Editor's note: This article is an excerpt from Entrepreneur Magazine's Ultimate Book on Forming Corporations, LLCs, Sole Proprietorships and Partnerships.

A close corporation is generally a smaller corporation that elects close corporation status and is therefore entitled to operate without the strict formalities normally required in the operation of standard corporations. Many small-business owners find this benefit invaluable. In essence, a close corporation is a corporation whose shareholders and directors are entitled to operate much like a partnership. The close corporation election is made at the state level, and state laws vary with respect to the eligibility of close corporation status and with respect to the rules governing them. Some states do not authorize them.

Corporations must meet particular requirements to be eligible for close corporation status. Generally speaking, a close corporation cannot have more than a particular number of shareholders--between 30 and 35 is the limit in most states. A close corporation cannot make a public offering of its stock. Typically, shareholders must agree unanimously to close corporation status, and a written shareholders' agreement governing the affairs of the corporation must be drafted. Shareholders' agreements are fairly complex and should probably be left to experience counsel.

Close corporations enjoy relaxed rules with respect to the formalities of governance. For example, close corporation shareholders typically need not hold formal annual meetings. Close corporation shareholders may override the directors and act on their own--thereby usurping an authority typically lodged with the directors.

Typically, the statement electing close corporation status must appear in the articles of incorporation. For example, the following clause effectively elects close corporation status in the state of California.

All of this Corporation's issued shares of all classes shall be held of record by not more than 35 persons, and this Corporation is a close corporation.

The shares in a close corporation are subject to restrictions on resale by both shareholder agreements and state law. Shareholders in close corporations have a great degree of control over other shareholders who wish to sell their shares to outsiders. Typically, close corporation shareholder agreements contain buy-sell provisions that give existing shareholders first rights of refusal with respect to subsequent sales or transfers of shares. Control of close corporations thus remains with insiders. (For more detailed information about close corporation shares and the laws surrounding them, please consult a knowledgeable attorney.)

Close corporations are generally more expensive to organize than C corporations or S corporations because they require a written shareholders' agreement, which typically must be drafted by an attorney. However, close corporations require fewer ongoing formalities, so organizers can save time and money in the long run by electing close corporation status.

Weighing Your Options

Like other business forms, there are both advantages and disadvantages to close corporations. Advantages

  • They require fewer formalities than standard corporations.
  • Close corporation shareholders have a great degree of control over sales of shares to outsiders.
  • Liability protection for shareholders is strong. Corporate liability protection requires the faithful observance of corporate formalities. Fewer formalities means that the corporation is far less likely to misstep in following those formalities.
  • Disadvantages
  • Close corporations are not available in all states. Of course, you can always incorporate in a state that does observe close corporations. Remember, your corporation will be governed by the corporate law in the state of charter.
  • Close corporations cost a bit more to organize.
  • Close corporations are governed by both bylaws and a shareholders' agreement, which are a more complicated and restrictive set of governance rules.
  • Shareholders have increased responsibility and participation.
  • Close corporations shares have limited resale value.
  • A close corporation cannot make a public offering of its stock.