A Different Kind Of Risk: 3 Things You Must Know When Funding A Sole Proprietorship Published July 15, 2016
According to the United States Small Business Administration, 70% of U.S. businesses are owned and operated by sole proprietors. It is likely that, at some point, these sole proprietors will seek a loan. This presents great opportunity but also a different kind of risk for you, the lender.
When talking about sole proprietors, things get a bit dicey in regards to lending. There is no separation between business and personal finances, so things can get tricky quickly for your due diligence, and can create problems as you are attempting to determine credit worthiness. Let’s cover some important topics to consider before you lend:
3 THINGS YOU MUST KNOW WHEN FUNDING A SOLE PROPRIETORSHIP
1. Federal tax debts of the individual are one and the same as federal tax debts for the business.
The business income and losses are reported on Schedule C of the individual’s Form 1040 income tax return. This seems straightforward enough – search for the individual’s tax debts under their Social Security Number (SSN) and you’ll be able to glean your risk of both the individual and the business in one fell swoop. But in actuality, this limited search only shows you part of your exposure – the income tax liability. There could be more out there.
2. Many sole proprietors have federal tax debts under their Federal Employee Identification Numbers (FEIN).
A sole proprietor can be responsible for other types of taxes as well, not just income taxes. This is where it gets tricky. For example, sole proprietors sometimes have employees, which means they are required to file Form 941 withholding and Form 940 unemployment returns. Another example is an owner operator trucker, who could have a Form 2290 heavy use tax filing requirement under their FEIN.
The bottom line is, these business returns are filed under an FEIN number, not an SSN. So, if you’re only doing searches under the SSN, you could be missing substantial tax debts that could jeopardize your funding.
3. The IRS can levy (seize) a sole proprietor’s accounts receivable to satisfy an individual or business tax debt.
If you are lending against a sole proprietor’s accounts receivable, you are at increased risk of having your collateral seized if you are not searching for both individual and business federal tax debts.
Because many sole proprietors can be a bit inexperienced regarding their tax requirements, lenders need to be extra diligent. Therefore, it can be a dicey proposition taking your sole proprietor borrower’s word for their filing requirements. To protect yourself, you need to search under SSN and FEIN to ensure your borrower has filed the proper returns and there are no hidden tax debts.
Important note: If the business is a single-member LLC, there are additional complexities to consider to determine your collateral exposure. Our VP of Resolutions, Jason Peckham, expanded on this in his most recent blog post.
Determining whether to lend to a sole proprietorship is a complex decision and should be treated as such. It is impossible to cover all the nuances in a short blog. Knowledge of these 3 tips listed above is only part of the equation for commercial lenders to be on top of their risk when funding a sole proprietorship. Stand by for our next post where we’ll explain how to ensure that you get all the necessary information from your borrower and how to accurately search for all federal tax debts that could put you at risk.
Please note there are exceptions to all scenarios presented above and this should not be interpreted as legal advice. Should you have specific questions about your situation please feel free to contact us for a consultation.