Closed Corporation Basics, Benefits, and Key Considerations

Key Takeaways

• A closed corporation (or close corporation) limits ownership to a small group of shareholders and avoids many formalities of traditional corporations.
• Most states limit closed corporations to 30–35 shareholders, and shares cannot be publicly traded.
• Advantages include flexibility, streamlined operations, and stronger control by shareholders.
• Disadvantages include limited liquidity, state restrictions, and potentially reduced access to capital.
• Delaware and other states allow for specific provisions in the certificate of incorporation that provide unique protections for shareholders.
• Closed corporations are especially useful for family businesses or companies wanting to maintain tight ownership control.

Closed Corporation

What is a closed corporation? A smaller company can elect to have close corporation status which then allows it to operate without many of the same strict formalities that exist with standard corporations. Other names by which close corporations may be called are: privately held company, family corporation, private company, and incorporated partnership.

Some key points regarding a close corporation include:

• Shares are owned by a small, select group of people.
• The shareholders generally have a strong involvement with the business.
• The nature of the shareholders and directors relationship with the business allows the company to function more as a partnership.

What it Takes to be a Close Corporation

Obviously, to be exempt from some of the formalities and restrictions placed on standard corporations, there are certain requirements that must be met to be eligible for close corporation status. Some of these include:

• In most states, a close corporation can only have between 30-35 shareholders
• Shares or stocks cannot be [publically traded].(http://www.investorwords.com/3940/publicly_traded.html)
• Generally, the unanimous agreement of shareholders for close corporation status is needed.
• A written shareholder agreement, spelling out the specifics of the close corporation status must be drafted.

Legal Structure and Formalities of a Closed CorporationContent:A closed corporation operates with fewer regulatory formalities compared to publicly traded corporations. However, it still requires basic corporate governance:

• It must file articles of incorporation with the appropriate state agency.
• Shareholders usually enter into a shareholder agreement that outlines governance procedures, share transfer restrictions, and conflict resolution mechanisms.
• The corporation can often bypass requirements like regular board meetings, although it is still governed by bylaws and corporate laws applicable in its state.
• Delaware, for instance, allows closed corporations to eliminate the board of directors if specified in the certificate of incorporation.

These structural features help a closed corporation resemble a partnership while retaining corporate protections like limited liability.

Legal Structure and Formalities of a Closed Corporation

A closed corporation operates with fewer regulatory formalities compared to publicly traded corporations. However, it still requires basic corporate governance:

• It must file articles of incorporation with the appropriate state agency.
• Shareholders usually enter into a shareholder agreement that outlines governance procedures, share transfer restrictions, and conflict resolution mechanisms.
• The corporation can often bypass requirements like regular board meetings, although it is still governed by bylaws and corporate laws applicable in its state.
• Delaware, for instance, allows closed corporations to eliminate the board of directors if specified in the certificate of incorporation.

These structural features help a closed corporation resemble a partnership while retaining corporate protections like limited liability.

Advantages of a Close Corporation

There are certainly some advantages to having status as a close corporation. Among some of these advantages are:

• Shareholders have a lot of control over how and when they sell shares to outside investors; shareholders do not have to adhere to same level of oversight from the board of directors as standard corporations.
• As they are not bound by many of the same reporting requirements, it allows for greater operational freedom and flexibility.
• Shareholders can benefit from strong liability protection.

Additional Benefits of Forming a Closed Corporation

Beyond operational flexibility and shareholder control, closed corporations offer:

• Privacy: Because they are not publicly traded, financial and operational information remains internal and is not subject to public disclosure rules like those of the SEC.
• Taxation Options: Depending on eligibility and elections made, a closed corporation may choose S corporation status, allowing pass-through taxation and avoiding double taxation on profits.
• Enhanced Protection Against Hostile Takeovers: Restrictions on share transfers make it more difficult for outsiders to gain control.
• Continuity and Succession Planning: The structure supports long-term ownership by a family or tight-knit group, allowing easier business succession planning.

