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What Is a Close Corporation?

The easiest definition of a close corporation is one that is held by a limited number of shareholders and is not publicly traded. The company is run by the shareholders and is generally exempt from many requirements of other corporations, including having a board of directors and holding annual meetings. Close corporations are state-specific statutory entities usually created to relax corporate formalities in operation and to be less focused on taxation. Some states have no provisions for allowing close corporations.

Close Corporation Formation

Advantages and Disadvantages of Close Corporations

As with any type of business structure, there are upsides and downsides that owners should be aware of. Some of the advantages of close corporations include the following:

  • Liability limitations – While there are fewer corporate formalities required with close corporations, the shareholders do not face any personal liability for the debts of the corporation.
  • Operational flexibility – As there are fewer shareholders, and depending on how the shareholder agreements are written, there are far fewer reporting requirements.
  • SEC requirements – Unlike a publicly traded company, a close corporation has no obligation to submit information about issues that impact the company and require a vote by a certain date. In many cases, changes may be considered without the requirement of a meeting.
  • Lower costs of operation – There are fewer reporting requirements, making the overall cost of accounting, legal counsel, and administrative fees much more inexpensive and saving the company thousands of dollars annually.
  • Buyout of stock – The shareholder agreement will typically have clear directions for buying back stock for shareholders who are deceased, when a shareholder exits the corporation for any reason, or to handle stock transfers in the event of divorce. This is typically to avoid having outsiders become part of the company.
  • Intellectual property rights – In most cases, a close corporation has less risk when it comes to protecting its intellectual property because only those inside the corporation are aware of what processes, methods, or documents are used inside the company.

There are also downsides to this type of business structure, as follows:

  • Limited options for divesting shares – The shareholder agreement will contain specific restrictions on divesting shares. In most cases, to sell the corporate shares, the interested shareholder can only sell shares to current shareholders. This may put limitations on how much the shareholder can earn on the sale and limits the number of people who may purchase the shares.
  • Limited options for capitalization – Unlike other business structures, the capital of a close corporation comes only from the owners of the corporation. This can be a serious limitation should the company wish to expand. Since there is no publicly traded stock, the owners cannot solicit funds from people other than the owners.
  • Close corporation taxation – Close corporations are taxed as a C corporation unless the owners and shareholders decide to seek S corporation status from the IRS. This means the income of the corporation may be subject to double taxation.

State Rules

Some states do not allow personal service corporations to declare close corporation status, so one must be certain it is allowed in their state before making this designation.

Minority Shareholders in Close Corporations

Minority shareholders in a close corporation face daunting challenges. Typically, the majority shareholder would own at least 51 percent with the balance being distributed among the remaining shareholders. Keep in mind that the restrictions on the number are set by the states. Most state statutes governing close corporations do require there to be processes in place to address grievances of minority shareholders in the event they feel the management is not acting in the best interest of the company.

Minority shareholders are not always well represented in close corporations. In most cases, majority shareholders—typically the management of the company—will make nearly all of the decisions that impact the company. Additionally, all shareholders are typically prohibited by the shareholder agreement from transferring or selling their shares without the prior approval of the majority ownership. Generally, this will be accomplished through a buy-back clause or other clause that delineates exactly how the shares will be redistributed.

When a Majority Shareholder Leaves

Whether because of disability, death, or another reason, when a majority shareholder leaves a close corporation the stock they own is redistributed. When dealing with a close corporation, the redistribution of shares is done in accordance with the shareholder agreement. The articles of incorporation may have specific restrictions on who may be considered a majority shareholder while the shareholder agreement will typically identify the price of the shares.

Dispute Resolution for Close Corporations

One of the challenges of a close corporation is that most of the shareholders must agree on major aspects of the operation of the company. The shareholder agreement's terms must be made unanimously or nothing can be changed. There are two options for resolving shareholder disputes: there may be a process which is covered in the shareholder agreement, or the disagreeing shareholder may have the option of going to court. Taking a case to court would be done in extreme circumstances when one or more shareholders do not feel someone was acting in the best interest of the company.

Taxation Issues of Close Corporations

The tax status of a close corporation is determined by the type of corporation that is elected. The company may elect to use C corporation status or may take the IRS S corporation election. Since an S corporation limits the number of shareholders to 100, a close corporation would qualify for this designation. If a C corporation is the preferred structure, the same tax rules would apply to any company with a C corporation designation.

Close corporations, like any company, may have the need to hire employees. This means they are also required to file the appropriate quarterly employment taxes, may be required to carry unemployment insurance, and may also be subject to excise taxes. This is in addition to any federal, state, or local taxes the company may be liable for.

Not every business wants or should consider a close corporation. If significant amounts of capital may be needed in the future, the company management may have to change their structure to obtain additional working capital. Generally, a close corporation can only receive investments from its shareholders. There are substantial advantages including no public information about shareholders, company value, or number of employees.

Pros and Cons

Everyone who is considering forming a corporation should carefully examine the pros and cons of each company structure before determining which one is right for their needs.

Necessary Corporate Documents

Like any corporation, there are governing documents which must be prepared before getting started. This is true whether the company is closely held or if the principals are planning on forming a public company. With a close corporation, the shareholder agreement must be very detailed. Information such as the role of the majority and minority shareholders, buyout clauses, and dispute resolution procedures must be clearly explained.

If a company intends to hire employees, use independent contractors, or has a need for specific vendors, there are human resources agreements it should have in place to protect the business.

As every state does not recognize a close corporation, it is a good idea to check with the Secretary of State where the business will incorporate. Currently, there are a limited number of states that accept close corporation status. The states where close corporations are recognized include Alabama, Arizona, California, Delaware, Georgia, Illinois, Kansas, Maryland, Missouri, Montana, Nevada, Pennsylvania, South Carolina, Texas, Vermont, and Wyoming.

Large and Small Companies

Just because a company is a close corporation does not automatically mean it is a small company. Companies of all sizes may choose this designation with limits placed only by specific state statutes:

  • Alabama – Exclusive of treasury shares, all shares must be held by 30 or fewer people.
  • Arizona – An Arizona close corporation may have no more than 10 initial investors.
  • California – The corporation’s issued shares of all classes shall be held by no more than 35 people.
  • Delaware – Close corporations are restricted to no more than 30 shareholders.
  • Georgia – Corporations with 50 or fewer shareholders may become a statutory close corporation.
  • Illinois – There are currently no limits on the number of shareholders who may participate in a close corporation.
  • Kansas – Close corporation shares, except treasury shares, must be held by 35 or fewer people.
  • Maryland – The corporation’s shares, except treasury shares, must be held by no more than 35 people.
  • Missouri – A corporation having 50 or fewer shareholders may become a statutory close corporation.
  • Montana – A corporation having 25 or fewer shareholders may become a statutory close corporation.
  • Nevada – Issued stock of the corporation, exclusive of treasury shares, must be represented by certificates and must be held by no more than 30 people.
  • Pennsylvania – Corporations with 30 shareholders or less may be close corporations.
  • South Carolina – The corporation’s shares, except treasury shares, shall be held by no more than 35 people.
  • Texas – Domestic for-profit corporations or professional corporations must have fewer than 35 shareholders.
  • Vermont – Stock of all classes must be held by no more than 35 shareholders.
  • Wyoming – Corporations with 35 shareholders or less may be a close corporation.