A corporation is a legal entity owned by shareholders. The shareholders elect a board of directors who set policies for the corporation, allowing their selected officers (president, secretary, etc.) to run the corporation day-to-day.

There can be as few as one shareholder who owns the corporation and elects a board consisting of one director. In this way, one person can be a corporation's sole shareholder, sole director and serve as every officer (president, vice president, secretary and treasurer).

For tax purposes, corporations can be taxed as either "C" or "S" corporations — the letter stands for a section of the tax code that controls that type corporation. C corporations are taxed on income twice (first the corporation is taxed and then the shareholders are taxed), while S corporations are not taxed, only the shareholders are taxed. There are pros and cons to each type of tax treatment.

The most important aspects of a corporation for asset protection purposes are:

Created by state law

Each state has a statute that sets the requirements for establishing and maintaining a corporation. Some state laws are more corporate-friendly than others.

Distinct legal entity: Like another person

A corporation is a separate legal entity, distinct from its shareholders. The law, in fact, treats the corporation as a separate person in many circumstances.

For example, the corporation has constitutional rights, such as the right to due process under the Fifth and 14th Amendments and the right to be free of unreasonable searches and seizures under the Fourth Amendment, among others. Thus, if an asset is titled in a corporation, that corporation owns the asset, not the corporate shareholders.

Limited liability of shareholders

This is the key attribute in terms of asset protection. Because a corporation is a legal entity distinct from its shareholders, its shareholders are not generally liable for the debts of the corporation.

In other words, the shareholders can only lose their investment in the corporation (what they paid for their shares) if the corporation cannot pay its debts.

Unlimited existence

Unless the corporation states otherwise in its articles of declaration, it lasts in perpetuity.

Centralized management

Shareholders do not manage the corporation, even though they are its owners. The board of directors, elected by the shareholders, sets the overriding corporate policy and approves major deals. The daily operations are run by the corporate officers, who are chosen by the board.

Using a corporation to protect your wealth from your business

Incorporating your business is an absolute must — your only other option should be using a limited liability company (LLC). While it may not provide 100 percent protection from business creditors, incorporation is an important first step.

Incorporating protects you from tort claims and business debts

You can shield your personal wealth from many of the most popular forms of lawsuits against the business by incorporating it.

Claims based on negligence (slip and falls, car accidents, etc.) or those that arise out of the employer-employee relationship (being held responsible for the acts or omissions of your employees, employment discrimination) can be isolated to the business, not its owners, if a corporation is used properly. You are also protected from debts that the corporation owes, provided you did not personally guarantee the debt.

Incorporating protects you from claims of your customers

By incorporating, you can usually protect yourself from claims arising from the goods or services you provide to your clients or customers. These lawsuits include product liability claims, negligence, breach of warranty and even malpractice — which often bring outstanding jury awards.

Incorporation does not protect you on personally-guaranteed debts

Often someone doing business with a corporation will require an officer (i.e., president, vice president, etc.) to sign a personal guarantee backing up the corporation's debt.

For example, your landlord may ask you to guarantee your corporation's lease for the business premises. If the corporation breaches the lease and cannot make the payments, the landlord can sue you personally on the guarantee. In this way, any debt that you guarantee for your corporation overrides any corporate protection.

Incorporation does not protect you when you cause the harm

If you are the one who personally caused the harm for which someone is suing, you are not protected by the corporate shield. For example, if you are driving the corporate car and cause a car accident, the victim can sue both the corporation and you personally, as you were personally negligent.

Requirements for corporate protection

You will not enjoy the limited liability associated with corporations simply by setting up the corporation and paying the registration fees. You must strictly adhere to "corporate formalities" to enjoy corporate asset protection. Observe these procedural formalities:

• Do not commingle cash or other assets: You cannot commingle corporate funds with personal funds. Use separate bank accounts. If you loan money to the corporation or vice versa, make certain the loan is well documented. The same prohibition against commingling applies to other assets, like accounts receivable or inventory.
• Always sign corporate documents with your corporate title: Documents signed on behalf of the corporation should state your position in the corporation. Correct: "President of XYZ Corp., John Doe" or "John Doe, as President of XYZ Corp." Incorrect: "John Doe." This is true for invoices, contracts, checks, orders, etc.
• Identify the corporation: Have the word "incorporation" or "Inc." on all letters, signs, bills, checks, etc. Creditors and others then know that the business is a corporation — this in itself will discourage lawsuits.
• Keep adequate corporate records: Maintain records of the articles of incorporation, the corporate bylaws and minutes of board meetings, and pay the annual registration or franchise fees.
• Keep the corporation sufficiently capitalized: Check with a corporate attorney to determine the proper capitalization for your type business, with a given amount of debts. Certain states require predetermined minimal capitalization.
• Maintain other indicators of a legitimate corporation: This can be as simple as listing a phone under the corporate name, transacting business with noninterested third parties, and obtaining a business license under the corporate name, among others. Set up the corporation with the formalities of a Fortune 500 corporation, on a tiny scale.

If you do not follow these formalities, then the court may not recognize the corporation as a legitimate standalone entity. Instead, the court will decide that the corporation is a sham entity and your alter ego. If the court makes this decision, it may then pierce the corporate veil — ignoring the protection the corporation gives to its shareholders.

Rather than limit your liability to your investment for the corporate shares, the court will then allow your personal wealth to be seized by the creditors of the corporation. When the corporate veil is pierced in this way, you are as vulnerable as when operating with no entity at all.

How strictly you must adhere to the required formalities is difficult to say. Certainly, if you are missing minutes of one director's meeting, or failed to use the word "Inc." in certain letterheads, this alone will not be enough to lose corporate protection.

However, there are cases where an officer/shareholder lost corporate protection for certain contracts where she forgot to sign using her corporate title. Safest strategy: Learn and adhere to the corporate rules as diligently as you can.

In future articles, we will show you a number of ways to maximize the protection corporations can provide.