A sole proprietorship is an unincorporated business that is individually owned and managed. The individual owner has unlimited personal liability for all debts of the business. If the business fails, the borrower not only will have to replace his or her lost income, but also will be expected to satisfy the outstanding obligations of the business. Since no distinction is made between the owner’s personal assets and the assets used in the business, creditors may take either (or both) to satisfy the borrower’s business obligations.
The financial success or failure of this type of business depends solely on the owner’s ability to obtain capital and to manage the various aspects of the business. Poor management skills or an inability to secure capital to keep the business running will compromise the continuance of the borrower’s business (and income). The owner’s death terminates the business and may cause the assets to be placed into probate, thus delaying the disposition of the assets to creditors and heirs.
The income, expenses, and taxable profits of a sole proprietorship are reported on the owner’s IRS Form 1040, Schedule C, and are taxed at the tax rates that apply to individuals. (See B3-3.3-03, Income or Loss Reported on IRS Form 1040, Schedule C)
When evaluating a sole proprietorship, the lender must:
- review the owner’s most recent signed federal income tax returns to ensure that there is sufficient and stable cash flow to support both the business and the payments for the requested mortgage, and
- determine whether the business can accommodate the withdrawal of assets or revenues should the borrower need them to pay the mortgage payment and/or other personal expenses.
For additional information, see B3-3.2-02, Business Structures.