Litigation Law Newsletter, Volume 1, Number 6: The Need to Incorporate
- Mednick, Mordy
- Industry Alerts
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In the course of my practice, people always ask me whether it is a good idea to incorporate their business. I almost always say yes. The question is why.
When a business is incorporated, the law treats the company as a separate legal entity, distinct from its shareholders. Conversely, if the business is not incorporated, then the business and its shareholders are treated as one and the same. In other words, whatever liability the business has, the businesses’ shareholders have as well. This is known legally as a sole proprietorship.
The legal consequence between a sole proprietorship and incorporation are significant.
For example, suppose a company is incorporated and is unable to pay its creditor, the creditor is only entitled to sue the company and not its shareholders. In this regard, the creditor can commence enforcement proceedings against the company by removing the company’s assets for resale in order to collect the debt. However, if the business is not incorporated, then the creditor is able to commence enforcement proceedings against both the business and the shareholders and force the shareholders to sell their personal assets to repay the debt.
This same logic applies to personal injuries. Suppose an employee of the business slips and falls and breaks his neck, the employee can only sue the business if the company is incorporated but can sue both the business and the businesses’ shareholders if the business is not incorporated.
Given this, it is unsurprising that many individuals incorporate their businesses to avoid the potential of losing their personal assets.
There is one major exception to this rule. If a company is incorporated but the conduct of the company is so egregious (for example, the shareholders of the company committed fraud), the party who has suffered as a result of the fraud can sue the individual shareholders in addition to the company. This is known as piercing the corporate veil. Effectively, it means that although shareholders are normally protected from lawsuits against acts committed by the company, the law will permit, in certain circumstances, for the individual shareholders to also be sued if their conduct is sufficiently egregious.
In conclusion, it rarely ever makes sense to run a business without incorporating it. If you do not incorporate, your personal belongings and real estate holdings, including your personal residence, can all be taken from you for acts done by the company. Although it takes time and money to incorporate a business, those costs are far outweighed by the potential consequences of not incorporating it.
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