Pros and Cons of a Closely Held Corporation

Although incorporated small businesses are often referred to as closely held corporations, the term isn't a legal one. A corporation is considered to be closely held if it has a small number of shareholders, or owners, as compared to a widely held corporation, which has a large number of shareholders.

Closely held corporation vs. publicly held corporation

Closely held corporations are private corporations, which means that their shares are not listed on public stock exchanges. As mentioned above, there is no standard legal definition of a closely held corporation, although the term itself may be defined in various state and federal statutes.

A publicly held corporation, on the other hand, has shares available for sale on different public stock exchanges. Because of this, the shares of a publicly held corporation can be purchased by any individual interested in investing in the company.

Advantages of a closely held corporation

The nature of a closely held corporation offers several advantages, including:

• Control. Because most of the company's shares are in the hands of only a few people, managers who are also major shareholders have a greater degree of control over the operation of the business and any decisions that may affect it.
• Close corporation status. Closely held corporations can often take advantage of statutory close corporation rules. While not all states offer corporations the ability to register as a close corporation, if yours does and you choose to register as one, you can obtain many of the benefits of incorporation while also retaining the ability to run your company without having to meet certain corporate formalities. For example, many states do not require close corporations to file annual information returns.
• Election of S-Corporation tax status. Most closely held corporations meet Internal Revenue Service (IRS) conditions for electing to be taxed as an S-Corporation. Holding S-Corp. tax status means that the corporation's income is passed through to individual shareholders, who report it on their personal tax returns, thus eliminating the need for the S-Corp. to file its own federal tax return.

Disadvantages of a closely held corporation

Despite the above benefits, a closely held corporation also has some drawbacks, including:

• Raising capital. It is more difficult to use share equity to raise funds, since the shares of a closely held corporation are not listed on a public stock exchange for investors to purchase. Instead, most closely held corporations achieve funding goals by generating profit and through contributions of capital from its shareholders.
• Sale of shares. Individual shareholders may face difficulties if they wish to dispose of their shares in a closely held corporation. Not only are the shares not listed on a public stock exchange, but the shareholder agreements of most closely held corporations contain restrictions on the transfer of shares.
• Fiduciary duty. Because a closely held corporation is still a corporation, those who control its management are held to a higher standard of duty to the company, known as fiduciary duty. This legal term refers to the managers' obligation to make decisions that are in the best interests of the corporation rather than their own personal interests.

Taxation of a closely held corporation

Like any other corporate entity, if a closely held corporation meets IRS conditions for S-Corporation status, it can elect to be taxed as an S-Corp. by filing Election by a Small Business Corporation (Form 2553). If you do not make this election, the corporation is taxed as a C-Corporation.

However, it's important to note that the IRS does offer a definition of a closely held corporation: a corporation, that is not a personal service corporation, where five or fewer individuals own more than 50 percent of its shares. While not a standard legal definition, it does set out the criteria the IRS uses to assess whether it considers your corporation to be closely held or not.

A corporation that falls within this general definition and that is taxed as a C-Corporation is subject to additional tax rules. If this is the case for your closely held corporation, it's advisable to consult with a tax adviser to see how these additional rules might affect you.

Taxation as a C-Corp. also requires you to consider how you distribute income from your corporation, such as through dividends. However, dividends from closely held corporations often come with double taxation issues, as corporations cannot take a deduction for dividends, which are also taxed at the shareholder level.

For the small business owner, there are many advantages of being a closely held corporation, including the ability to exercise greater control over the corporation's management. There are also, however, a number of disadvantages. As you embark on the process of forming your new company, a careful assessment of these pros and cons can prove beneficial.