Can a Sole Proprietor Escape Debts by Incorporating in South Korea? Court Standards

1. Can You Avoid Existing Debts by Incorporating?

Key Answer

In principle, a sole proprietor and a corporation are completely separate legal entities under Korean Commercial Act Article 169, so debts from the sole proprietorship period do not automatically transfer to the corporation. However, if the corporate personality has become a mere shell or has been abused as a means of debt avoidance, or if the corporation has effectively succeeded to existing contractual relationships, the corporation may exceptionally be held liable for debts.

Principle: Corporate Independence – Individuals and Corporations are Separate Entities

The Principle of Corporate Independence

According to Korean Commercial Act Article 169, a company has independent legal capacity as a corporation. This is called the “principle of corporate independence.”

Under this principle:

• Sole proprietor Mr. A and Company B established by Mr. A are completely separate legal entities
• Debts incurred by Mr. A during the sole proprietorship period are not, in principle, transferred to Company B
• Creditors can only claim debt performance from sole proprietor Mr. A

Debts Do Not Transfer Without Explicit Agreement

For a corporation to succeed to a sole proprietor’s debts:

• An explicit “debt assumption agreement” between the creditor and corporation is required
• Or a “discharge debt assumption” agreement among the creditor, sole proprietor, and corporation must exist
• Simply establishing a corporation does not transfer debts

Exceptions: Piercing the Corporate Veil and Implied Contract Assumption

However, courts prioritize the substance of transactions over formal corporate personality. In the following cases, corporations may exceptionally be held liable for debts.

1. Application of the Piercing the Corporate Veil Doctrine

The Korean Supreme Court has ruled that when “the corporate personality has become a mere shell and is nothing more than the individual behind it” or “the corporate personality has been abused as a means of debt avoidance,” the independence of the corporate personality may not be recognized (Supreme Court Decision 97Da21604, January 19, 2001).

Typical cases where corporate personality is denied:

• When the business premises, personnel, and assets of the sole proprietorship and corporation are substantially identical
• When the trading partners, customers, and business methods of the sole proprietorship are transferred directly to the corporation
• When debts rapidly increase just before incorporation and the sole proprietorship is closed immediately after
• When corporate assets and personal assets are commingled

2. Recognition of Implied Contract Assumption

Even without an explicit contract assumption agreement, if the corporation is effectively operating by succeeding to existing contractual relationships, “implied contract assumption” may be recognized.

Cases where implied contract assumption is recognized:

• When the corporation continues to use and perform contracts from the sole proprietorship period
• When invoices are issued to existing trading partners under the corporation’s name
• When the corporation succeeds to and completes unfinished construction from the sole proprietorship period
• When actions are taken that cause the counterparty to trust the corporation as the contracting party

This is to protect the legitimate trust of the counterparty.

2. When Do Courts Recognize Corporate Liability?

Key Answer

Courts comprehensively consider (1) whether the same person substantially controls and operates the corporation, (2) whether the corporation has performed even part of existing debts, (3) whether the same business continues after incorporation, and (4) whether the counterparty recognized continuing transactions with the corporation.

Key Factors in Recognizing Corporate Liability

First, the substantial control and operation relationship. If the sole proprietor operates the corporation as a representative director or substantial controlling shareholder, the corporation can be viewed as an extension of the sole proprietorship. This determination is particularly easy when the sole proprietor holds 100% of the corporation’s shares or when shareholders consist only of family members.

Second, partial performance of debts. When the corporation has performed part of debts incurred during the sole proprietorship period, this is strong evidence that the corporation has acknowledged those debts as its own. In this case, the fact that the corporation paid part of the pump truck usage fees to the plaintiff was a key basis for recognizing contract succession.

Third, business continuity. If the same business continues at the same premises with the same trading partners after incorporation, substantial business identity is recognized. In this case, the corporation continued to use the same equipment at the same construction site as during the sole proprietorship period.

Fourth, the counterparty’s perception. If the counterparty was unaware of the incorporation or, even if aware, perceived that the corporation had succeeded to the contract, this works in favor of recognizing corporate liability.

Principle of Comprehensive Judgment

The important point is that corporate liability is not determined by any single factor alone. Courts comprehensively consider all circumstances and determine whether imposing liability on the corporation is consistent with fair trading and the principle of good faith.

3. What is Succession of Contractual Status?

Key Answer

Succession of contractual status refers to the transfer of all rights and obligations arising from a contract from one party to a third party. When succession occurs, the new party (corporation) assumes the status of the former party (sole proprietor) and exercises contractual rights and bears obligations.

Legal Nature of Succession of Contractual Status

Succession of contractual status, in principle, requires the consent of the counterparty (by analogy to Korean Civil Act Article 539). However, case law holds that even without explicit consent, if the counterparty continued transactions with the new party without objection, “implied consent” may be found.

