprietorship, which is a business owned directly by

one individual, called a sole proprietor. Since a sole proprietorship has

no formal elements of co-ownership,1 it is usually not thought of as

‘‘business organization’’ in the legal sense. The fact is, however, that a

business owned by a sole proprietor may be large and complex, involving

many people other than the owner, and can plainly be an ‘‘organization’’

in the nonlegal sense of the term.

B. OWNERSHIP AND MANAGEMENT

Suppose that a grocery store is owned by a person, Pamela, who

devotes her full time to the management of the store. That is, she owns

and operates the store. The two functions, ownership and management

(operation), need not be combined in the same person. If Pamela hires a

person to serve as manager in her place and delegates broad decision-

making powers to that person, she is still the owner and is still called a

sole proprietor. The possibility of specialization, or separation of func-

tions, is an attribute of a sophisticated (and efficient) economic system;

it also produces the kinds of problems that require the application of

lawyer skills. But that gets ahead of our story.

C. NATURE OF OWNERSHIP INTEREST

As sole proprietor of the store, Pamela will acquire an inventory of

goods to be sold. She will become the owner of each individual item in

that inventory. (Conceivably, however, some items might be held by

Pamela, in the store, on consignment—that is, under an agreement

whereby she will sell on behalf of another person, who retains legal title

and certain risks associated with that retention of ownership.) In the

eyes of the law, she owns the food and other goods in the store in the

same sense that she owns the food in her refrigerator at home or the

shoes on her feet. She will, of course, keep separate records or accounts

1 We will disregard the element of co-

ownership created by the laws of communi-

ty property. For our purposes it is best to

think of husband and wife in a community

property state as if they were a single per-

son or economic unit.

6THE SOLE PROPRIETOR Ch. 1

of the assets devoted to the business—for the purposes, among others, of

filing tax returns and of determining for her own purposes how well, or

how badly, the business is doing. But the existence of such records does

not diminish our legal system’s concept of a sole proprietor’s direct

ownership of the assets used in the business. It is important to

understand this point in order to be able later to appreciate the signifi-

cance of incorporating the business and thereby interposing a corporate

‘‘veil’’ between individuals and the assets that they devote to a business.

II. OWNERS AND CREDITORS

A. LIABILITY FOR DEBTS; OPEN ACCOUNTS

Many of the goods in Pamela’s store will have been acquired on open

account. For example, suppose that Shirley, a soft-drink supplier with

whom Pamela does business, delivers soft drinks twice a week but mails

bills monthly and allows 20 days for payment. The amount owed by

Pamela to Shirley will depend on the amount of soft drinks that Shirley

delivers to the store, which can vary. Any indebtedness to Shirley on

this open account (sometimes called a trade account) is a personal

obligation of Pamela to Shirley. Pamela must pay the amount owed

even if her business becomes worthless. Regardless how much she owes,

she personally owns any soft drinks that have not been sold to her

customers. If she becomes bankrupt, they are an asset that is available

to settle the claims of all of her creditors.

B. LIABILITY FOR DEBTS; UNLIMITED LIABILITY

Shirley is a general creditor—as distinguished from a secured credi-

tor. A secured creditor is one whose claim is secured by specific

property, and who has first claim to the proceeds of the sale of such

property. All other creditors are general creditors. Suppose that Pame-

la owes a total of $10,000 on open accounts with suppliers such as

Shirley. Suppose further that she has borrowed $15,000 from a bank for

use in the business, on a promissory note without security. (That is, she

has borrowed $15,000 and has simply signed a piece of paper evidencing

her obligation to repay.) This, again, is a personal obligation; Pamela is

bound to repay the $15,000 regardless what happens to the business.

This would also be true if the debt were secured by business or other

property—for example, if the debt were secured by a mortgage on the

land and building used in the business. If the business fails, Pamela can

lose more than the amount that she initially decided to invest in the

business. This is the frightening prospect that is associated with the

notion of personal liability.

7OWNERS AND CREDITORSCh. 1

C. NONRECOURSE LOANS

It is possible to avoid personal liability for business debts by execut-

ing a nonrecourse loan. Such a loan would ordinarily be secured by

specific property; the lender would agree that in the event of nonpay-

ment its sole recourse would be to sell the property and apply the

proceeds to the debt. Such an arrangement would be unusual in the

kind of situation that we are examining. It would be especially unusual

and difficult to arrange for accounts with trade creditors such as the

soft-drink distributor. But it is a potential device for avoiding personal

liability—that is, for limiting loss to the amounts initially invested in the

business. A more convenient way to avoid personal liability may be to

incorporate the business; we come back to that in Chapter 3.

D. BUSINESS AND PERSONAL DEBT

Suppose that in addition to the $10,000 owed to trade creditors on

open account, and the $15,000 owed to the bank, Pamela owes $1,000 to

another bank for expenses that she charged to her credit card on a

recent vacation. Obviously this amount is also a personal obligation of

Pamela’s. If she fails to pay any of the debts, any creditor can go after

any asset. Her business creditors can seek recovery from her personal

as well as her business assets and her personal creditor can seek

recovery from her business as well as her personal assets. In the event

of bankruptcy, no distinction is drawn between business and personal

debts or between business and personal assets, except that there are

modest exemptions for certain personal assets. All non-exempt assets,

business and personal, are in the same pot and all creditors take a share

from that pot based on the amount owed to them. (Compare Sec. I(C)

above.)

E. DEBT AND EQUITY

This brief reference to personal assets and obligations is intended to

emphasize the personal nature of the obligations that Pamela incurs in

connection with her business. That point having been made, let us put

aside those obligations not connected with the business. At this point it

is convenient to introduce the terms ‘‘debt’’ and ‘‘equity.’’ Pamela’s

business debt, in our example, amounts to a total of $25,000. The

difference between the value of the business and the amount of the debt

is her equity in the business. Confusion can easily arise over the

quantity of debt and equity. For some purposes we may measure the

amounts of debt and equity in terms of market values and for other

purposes in terms of less realistic but more readily accessible figures.

Suppose, for example, that after the bank made its $15,000 loan to

Pamela, she experienced a series of reversals in her business that

reduced considerably her capacity to repay. The loan is now subject to a