A close corporation is one that has been exempted from the formal rules that govern a corporation. This exemption is granted because the corporation has a small number of shareholders. In the United States, the specifics of what qualifies as a close corporation varies state-to-state.
In general terms, a close corporation cannot be publicly traded. There is a set number of shareholders allowed, which is usually around 35. The corporation must usually be operated by the shareholders, without having a formal Board of Directors in place. There may be a requirement that the corporation not hold a formal annual meeting as well.
There are certain advantages and disadvantages to consider when looking at the close corporation structure.
List of the Advantages of Close Corporations
1. There are fewer formalities which must be followed in the close corporation structure.
The primary advantage of a close corporation structure is that it removes many of the formalities that a standard corporation is required to follow. There isn’t a need to hold an annual meeting, for example, because the shareholders are already actively involved in the business. There is less of a need for a formal C-Suite structure as well, though a majority owner will often take control in leading the business. There isn’t the same need to have a Board of Directors either. That makes it easier for those in the corporation to focus on running it instead of maintaining compliance with rigid regulations.
2. The shareholders in a close corporation have greater control of share sales.
Shareholders within a close corporation have the discretion to ask certain owners to leave. Some owners may decide to leave because they’re ready to make a change. Either way, the sale of shares within this structure is kept under the control of the existing shareholders. During a voluntary sale, they may be able to control who is eligible to purchase those shares. If an owner is asked to leave, the shareholders may be able to distribute the sale amongst themselves to retain full company ownership.
3. There are strong liability protections offered for shareholders.
Although shareholders are exposed to higher levels of liability in a close corporation than they would be in other structures, there are also stronger protections in place for them. The structure is similar to what would be found within a limited liability corporation, with its decentralized management structure and overall limited liability to personal assets should something happen with the business. There is also the same advantage in that a close corporation does not present double taxation, just like an LLC.
4. There is more freedom of management.
Because shareholders have more overall control over the business under a close corporation structure, they have more freedom. That means the company can try new ideas or take risks that other companies may be unwilling to try. That is because there are no outside pressures in place from public shareholders which direct the company’s decision-making processes. In some situations, there may not even be a need to account for how money is spent within this company structure.
5. There is freedom in financial structuring.
In a publicly-traded company, there are legal obligations in place which require shareholder interests to be placed first, which requires maximizing profits. Under a close corporation structure, this issue is non-existent. Companies under this structure can choose to give their profits to a charity. They can reinvest their profits back into their company. They could even take the profits as a dividend or a bonus if desired.
List of the Disadvantages of Close Corporations
1. It is a structure which may not be available to every qualifying corporation.
According to information published by BizFilings, there are only 16 states in the U.S. which recognize the statutory close corporation structure. Close corporations are also permitted in the District of Columbia. Because the structure of this corporation is more informal than other structures, the decentralized format is not always approved.
2. It costs more to organize a close corporation in most circumstances.
With a close corporation, many are still structured in their states as a C corporation under U.S. laws. They simply qualify for the close corporation status because of the number of shareholders they have. That means the costs of incorporation are roughly the same. There is the added cost of distributing a shareholders’ agreement for negotiation and approval. Under the C corporation status, the company is a tax-paying entity as well, which creates certain tax obligations that must be met.
3. Close corporations are governed by a shareholders’ agreement and bylaws.
Although a shareholders’ agreement creates more flexibility for a corporation, and the bylaws can be structured in a way which lessens the need for formalities, this structure creates more administrative red tape than less. For many corporations, there are actually more rules to follow in the close corporation format than if they were following government rules or regulations. These agreements can be very complex and take more time to negotiate than a standard incorporation rule set or LLC structure.
4. Shareholders have increased responsibilities in participation and in the responsibility of the business.
When a close corporation structure is approved, then the shareholders’ agreement allows for the management of the corporation. That means the shareholders become liable for omissions or acts that would normally fall upon the corporate leadership for liability. That means each shareholder could be held potentially liable for illegal conduct within an organization, even if no personal knowledge of such conduct existed. That level of liability exposure, when added to the costs of this structure, make it an unappealing format for many investors.
5. The resale value of shares held in a close corporation is often limited.
There is a limited market available to sell shares of a close corporation. In some instances, there may not be any market at all. Part of a shareholders’ agreement may be to restrict the ability for any shareholder to sell their stake in the company. There may be specific stipulations as to who qualifies within a market when a sale or buyout is desired. Buyers and sellers, even when a transaction is approved, will often disagree on the value of the company. That makes it difficult to reach a price both parties can agree upon.
6. There cannot be a public offering made for stock with a close corporation.
Close corporations are not permitted to make a public offering of stock as a way to raise money. They are forced to look at other financial products to create more liquidity for themselves. Even if they wanted to offer an IPO, the corporation would be forced to restructure itself into a C corporation to do so. That would change the value of the shares owned by the stakeholders in the company, which is why this structure is often limited to family companies, religious-based companies, or closely-held ventures where there is mutual ownership of IP.
7. Minority shareholders can be oppressed.
Within a close corporation, any minority shareholders that are part of the organization answer to the majority owner. They are not permitted to elect directors or officers as a way to protect their financial interests. Minority shareholders only have the amount of influence that the majority owner allows them to have. If there is no agreement in place, then a minority shareholder has no control over how any dispute is resolved. This often results in pressure to either sell shares at an artificially low price or to make their ownership share of the company effectively meaningless.
8. There can be compensation issues to consider.
Individuals in a close corporation have two ways to extract value from the company. Shareholders can be paid for services rendered as an employee, or shareholders can be paid in dividends in their capacity as a shareholder. From a taxation perspective, there are individual and business factors to consider. Taking a dividend means no payroll taxes and a capped taxation rate. Taking a salary puts shareholders into the ordinary income tax brackets. From the corporation side, salaries and bonuses are deductible, but dividends are not. Either way, someone wins and someone loses with the tax structures of a close corporation structure.
These close corporation advantages and disadvantages show that there are some situations where this structure makes sense. If a company is owned by a family, a religious community, or like-minded partners who developed an idea together, then this structure gives everyone equal rights when an appropriate shareholders’ agreement is in place. Without an agreement, the majority owner gains more control over the company, which can force some shareholders out over time.