The Liability of an S Corporation

by John Cromwell

It is important for any corporate shareholder to understand what liability he may be exposed to by owning a portion of an S Corporation. S Corporations are regular corporations that qualify for a special tax status with the IRS. While an S Corporation is taxed as a partnership, it has the same liability issues as a normal corporation. A discussion about liability of a corporation could be about one of two things. The first concerns the liability of the S corporation’s shareholders for the actions and financial obligations of the business. The second regards the liability of the S Corporation for the work done on its behalf.

Liability Shield

An advantage of a corporation is that is offers liability protection to its owners. What this means is that in most situations the owners are not personally liable for the business’s liabilities. As a result, if the business runs out of money and it still has outstanding debts, in most cases the owners will not have to pay off the debts using their personal funds. An exception to this rule is if a shareholder personally guarantees that a business obligation will be paid.

Piercing the Veil

While a corporation often acts as a barrier protecting shareholders from business liabilities, that veil can be pierced. Shareholders or officers can be forced to pay out of personal assets for liabilities incurred by a corporation if they were grossly negligent or acted in bad faith. An example of an act of bad faith would be fraud on the part of a corporate officer. Creditors of the S Corporation may also be able to sue the shareholders and officers if the corporation was formed to perpetrate a fraud. An example of a corporation formed with a fraudulent purpose is one where the shareholders fund the corporation with a little capital and incur significant liabilities that the shareholders never intended to repay.

Liability for Employees

A corporation is responsible for any damages caused by any action an employee takes during the course of his employment. Generally, the corporation is only liable for those acts that it authorized the employee to take or that are closely related to the task that the employer authorized. So if an employee is acting for purely personal reasons, such as going to a bar with friends, any damages that result from that a action are not the corporation’s responsibility. If the employee injures someone in the course of doing business, as by dropping a hammer on someone’s head while working for a construction company, the corporation is liable.

Employees vs. Independent Contractor

Both employees and independent contractors can be hired by an S Corporation to do work on its behalf. However, a business is liable for the actions of the employee but not the independent contractor. The reason for this difference in responsibility is based on the relationship between the corporation and the person doing the work. When an independent contractor gets work from a business, he is answerable to the company only for delivering the product; he is not supervised, must provide his own tools, and has clients other than the corporation. An employee is supervised by the corporation, is provided the resources to do the job, and generally works for no one else.