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 corporations may be ideal when everyone involved in the corporation is a family member, when the principals are not interested in taking the company public, and when the owners of the corporation do not wish to make public disclosures about their activities or earnings.
Unlike general or stock corporations, in most states that allow close corporations, there need not be a formal board of directors. Since each state that allows close corporations has its own requirements, it is imperative to review the statutes carefully to ensure you are meeting the applicable laws.
Shareholder agreements can be vital when setting up a close corporation. Corporate documents should address voting requirements on company issues, such as whether votes require a unanimous vote and what process may be in place for resolving disputes etc. to avoid future issues. When considering a close corporation, you should think about the shareholder agreement in the same manner as you would think about a partnership agreement.
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:
There are also downsides to this type of business structure, as follows:
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 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.
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.
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.
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.
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.
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.
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:
When you are ready to start the formation of your company, we know you will have a lot of questions and will need certain legal documents that can be easily tailored to meet your specific needs. Our legal documents, including business plans, articles of incorporation, shareholder agreements, and more, can be customized and tailored to your needs quickly, efficiently, and affordably. Decide ahead of time what type of documents you need, contact your Secretary of State, determine what limitations are placed by the state, and craft a plan that works best for your company. A close corporation is an ideal business solution for families who wish to pass their company from generation to generation, who currently do not plan on their company being publicly traded, or for those who wish to limit the number of decision-makers in a company. Every company owner must make the decision as to what works best for their specific needs.
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