If you're organizing a small business, you should know about the concept of a close corporation, an organizational structure that can affect your personal liability as well as your enterprise's financing and taxation. Close corporations, also known as statutory close corporations because they are governed by state statutes, have a small number of shareholders. In California, for example, the maximum number of shareholders allowed in a close corporation is 35, while in Arizona, a close corporation may have no more than 10 original investors.
Close corporations differ from general stock corporations, more commonly known as C corporations, in that they are not publicly traded. As such, a close corporation is exempt from the rules and regulations that apply to general stock corporations, such as those requiring formal annual meetings, a board of directors, and annual reports. Note that not every state allows for the formation of a close corporation.
Pros of Close CorporationsAs with all types of business structures, a close corporation has advantages and disadvantages. Here are some of the pros:
Fewer formalities. The most obvious advantage of a close corporation is that there are fewer rules to follow. You still must abide by regulations concerning the filing of incorporation documents, but beyond that, owners can focus on running the company instead of worrying about corporate regulatory compliance.
Limited liability. In general, shareholders of a close corporation are not personally liable for the business's debt, although there are exceptions, such as when a shareholder has signed an agreement to be personally responsible for corporation debts.
More shareholder control. With fewer shareholders and a relaxed corporate structure, a close corporation provides each shareholder with more control over shares. For example, if one owner wants to leave the company, the other shareholders can better control what happens to those shares.
More freedom. Without having to comply with corporate regulations, business owners are free to operate the company exactly as they want, such as exploring new markets or donating profits to charity, without having to consult with a board of directors or answer to public shareholders. The close corporation shareholder agreement should detail all such important aspects of the business's management and financial structure.
Cons of Close Corporations
With so much going for them, close corporations may seem like an obvious choice, but there are also some cons to consider.
Time and money. In states in which a close corporation is a separate, recognized entity, it may actually cost more time and money to set one up because, in addition to filing registration documents with the state as you would for any corporation, you also have to draw up, distribute, and possibly negotiate a close corporation shareholder agreement. Moreover, complying with your own shareholder agreement could actually end up being more of an administrative burden.
Taxation. If your state treats close corporations as ordinary C corporations, the entity is taxed as a separate entity, which can lead to double taxation. Owners can, however, seek S corporation status from the Internal Revenue Service (IRS), which gives shareholders pass-through taxation, meaning profits pass through the corporation to owners' individual tax returns.
You may not need to decide between a close corporation versus an S corporation, as your company could be both. The former is a business structure regulated by the state while the latter is an IRS taxable entity.
More shareholder responsibility. Although more control can be a positive, as mentioned above, it comes with more responsibility for shareholders, who must also manage the business (a duty that would be left to corporate leadership), leaving them legally accountable for acts and omissions.
Stock concerns. Shares cannot be publicly traded in a close corporation, so if you think you may eventually want to go public, organizing as a close corporation may not be the best option. Moreover, with a close corporation, there may be difficulties reselling shares, either because of a lack of interest in the market or disagreements over value among shareholders.
As mentioned above, not all states have provisions concerning close corporations. If your state is among those without dedicated close corporation statutes, your company—no matter how many shareholders—would be responsible for complying with the same formal corporation requirements as every other corporation in the state. Choosing the right business structure is critical, so you may find it helpful to get advice from an attorney or online service provider.