One of the primary advantages of incorporating is that the owners' personal assets are protected from creditors of the corporation. Because only corporate assets need be used to pay business debts, you stand to lose only the money that you've invested in the corporation.
However, there are some circumstances in which limited liability will not protect an owner's personal assets. An owner of a corporation can be held personally liable if he or she:
- personally and directly injures someone
- personally guarantees a bank loan or a business debt on which the corporation defaults
- fails to deposit taxes withheld from employees' wages
- does something intentionally fraudulent or illegal that causes harm to the company or to someone else
- treats the corporation as an extension of his or her personal affairs, rather than as a separate legal entity
This last exception is the most important, because in some circumstances, courts can rule that a corporation does not really exist and that its owners should not be shielded from personal liability for their acts. This might happen if the owner fails to follow routine corporate formalities, including:
- adequately investing money in the corporation
- formally issuing stock to the initial shareholders
- regularly holding meetings of directors and shareholders
- keeping business records and transactions separate from those of the owners
Basically, the owner of the corporation needs to be highly organized in order to protect his or herself.
Incorporating should not take the place of good business insurance. Even though forming a corporation protects personal assets, you should use insurance to guard your corporate assets from lawsuits and claims. A solid liability insurance policy can protect you against many of the risks of doing business.
Furthermore, insurance can protect you where the limited liability feature will not. However, insurance will not help if your corporation fails to pay the bills: commercial insurance usually does not protect personal or corporate assets from unpaid business debts, whether or not they are personally guaranteed.
If an owner of a corporation works for the corporation, that owner is paid a salary, and possibly bonuses, like any other employee. The owner pays taxes on this income just like regular employees, reporting and paying the tax on his or her personal tax return. The corporation pays taxes on whatever profits are left in the businesses after paying out all salaries, bonuses, overhead, and other expenses. To do this, the corporation files its own tax return, Form 1120, with the IRS and pays taxes at a special corporate tax rate.
Alternatively, corporate shareholders can elect what's called "S corporation" status by filing Form 2553 with the IRS. This means that the corporation will be treated like a partnership (or LLC) for tax purposes, with business profits and losses going through the corporation to be reported on the owners' individual tax returns.