Furthermore, there are cases where succession of contractual status is recognized even without the counterparty’s consent. A representative example is business transfer. Korean Commercial Act Article 42(1) provides that “when a business transferee continues to use the transferor’s trade name, the transferee is also liable for claims of third parties arising from the transferor’s business.” The purpose of this provision can be applied by analogy to the conversion of a sole proprietorship to a corporation.

Succession of Contractual Status in This Case

The Suwon District Court Ansan Branch ruled in this case: “It is reasonable to conclude that the party who entered into the pump truck lease agreement with the plaintiff was A, and that A’s lessee status was directly succeeded by the defendant company established by A thereafter.”

The grounds on which the court reached this conclusion are as follows. First, A was substantially operating the defendant company after establishing it. Second, A himself testified in court that “It is true that I have been substantially operating the defendant company since establishing it.” Third, A signed several of the “construction equipment lease usage confirmations” submitted by the plaintiff. Fourth, witness B testified in court that although he introduced the plaintiff, A also participated in determining the pump truck usage estimates and unit prices. Fifth, the plaintiff continued to lease pump trucks to the construction site even after A established the defendant company, and pump truck usage fees were paid to the plaintiff under the defendant company’s name.

4. When Does the Piercing the Corporate Veil Doctrine Apply?

Key Answer

The piercing the corporate veil doctrine (also called the alter ego doctrine) allows courts to disregard corporate independence and hold the actual controller behind the corporation liable when the corporation is merely an extension of individual business or was established for illegal purposes such as debt avoidance. The Korean Supreme Court applies this very strictly and recognizes it only in exceptional cases.

Legal Basis for the Piercing the Corporate Veil Doctrine

The piercing the corporate veil doctrine is not specified in statutory law but has developed through case law. The Korean Supreme Court ruled: “When a company has the form of a corporation in appearance but this is merely borrowing the corporate form, and in substance it is nothing more than an individual enterprise of another person behind the corporate personality, or when it is recklessly used as a means to evade the application of law to the person behind it, it cannot be permitted as an abuse of corporate personality contrary to the principle of good faith and seriously contrary to justice and equity to assert that legal effects accrue only to the company based on the company and its background being separate personalities while denying the liability of the person behind it, even though it appears to be an act of the company” (Supreme Court Decision 97Da21604, January 19, 2001).

Requirements for Applying the Piercing the Corporate Veil Doctrine

For the piercing the corporate veil doctrine to apply, the following requirements must be met.

First, the corporate personality must be a mere shell. This is when the corporation lacks independent decision-making ability or assets and is merely an instrument of an individual. For example, cases where corporate assets and personal assets are commingled or where corporate management is entirely according to individual will.

Second, abuse of corporate personality. This is when the corporate personality is used for improper purposes such as debt avoidance, contract violation, or law evasion. Simply seeking tax savings or the benefit of limited liability is not considered abuse of corporate personality.

Third, violation of good faith. Piercing the corporate veil is recognized only when recognizing corporate independence would result in outcomes contrary to justice and equity.

Difference Between Piercing the Corporate Veil and Succession of Contractual Status

The piercing the corporate veil doctrine treats the corporation and its background (individual) as identical and holds the individual directly liable. In contrast, succession of contractual status holds the corporation liable by viewing the contractual relationship as having transferred from the individual to the corporation. In this case, the court applied the succession of contractual status doctrine, not the piercing the corporate veil doctrine. That is, the court determined that because the sole proprietor’s lessee status was succeeded by the corporation, the corporation bears the obligation to pay the lease fees.

5. How Did the Court Rule in the Actual Case?

Key Answer

The Suwon District Court Ansan Branch determined in this case that the corporation established by the sole proprietor had succeeded to the existing lease contract status and ordered the corporation to pay the unpaid usage fees and delay damages.

Background of the Case

The plaintiff is a concrete pump truck leasing business. The plaintiff leased pump trucks to a building construction site in Ansan City. At the time of the contract, the counterparty was A, who operated a sole proprietorship.

However, while the construction was in progress, A established a corporation and became its representative director. Even after incorporation, the same pump trucks continued to be used at the same site.

When the plaintiff received only part of the total usage fees and did not receive the rest, the plaintiff filed a lawsuit against the defendant corporation. The defendant corporation argued, “The contract was concluded with individual A, and has nothing to do with the defendant corporation.”

The Court’s Ruling

The court rejected the defendant’s argument and mostly accepted the plaintiff’s claim. The court stated in the judgment:

“Considering the following circumstances: (1) In a complaint case filed by the plaintiff against A, A stated to the effect that ‘Since I received all construction payments from the client, I should pay the plaintiff for the pump truck, but I did not pay because additional labor costs were incurred due to the plaintiff’s fault and other financial damages occurred’; (2) A testified in this court that ‘It is true that I have been substantially operating the defendant company since establishing it, and I also signed some of the construction equipment lease usage confirmations submitted by the plaintiff’; (3) B testified in this court that ‘A invited me to take charge of construction for about 100 million won, but I refused because the amount did not work out at all, so I agreed with A that I would only supply labor and A would be responsible for equipment costs. It is true that I introduced the plaintiff, but A also participated in determining the pump truck usage estimates and unit prices’; (4) The plaintiff continued to lease pump trucks to the construction site even after A established the defendant company, and pump truck usage fees were paid to the plaintiff under the defendant company’s name – it is reasonable to conclude that the party who entered into the pump truck lease agreement with the plaintiff was A, and that A’s lessee status was directly succeeded by the defendant company established by A thereafter.”

