California “Close” Corporations

Wed, 5/23/18
Kathryn Andrews

The statutory "close" corporation permitted under Section 158 of the California Corporations Code is a specific type of legal entity that is well-suited for certain businesses where a tight-knit group of shareholders will maintain control over the management and ownership of the business.  Close corporations are ideal for businesses that are run as family ventures or other small businesses that do not want to be bothered with corporate formalities.

Requirements for Close Corporation Status

  • Number of Shareholders: A California close corporation can have no more than 35 shareholders. Married couples and trusts count as one shareholder. Since the law also curtails certain corporate formality requirements, it makes up for this leniency by ensuring that close corporations are necessarily small.
  • Legal Compliance: Include statement directly in the Articles of Incorporation: “This corporation is a close corporation.” Affirm directly in Articles that the corporation cannot have more than 35 shareholders. Also stock certificates must have a restrictive close corporation legend about the number of shareholders. Conversion to a close corporation requires unanimous shareholder consent.
  • Shareholder Agreement: In a practical sense, shareholders are allowed to operate the corporation how they wish, including doing away with corporate formalities such as annual meetings. A shareholder agreement may authorize shareholders to make decisions usually granted only to directors of a corporation. Ultimately, the shareholder agreement is the final word on how a close corporation operates.

Benefits of Close Corporation Status

Many small business owners find close corporation status advantageous because it allows them to bypass the formalities and restrictions normally placed on corporations. For instance, when a corporation is owned by only three or four business family members, it may seem unnecessary to provide notice of formal annual meetings for the corporation. Close corporation status eliminates this meeting requirement.

One of the main appeals of the close corporation is that shareholders can choose to disregard corporate formalities that they deem unnecessary. If shareholders do not want to hold annual meetings or keep meeting minutes, then these stipulations can be written into the shareholder agreement and adopted. A close corporation is also allowed to distribute profit disproportionately from the amount of stock each shareholder possesses (provided these requirements are set forth in a properly drafted shareholder agreement).

This more flexible approach to distributing profits is also akin to how partnerships and LLCs operate. Close corporations are designed for shareholders who want to have a direct hand in the daily operations of the company. The shareholder agreement can give specific powers and controls to shareholders that are normally reserved for directors and officers. Directors and officers can even be done away with altogether, should shareholders see fit.

With fewer corporate formalities required, shareholders of close corporations are less vulnerable to piercing the corporate veil suits. Section 300 of the California Corporations Code states: “The failure of a close corporation to observe corporate formalities relating to meetings of directors and shareholders in connection with the management of its affairs, pursuant to an agreement authorized by subdivision (b), shall not be considered a factor tending to establish that the shareholders have personal liability for corporate obligations.”

Disadvantages of Close Corporation Status

The restricted number of shareholders means that the business cannot be publically traded. Also any one shareholder has standing to petition an involuntary dissolution action. Because of this, it is prudent to have an agreement among the shareholders (which adds additional formation time and expense of forming a close corporation). Mergers and reorganizations also require super majority shareholder vote. Disproportionate distribution of profit is not compatible with S election status.

 

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