Close Corporation Laws

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 What is a Corporation?

Corporations are entities, typically businesses, which have the authority under the law to act as single entities, which are distinct from the shareholders who own them. Only the corporations themselves can be held liable for obligations of the corporation, including maintenance of required business records.

There are numerous different types of corporations. Corporations are classified depending upon certain specific factors, which may include:

  • The corporation’s business purpose;
  • The manner in which the corporation’s income is taxed;
  • The number of shareholders in the corporation;
  • The amount of stock to be issued by the corporation; and
  • Whether or not the purpose of incorporation is to make a profit.

Usually, when individuals refer to corporations, they are referring to one of the two main categories of corporations which exist pursuant to tax laws, C Corporations and S Corporations. C Corporations are corporations which are taxed separately from their owners. S Corporations, however, are not.

There are benefits to forming corporations, including:

  • The corporation can survive changes in ownership;
  • The corporation can exist perpetually;
  • A corporation is considered an individual and is, therefore, entitled to certain constitutional protections; and
  • There is limited liability because only the corporation itself is held responsible for its obligations.

How is a Corporation Formed?

Corporations are typically formed by complying with the corporate laws of the state in which the corporation operates. The majority of states base their corporation laws on the model act, called the Revised Model Business Corporation Act (RMBCA).

A corporation is formed when the Articles of Incorporation are filed in the state where the corporation is forming with the Secretary of State. The Articles of Incorporation are required to contain a number of factors.

It is important to note that each state has its own requirements for corporations. Because of this, there may be additional requirements for corporations in some states. Due to these differences, it is important to seek the advice of a lawyer when forming a corporation in order to ensure that all of the state and other legal requirements are satisfied.

What is a Close Corporation?

Close corporations are defined as corporations which are owned by a limited number of stockholders. Laws which govern close corporation requirements may vary by state.

However, the majority of laws limit close corporations to 35 shareholders. A close corporation is often composed of family members or friends.

The members of a close corporation are often relatively active in the daily affairs of the business. The majority of states permit close corporations to operate in a less formal manner than other types of corporations.

For example, the members of a close corporation can sometimes make decisions without having to convene a formal meeting with the board of directors. In order to take advantage of the benefits of the close corporation status, an organization must follow all of the requirements for the formation of a closed corporation in the state in which the organization is incorporated.

In addition, the treatment of stocks in closed corporations differs from those in a regular corporation. Because of shareholder agreements which are often present among the shareholders in close corporations, shareholders typically have much more control over stocks and how they are:

  • Bought;
  • Sold; and
  • Resold.

Close corporations are also typically prohibited from making public offerings of their stock.

What Are the Pros and Cons of Close Corporations?

There are numerous pros and cons which are associated with close corporations. Depending upon the needs of the individuals forming the close corporation, the unique characteristics of this type of corporation may either assist the individual or hinder them in achieving their business goals.

Close corporations combine the liability and debt protections of regular corporations and have a more relaxed and informal practice of governance mechanisms. The advantages of a close corporation may include:

  • Fewer formalities than regular corporations;
  • Increased control over shares; and
  • Less complex formation.

Close corporations often have fewer formalities than regular corporations. For example, numerous states do not require close corporations to have formal or annual meetings.

In addition, the decisions of the shareholders are typically allowed to override the decisions which are made by the directors. This changes the management dynamic of the typical corporation.

There is also increased control over shares in close corporations. Shareholders will typically draft a collective agreement which addresses the conditions for the purchase and sale of shares.
This collective agreement typically gives shareholders the first rights of refusal on sales and transfers. Therefore, control of a close corporation is held within the insiders.

The formation of a close corporation is less complex. A close corporation has fewer formal requirements, meaning that there is less of a chance of an error being made during the formation process. In addition, a closed corporation is often less costly and complicated to maintain in the long run.

In contrast, disadvantages of close corporations may include:

  • Increased liability for shareholders;
  • No public sales of stock;
  • Shareholder decision-making processes; and
  • Initial costs.

A close corporation may have increased liability for shareholders. In some states, shareholders may also be treated as though they are directors.

Because a shareholder can be more active in a close corporation, the shareholder is also exposed to more liabilities. For example, the shareholder may be held responsible for a decision which was made on behalf of the company.

A close corporation is not permitted to offer their shares of stock to the public. This may limit marketing capabilities and public exposure for a close corporation in addition to resale potential for the stock.

In a close corporation, certain shareholder decisions are required to be unanimous, including deciding whether to terminate the corporation. In addition, a written shareholder agreement and bylaws are often required in order to allow the corporation to have close corporation status, which can be complicated and must be written by a lawyer.

A close corporation may include a fair amount of start-up costs, although they may be cheaper to maintain in the long run. This is especially true when compared to other types of business options, including sole proprietorships and limited partnerships.

Before a business owner determines they should file for close corporation status, they should review the various features and limitations which are associated with this type of business structure. In addition, they should review the laws of their state as well as the requirements for close corporations, since they can differ widely by jurisdiction.

Certain states do not allow close corporations. It is important to note that the business can incorporate in a different state, if qualified to do so.

Do I Need a Lawyer to Start a Close Corporation?

It is essential to have the assistance of a corporate lawyer when starting a close corporation. The central focus of most close corporations is the shareholder agreements, which give the shareholders the power to sell stocks or to restrict stock sales.

These agreements can often be complex due to the fact that they need to reflect the overall goal of the corporation as well as considering the backgrounds of the shareholders. Your lawyer can assist you with drafting and reviewing the close corporation’s documents, including the bylaws and the articles of incorporation.

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