The idea behind incorporation is that the rights and liabilities of a corporation are separate and distinct from those of its shareholders.

In theory, if you own a corporation and creditors are chasing after you, there's a line they cannot cross. They cannot reach your personal assets. They can only chase after what's owned by the corporation.

However, the possibility exists that creditors can "pierce the corporate veil" as they say. That's legal language for an action to have the corporation set aside for purposes of the litigation such that personal liability attaches, and personal assets can be reached.

Some courts have ruled that if a corporation is not operating as a true legal entity and is being used by its shareholders as a "shell" to control private interests, assets or debts, then the corporation is said to be the "alter ego" of its shareholders. If your company is designated to be your alter ego, watch out. Creditors can get your house and all your personal assets.

To avoid this worst-case scenario, make sure you operate as a true legal entity. That means you must make sure that after you incorporate, you do everything that corporations are supposed to do.

For example, be sure you issue corporate stock following formation of the corporation. Elect your directors, file your annual reports and keep good corporate records. Finally, don't co-mingle your personal assets with those of the corporation.

The corporate veil can also be pierced when there is outright fraud. If the corporation is simply a sham, formed to perpetuate a fraud, then judges will allow creditors to chase after personal assets.

For example, if a shareholder drains funds from the corporation, resulting in the corporation being unable to pay its creditors, there will likely be a ruling that pierces the corporate veil.

As a small business owner, it's important that you understand that incorporation may not protect you completely. Still, relative to having no protection at all, it's a pretty good thing.