What Is a "Close Corporation"? This corporate status allows you to operate less formally, but the restrictions on corporate shares may prove to be a burden.

Editor's note: This article is an excerpt from Entrepreneur Magazine's Ultimate Book onForming Corporations, LLCs, Sole Proprietorships andPartnerships.

A close corporation is generally a smaller corporation thatelects close corporation status and is therefore entitled tooperate without the strict formalities normally required in theoperation of standard corporations. Many small-business owners findthis benefit invaluable. In essence, a close corporation is acorporation whose shareholders and directors are entitled tooperate much like a partnership. The close corporation election ismade at the state level, and state laws vary with respect to theeligibility of close corporation status and with respect to therules governing them. Some states do not authorize them.

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

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

Typically, the statement electing close corporation status mustappear in the articles of incorporation. For example, the followingclause effectively elects close corporation status in the state ofCalifornia.

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

The shares in a close corporation are subject to restrictions onresale by both shareholder agreements and state law. Shareholdersin close corporations have a great degree of control over othershareholders who wish to sell their shares to outsiders. Typically,close corporation shareholder agreements contain buy-sellprovisions that give existing shareholders first rights of refusalwith respect to subsequent sales or transfers of shares. Control ofclose corporations thus remains with insiders. (For more detailedinformation about close corporation shares and the laws surroundingthem, please consult a knowledgeable attorney.)

Close corporations are generally more expensive to organize thanC corporations or S corporations because they require a writtenshareholders' agreement, which typically must be drafted by anattorney. However, close corporations require fewer ongoingformalities, so organizers can save time and money in the long runby electing close corporation status.

Weighing Your Options

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

• They require fewer formalities than standard corporations.
• Close corporation shareholders have a great degree of controlover sales of shares to outsiders.
• Liability protection for shareholders is strong. Corporateliability protection requires the faithful observance of corporateformalities. Fewer formalities means that the corporation is farless 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 closecorporations. Remember, your corporation will be governed by thecorporate law in the state of charter.
• Close corporations cost a bit more to organize.
• Close corporations are governed by both bylaws and ashareholders' agreement, which are a more complicated andrestrictive set of governance rules.
• Shareholders have increased responsibility andparticipation.
• Close corporations shares have limited resale value.
• A close corporation cannot make a public offering of itsstock.