This excerpt is part of Entrepreneur.com's Second-Quarter Startup Kit which explores the fundamentals of starting up in a wide range of industries.

In Start Your Own Information Marketing Business, the staff at Entrepreneur Bookstore and writer Robert Skrob explain how to start and run a successful information marketing business. In this edited excerpt, the authors explains the benefits of incorporating your information marketing business, no matter the size.

If you're like many small-business owners, right now you're operating as a sole proprietorship. But in today's ultra-competitive and dangerously litigious business climate, you can't afford to roll the dice with your most valuable asset. Your exposure is far greater than you may think, both personally and professionally. As a sole proprietor without incorporation, you personally have unlimited liability if your company is sued -- you could actually lose your personal assets.

Most people are naively unaware of what can happen to them if their business is hit with even a frivolous lawsuit. Here are just a few problems you'd encounter if your business was sued:

  • You may not be able to get a loan for a new home, or refinance or take a second mortgage on your current home. At best, you'd have to pay a much higher interest rate because you're now considered a higher risk to the lending institution--through no fault of your own.
  • You may not be able to finance a new car.
  • You may not be able to lease office space.

Why are loans so difficult to obtain for people who have pending lawsuits? If you haven't recently applied for a home loan, a second mortgage or financing for a car, you may not be aware of how times have changed. Five years ago, financial forms asked "Do you have any judgments against you?" But financial institutions have tightened up the system they use to rate risk levels for loan applicants. Today's loan applications ask "Are you currently involved in a lawsuit?" That means that if anyone tries to sue you for any reason, frivolous or not, you'll be rated as a much higher risk and could be financially paralyzed.

Are you willing to forego that dream home or new car because someone tripped on a pavement crack in your business's parking lot? Just imagine what being unable to lease office space could do to your business. Creating a legal entity separates the business from you and your personal assets so that any legal action affects only that entity--not you personally. This is by far the biggest reason to incorporate or form an LLC.

And it's essential to do things properly when you incorporate. Remember, when your company incorporates, you create a legal entity separate from yourself, so it's imperative that your corporation is treated as such. If the corporation is sued and there aren't enough assets or insurance to cover the liability, the plaintiff may decide to go beyond the corporation and after you personally to recover alleged losses. This is called "piercing the corporate/LLC veil," and the consequences can be devastating.

To keep this from happening, your new corporate entity must do three things:

  1. Follow corporate formalities, keeping recorded minutes and resolutions
  2. Have proper capitalization, which is the amount of money you put into the corporation to get it started
  3. Not commingle funds with your personal account. Under no circumstances can you use corporate money to pay for your personal expenses

Let's take a closer look at how these three requirements can be breached or compromised.

1. Lack of corporate formalities. Here's an example: When an officer of the corporation goes on a business trip, the corporation must have a meeting to authorize that trip. This may be hard to understand, especially if you're a one-person corporation and you wear all the hats. Still, you must show in your corporate meeting minutes that the trip was approved, because the corporation is not you. It must be treated as a separate legal entity.

2. Lack of proper capitalization. When you form a corporation, it has to be capitalized. That usually means money is put into a corporate checking account, and stock for the corporation is issued to whoever capitalized it. There are certain guidelines in each state that ask "Did you capitalize the corporation with enough money/assets, or was it too thinly capitalized?" Lately, an unfortunate trend has been taking place in the courts. In some situations, they've adopted a sort of "20/20 hindsight," and companies in high-liability sectors like manufacturing are especially at risk.

For example, let's say you're a widget maker with five employees, and you're capitalized at $50,000 and have a $1 million insurance policy, which is appropriate because widgets are cheap and you don't sell many. Then one day, Joe Employee cuts off a hand with a box cutter and saddles you with a $3 million lawsuit. The court says, "Mr. Business Owner, when you formed this company, you should have known Joe would slice off a hand someday and that your insurance would cover only $1 million of the $3 million he'd want. Since you only have $50,000 in capitalization, we're going to consider your company too thinly capitalized. Therefore, we're going to allow for piercing your corporate veil to recover the rest."

3. Commingling of funds. As a sole proprietor, you no doubt have a company bank account. You can use that money for your business or personal expenses. At the end of the year, your CPA will help you determine which part of that money was deductible for business expenses and which portion was for personal expenses. Often your CPA will find that you spent a lot of money on personal items that aren't deductible business expenses. Still, the only consequence to you is that your net profit is higher than you thought, so you owe more in taxes than you expected.

It's very different in a corporation. There must be a separate checking account used for business purposes only. Using that money for personal reasons is called "commingling of funds," and the consequences are dire. A judge may actually set aside the corporate veil because you ignored the fact that the corporation is a separate legal entity from yourself, leaving you totally exposed.