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.
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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.