Significance of the Ruling

This ruling clarified that a sole proprietor cannot escape existing debts simply by establishing a corporation. In particular, the fact that the corporation’s partial performance of existing debts became the decisive basis for recognizing contract succession provides important implications for creditor protection.

6. How Can Creditors Protect Their Rights?

Key Answer

Creditors can protect their rights through various legal means including claiming succession of contractual status, arguing for application of the piercing the corporate veil doctrine, filing fraudulent conveyance lawsuits, and directly claiming against the individual sole proprietor.

Claiming Succession of Contractual Status

The most effective method is to claim succession of contractual status as in this case. To do this, the following evidence must be secured.

First, evidence that the corporation performed even part of existing debts. This includes deposit records from accounts under the corporation’s name, tax invoices issued under the corporation’s name, and payment confirmations under the corporation’s name.

Second, evidence that the same person substantially operates the corporation. The connection between the sole proprietor and corporation can be proven through corporate registry (representative director, shareholder status), corporate seal certificate, and business registration certificate.

Third, evidence that the same business continues. Evidence includes the same business address, same telephone number, transaction records with the same trading partners, and employment of the same employees.

Direct Claim Against the Individual Sole Proprietor

Since the original contracting party is the sole proprietor, debt performance can be claimed from the individual separately from claims against the corporation. In this case, it is efficient to file a lawsuit with both the corporation and sole proprietor as co-defendants. However, if payment is received from one party, the claim against the other is extinguished to that extent (joint and several obligation relationship).

Fraudulent Conveyance Lawsuit

If the sole proprietor transferred assets to the corporation at below-market prices to evade debts, the creditor can file a fraudulent conveyance lawsuit under Korean Civil Act Article 406. If fraudulent conveyance is recognized, the asset disposition is rescinded and the assets are restored.

Preliminary Attachment and Provisional Disposition

If there is concern that the debtor (corporation or sole proprietor) may dispose of assets during litigation making enforcement impossible, the creditor can apply for preliminary attachment (for monetary claims) or provisional disposition (for specific performance claims) to freeze assets.

7. What Precautions Should You Take When Dealing with Sole Proprietors?

Key Answer

When dealing with sole proprietors, it is important to specify a contract succession clause for incorporation in the contract, obtain a personal guarantee from the sole proprietor, and secure evidence by obtaining signatures on usage confirmation documents for each transaction.

Essential Clauses When Drafting Contracts

The following clauses must be included when entering into contracts with sole proprietors.

First, a contract succession clause for incorporation. Specify a clause stating “If Party A converts to a corporation, Party A’s rights and obligations under this contract shall automatically be succeeded by that corporation.”

Second, a personal guarantee clause. If a clause stating “Party A’s representative ○○○ guarantees Party A’s debts under this contract jointly and severally” is included, personal liability can be imposed even after incorporation.

Third, a notification obligation clause. Include a clause stating “Party A shall immediately notify Party B of any changes in important matters such as trade name, representative, address, or business registration number.”

Securing Evidence During Transactions

One of the important reasons the plaintiff was able to win in this case was that signatures were obtained on the “construction equipment lease usage confirmations” from the lessee. Similarly, it is important to record the usage date, equipment specifications, usage time, and usage fees for each transaction and obtain confirmation signatures from the counterparty.

Also, when receiving payment, it must be received through the account of the contracting party. If payment is deposited under the corporation’s name, this is strong evidence that the corporation has succeeded to the contractual status.

How to Respond When Notified of Incorporation

If the counterparty notifies you of incorporation, respond as follows.

First, check the corporate registry to understand the representative director, shareholder composition, and capital.

Second, obtain written confirmation of whether existing contractual rights and obligations are being succeeded. It is good to obtain a confirmation letter stating “We confirm that existing contractual rights and obligations have been succeeded to your company following your incorporation.”

Third, obtain an additional personal guarantee from the individual sole proprietor if necessary.

8. FAQ

Atlas Legal has numerous successful cases in construction and real estate litigation, including contract succession issues following sole proprietor incorporation and construction equipment lease disputes. We provide systematic legal services from strategy development to evidence collection and litigation for responding to incorporation intended for debt avoidance.

※ The case introduced in this article is based on a judgment from the Suwon District Court Ansan Branch handled by Atlas Legal. Some facts have been modified for easier understanding, and client personal information has been protected.