D.S. Berenson, an attorney who specializes in home improvement companies and their legal woes, tells his clients never to do business as a sole proprietor. About 10 years ago, a client of Berenson's did some roofing work on a house. Part of the roof came down in a storm, injuring someone in the house. The client — who had been in business for 20 years — was sued and not only ended up in bankruptcy but lost his home and all retirement funds.

“All that could have been avoided if he weren't a sole proprietor,” Berenson says. The only advantage to sole proprietorship is that you don't have to file anything with local or state government to start up. “There are no other pros,” he says.

MULTIPLE DRAWBACKS But there are a lot of cons. These range from personal liability to tax consequences to IRS audits, which are more likely to happen to companies owned as sole proprietorships. “You have unlimited personal liability if something goes wrong,” Berenson explains.

Suppliers can come after you personally for payment, he adds. Even if you have insurance coverage, says attorney Barbara Weltman, “you still could face great exposure.”

Sole proprietors must pay 100% of their Social Security taxes — a little more than 12% of whatever it is they're paying themselves — which can take a big bite out of earnings. In addition, filing the required Schedule C with tax returns waves a red flag in front of the IRS, increasing chances of an audit, Berenson says.

CONSIDER INCORPORATING Smarter options include incorporating or forming a limited liability company. “Your accountant and a lawyer need to advise you on the best corporate form,” suggests speaker and author Linda Francis.

The right choice for each contractor depends on many factors, including the number of people involved in running the business and how much income is earned. If several people are involved, for example, a limited liability company offers a lot of flexibility in allocating earnings for each partner year to year, says John Green, president of G&A Business Services, in Healdsburg, Calif. A subchapter S-corporation — a very simple form of incorporation — helps cut back on the individual payment of Social Security taxes.

“The No. 1 consideration should be protecting your home, car, and personal assets,” Weltman says. “It has nothing to do with size or how long you've been in business. The cost for incorporation is so small compared to the risk that you're exposed to. It's never too late to make that change.”

—Diane Kittower is a freelance writer in Rockville, Md.