That’s the theory of incorporation: create a separate legal entity in the form of the corporation.
Let that entity incur debt and expose itself to other risks. If it fails, the personal holdings of the owners of the corporation are safe.
But, in the real world, most big ticket debts that a corporation might incur require the guarantee of the owner.
So if both corporation and owner are liable for the business debts, what has incorporation gained you?
You’ll be surprised.
Incorporate to protect the business
Consider the same move, incorporation, for the opposite reason.
Incorporate to protect the business from the owner’s debts.
A sole proprietor and his business are one and the same in the law.
When the proprietor has a tax problem or there’s a judgment outstanding against him, all of the business cash and assets are exposed to that debt.
The business bank account can be levied for the owner’s back child support or a judgment against the owner for unpaid magazine subscriptions.
Most exemption laws found in state statutes protect some part of a wage earners salary. The working man needs some part of his paycheck to put food on the table and gas in the car.
But a proprietor isn’t an employee of his business: he and the business are one.
The debts of the businessman can put his business out of business.
Corporation immune to shareholder debts
It’s a different story if the business is owned and run by a corporation.
The corporation is a legal entity separate from the shareholder. The shareholder’s creditors can’t take the corporation’s money to satisfy the owner’s debts.
As a shareholder, you don’t have to worry that your personal creditors will garnish the business’s account debtors to collect a personal debt.
The corporation can retain a reserve for its operation without regard to the claims of the shareholder’s creditors.
Get a job
Incorporating the business also allows the business owner to create a distinction between the money necessary to run the business and the money necessary to feed his family. He can pay himself a salary, and leave the balance of the business assets in the corporation.
His salary is exposed to his debts, but not his livelihood.
State law provides exemptions that protect a portion of the wage earner’s salary from creditors, a protection that a sole proprietor doesn’t get.
So a creditor of the shareholder-employee can garnish the shareholder’s wages, but they only get a fraction of the total paycheck. Exemption laws protect the balance of the earnings.
Knowledge workers and service businesses incorporate too
It’s not just brick and mortar businesses that can use protection from its owners.
Realtor and consultants who are not incorporated expose their business cash flow to their creditors.
Nothing is quite so devastating as having your clients served with legal process requiring them to pay the sheriff on your debts rather than paying you. Or close a big transaction as a realtor and have the tax authorities levy your entire commission.
Incorporation is a powerful tool. Its principal benefit is, however, just the opposite of the conventional thinking.
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