Will Incorporation Protect Me from the Collection of Corporate Debts?

Incorporation has become a common theme for small business owners, and it certainly offers some protections to those who are self-employed.  But the marketing of corporations and LLC’s (limited liability companies) may overstate the protections of incorporating, especially when it comes to protection from debt.

When a business is incorporated, a separate legal entity is established.  With certain exceptions, only the assets of the corporation are at risk if something happens to the corporation.  For instance, if a company worker injures someone while driving the company truck, only the assets of the company would be at risk if a lawsuit was later filed by the injured party.  The owner of the corporation does not have to fear the loss of his personal assets because of any legal action taken against the company.  However, there are common misconceptions with respect to the protection of personal assets from corporate debts which need to be considered when forming and operating a corporation.

Even if you are incorporated and have a separate Employer Identification Number (EIN), you can still be personally responsible for any type of “trust” taxes, such as sales taxes and payroll taxes.  In addition, you can also be responsible for any debts that you have personally guaranteed.  For instance, a bank may have extended a loan to the corporation, but required the owner to provide a personal guaranty.  This means that the bank can sue the corporation and/or the owner if that debt goes into default.  Many times the corporation will have insufficient assets to satisfy the indebtedness, and the lender will elect to pursue the owner for the debt.  So even though the business was properly incorporated, the personal guaranty deprived the owner of corporate protection from that particular debt.  It is standard industry practice for most banks to require a personal guaranty for a corporate loan, especially for small or new corporations.

Many small business owners may acquire a corporate credit card which is used exclusively for business purposes.  However, whoever uses the card may become personally responsible for the debt.  Whenever you sign the charge receipt (or computer screen at most retailers), you are agreeing that you will comply with the terms and the conditions of the cardholder agreement.  So even though you may not have signed the application in your personal capacity, your use of the card is deemed to be a personal acceptance of the liability on the card.  This personal liability could also be extended to any employees who routinely use the card.

A similar situation occurs when a business owner routinely deals with merchants and vendors, and is signing purchase orders on a routine basis.  Much like the credit card receipt, those purchase orders will contain similar language stating that the owner will be personally responsible for performance of the contact terms if the business fails to do so.

Finally, a business owner can become responsible for a corporate debt by improperly signing any contract or loan application.  For instance, a purchase order or contract may not contain any personal guaranty language which would make the business owner personally responsible for the debt.  But the owner must sign the document in his or her corporate capacity, i.e. as president of XYZ Corporation.  If the owner were to sign such a document without specifying that it was being done as an authorized agent of the corporation, on behalf of the corporation, they may become inadvertently liable for that debt.

These are all issues which the owner of a small business corporation must consider as they operate their business.  Keep in mind that the lenders are trying to protect themselves from loss, and avoid a situation which occurs too frequently – a corporation is shut down and the owner starts a new corporation under a new name, leaving the previous debts uncollectible.  Consult with a business attorney not only to incorporate your business, but also on how to operate your business so that you can enjoy the full amount of personal asset protection that a corporation can provide.