Usually the answer I give most clients is “yes.” Incorporating your business has many advantages. “Incorporate” doesn’t mean just forming a corporation, but can also mean forming a limited liability company (LLC), limited partnership (LP), limited liability partnership (LLP), or any other legal entity.
The main reason that people incorporate their businesses is to protect their personal assets. Generally speaking, your personal assets are protected from the contractual debts of the incorporated business. What this means is that if the business owes another person or company money, say the business failed to pay a bill or defaulted on a loan, only the business is responsible for that debt.
Your personal liability is limited to your interest in the business. If a judgment is obtained against the business, the creditors can only go after the assets of the business to satisfy the judgment.
**A special note: a general partnership - what people normally consider when they think of a “partnership” - does NOT provide you with any protection of your personal assets. You and the other partners are completely responsible for all the liabilities of the partnership. Likewise, general partners in a limited partnership are also responsible for all of the liabilities of the limited partnership (limited partners DO have asset protection, however).**
Exceptions
There are two notable exceptions to this limited liability that you need to be aware of. First is if you personally guarantee the debt. An example is if a lender requires you to sign a business loan personally and promise to pay the loan if the business is unable to. For a new business with no real credit or financial history of its own, you may have no choice but to personally guarantee a loan or lease for a business.
The other exception is if the creditor is able to pierce the corporate veil and bypass the company to get to you directly. This happens if a judge or jury determine that either you are only using the business entity to defraud other people or that you and the business are so intertwined that it is impossible to separate the two. If you are using the business as a front to commit fraud, there isn’t much you can do to protect yourself.
To prevent the second instance, it is important that you take steps to create a separation between your personal life and the business. This means, at the very least, 1) having separate bank accounts for personal and business funds, 2) following proper accounting procedures, 3) making it clear when you do business with others that they are dealing with a company and not you as an individual person, and 4) performing all corporate formalities that are required under state law (corporate formalities are things such as holding regular meetings and keeping a book of minutes).
Top-Down Creditors
A limited liability company has another side of limited liability that you should be aware of. In the situation described above, the debt belonged to the company and so a creditor (also known as a “bottom-up creditor”) can’t go after your personal assets. Normally, an LLC is not responsible for the debts of the individual members. This means that a personal creditor of a member (a “top-down creditor”) can’t go after the assets of the LLC.
So if you default on your home mortgage the bank can’t try to take the business’s furniture. In also means that a top-down creditor can’t take over your interest in the company and make management decisions (if you have management or voting rights). The creditor CAN, however, use the judgment to step in and take any distributions you are otherwise entitled to by the LLC (your right to receive a distribution is considered a personal asset).
This is one of the advantages of LLCs over corporations. In a corporation, a judgment creditor may take your shares and exercise any voting rights attached to those share.
Single-owner Businesses
Now, if you are the only person involved in your business, you might wonder if having a separate entity will really protect your personal assets. After all, you are the business, right? You are the one who has to come up with the money each month to pay the bills and keep the lights on.
While this is true, the business entity will still afford you protection from the company’s debts. If you take the necessary steps to keep your business and personal life separate, you can maintain the protection of your personal assets. A creditor of the company can only satisfy the debt with the assets of the company.
If you are a single-member LLC though, you will not get the top-down protection that most LLCs get. If you default on your house mortgage, the bank can take your interest in the company (which is everything) and get a receiver to run the company until the mortgage debt is satisfied.