These benefits make closed corporations particularly appealing to family businesses and tightly controlled startups.

Disadvantages to a Close Corporation

While some of the advantages to a close corporation are certainly appealing, it is not all rainbows and sunshine. There are some disadvantages that you will want to keep in mind, before you commit to close corporation status. Some of these disadvantages may include:

• Close corporations do not exist in all states. With that said, since you are able to potentially incorporate in any state, you do have the option of establishing your business in a state that does allow for close corporations. You will just want to ensure that you and your business advisors are up to speed on the governing laws of the state in which you are incorporating your business.
• A close corporation often costs more money to organize.
• While shareholders have the benefit of greater control over the sale of shares, shareholders in a close corporation are also burdened with increased responsibility.
• A close corporation has to be governed by both a shareholders agreement and the company bylaws. In turn, this creates a more complicated set of rules by which the company is governed.
• A close corporation cannot publically sell stocks, which can affect the overall value of the company, as well as cash flow.
• The resale value of a close corporation is often not as great as it would be with a standard corporation.

If you are leaning strongly towards obtaining close corporation status for your business, these are states in which you can file your corporate charter or articles of incorporation:

• Alabama
• Arizona
• Delaware
• Georgia
• Illinois
• Kansas
• Maryland
• Pennsylvania
• Montana
• Nevada
• Missouri
• South Carolina
• Texas
• Wyoming
• Vermont

Common Challenges in Operating a Closed Corporation

While the flexibility of a closed corporation is attractive, some notable operational challenges include:

• Limited Access to Capital Markets: Since stock is not publicly traded, raising funds through equity financing is more challenging.
• Liquidity Constraints: Shareholders may find it hard to sell their shares due to transfer restrictions.
• Potential for Internal Conflict: Close relationships among shareholders may create tension or deadlock if disagreements arise, especially in the absence of a formal board.
• Compliance Complexity in Some States: While fewer formalities exist, states may have specific and varying compliance rules for closed corporations.

Understanding these challenges in advance can help business owners determine whether this structure aligns with their long-term goals.

Close Corporation vs. General or Traditional Corporation

You may still be questioning which is the best course of action for you and your business. Some key points to consider, if you are thinking about going the route of a traditional corporation are:

• State laws often require bylaws to be drafted for a traditional corporation that stipulates that annual shareholder meetings be held. It is during these annual meetings that a board of directors is elected.
• While the shareholders may only be required to meet yearly, the board of directors is generally expected to meet more regularly, often quarterly or monthly. The board members then elect corporate officers, such as president, vice president, secretary, treasurer, etc. They then often are responsible for overseeing the daily operations of the company.
• Thorough minutes are required to be taken at both shareholder meetings and meetings of the board of directors, as these minutes are often required to be submitted, annually, to the secretary of state for the state in which the company is incorporated.

Close Corporation vs. S Corporation

A common point of confusion arises between a closed corporation and an S corporation. While both can be used by small businesses, they are fundamentally different in purpose and taxation:

Some businesses can even be both a closed corporation and an S corporation if they meet the respective legal and IRS requirements.

Frequently Asked Questions

1. What is the main benefit of a closed corporation?
   A closed corporation offers more operational flexibility and tighter control among a limited group of shareholders compared to a traditional corporation.
2. Can a closed corporation go public?
   No. By definition, a closed corporation does not offer shares to the public and restricts share transfers.
3. Is a closed corporation the same as a private company?
   Not exactly. While all closed corporations are private, not all private companies meet the legal requirements to be classified as closed corporations.
4. Can a closed corporation become an S corporation?
   Yes. If it meets IRS eligibility rules (such as shareholder limits and type), a closed corporation may elect to be taxed as an S corporation.
5. Which states allow closed corporations?
   States like Delaware, Texas, Nevada, and Illinois permit the formation of closed corporations. However, requirements and terminology can vary.

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