Structuring a User-Friendly “Close Corporation”

Introduction

As most of us remember from our law school corporations class, a typical corporation has three layers: (1) the shareholders, who own the corporation and meet annually to elect the board of directors; (2) the board of directors, who meet at least annually to decide corporate policy and oversee the corporation’s officers; and (3) the officers, who manage the day-to-day business of the corporation and report to the board of directors.

All of this makes sense for a corporation with many shareholders. However, the owners of a small business often find this structure pointless and cumbersome. After all, “Why do we need all these annual meetings and minutes when we work together every day?” The answer, of course, is liability: if a corporation does not follow these formalities, it is easier for a creditor to pierce the “corporate veil” that protects business owners from some types of liability.

Many business owners opt out of this problem by forming a limited liability company, or LLC, which allows for a simpler, more user-friendly governance structure. But, certain professionals are not authorized to use LLCs, and other business owners prefer corporations for tax reasons. The good news is that there is a workaround. A business owner who needs to use a corporation, but would prefer the simpler structure of an LLC, should consider a statutory close corporation.

Close Corporations in California Law

A California corporation may adopt a customized, streamlined governance structure if it meets the definition of a “close corporation” stated in Corporations Code section 158:

• Its Articles of Incorporation must include the statement that “This corporation is a close corporation.”
•  Its Articles of Incorporation must limit the total number of shareholders to 35 or less.
• The corporation may never actually acquire more than the authorized number of shareholders.
• Under Corporations Code section 300, the shareholders of a “close corporation” may jettison the usual corporate formalities in favor of a more streamlined structure by means of a shareholders’ agreement. For example, the shareholders’ agreement may:
  • Excuse a close corporation from the need to hold annual meetings of shareholders and directors.
  • Name the initial officers and directors of the corporation, and state the circumstances in which they can resign or be terminated.Require a supermajority vote for an important decision such as whether to sell a major asset or terminate an officer.
  • Provide that certain investors will be repaid before others.

On the other hand, to the extent that the shareholders’ agreement controls the “discretion or powers of the board,” each shareholder will be liable as if he or she was a member of the board of directors. Corporations Code § 300(d).

Practical Applications

A close corporation can be an excellent fit for a company that is owned by a handful of shareholders, all of whom are active in the business. This is particularly true for a company that is owned by a single person or by a married couple. By electing close corporation status, they can tailor the governance of the company to meet their needs.

For example, a basic shareholders’ agreement will appoint the initial officers and board of directors, waive the requirement that the corporation hold annual meetings, and state that the bylaws of the corporation will control except as stated in the shareholders’ agreement.

On the other hand, a close corporation may not be such a good idea for a company with passive investors. A passive investor, by definition, will not be involved in management and is unlikely to be intimately aware of the day-to-day workings of the corporation. He or she will have no reason to assume the liability of a board member under Corporations Code § 300(d). And, a passive investor may appreciate the opportunity to hold the board of directors accountable and gather information at annual meetings.

A Word of Caution About S Corporations

Many closely-held corporations elect to be taxed as “S Corporations” to take advantage of the tax benefits offered by Subchapter S of the Internal Revenue Code. In order to qualify as an S Corporation, a corporation must (among other things) have only a “single class of shares.” (See 26 U.S.C. section 1361(b)(1)(D).)

The “single class of shares” requirement can be a trap for the unwary. In practice, it means that any shareholder distribution (including a dividend or a distribution on liquidation) must be distributed strictly by percentage ownership of shares. If Shareholder X holds 25% of the issued and outstanding shares, Shareholder X must receive 25% of each and every dividend or other shareholder distribution.

So, even though a close corporation shareholders’ agreement may customize the “division of [the corporation’s] profits or distribution of its assets on liquidation” as a matter of California law (Corporations Code § 300(b)), this should not be done for a close corporation that plans to be taxed as an S Corporation. Unlike an LLC or another entity taxed as a partnership, an S Corporation is not allowed to be creative in this area. Any preferential distributions, shifting allocations, or similar techniques will literally kill the corporation’s election to be taxed as an S Corporation, resulting in unintended tax consequences and vexed clients.

Conclusion

A close corporation is an attractive option for small business owners who dislike the traditional corporate formalities but cannot use an LLC. In my experience, these business owners tend to go years without holding formal meetings of the shareholders or directors. Choosing a close corporation can make it easier for these business owners to manage their businesses while avoiding a potential threat to the corporate veil.