How and Why to Use a Statutory Close Corporation

How and Why to Use a Statutory Close Corporation

A corporation is often not the ideal entity choice for a closely held business – meaning one owned and operated by a small number of individuals. The primary reason is that by law, a corporation must observe certain formalities, such as regular meetings of shareholders and a board of directors to approve corporate acts, and failure to observe those formalities risks losing the limited-liability benefits of a corporation. That is, failure to carry out required procedures can allow third parties to “pierce the corporate veil” and make shareholders personally liable for the company’s debts and obligations.

Many small business owners are not fully aware of these requirements or view regular board and shareholder meetings as a nuisance or redundancy, particularly because the business “operators” and its shareholders and board members are usually the same people. However, corporations force those individuals to recognize the different hats they must wear. The limited liability company is often the sensible alternative, as such meetings are not legally required for an LLC. An LLC also allows owners substantial flexibility in customizing management of the entity and rights to profits and distributions. Unless there is a specific reason for choosing a corporation as the legal form of a business, an LLC is often preferable.

Sometimes, however, there is a specific reason why a corporation is needed. Under California law, certain businesses cannot be conducted by an LLC. Tax or accounting reasons, or the preferences of outside investors, may also favor a corporation. When these concerns are present but owners still want the flexibility of an LLC or partnership, they should consider using a “statutory close corporation.”

Statutory close corporations have existed in California since 1975. They are legally corporations, but offer several unique benefits.

1. A shareholders’ agreement for a statutory close corporation can modify, and in many cases eliminate, the formalities and requirements that typically apply to corporations. For instance, the agreement can eliminate the need for board and shareholder meetings. It can eliminate the necessity of the board itself, allowing the corporation to be managed, for practical purposes, as a partnership.

2. The shareholders’ agreement can also include customized terms on voting rights and dividends and distributions that are difficult or impossible with a conventional corporation.

3. With a statutory close corporation, failure to observe corporate formalities cannot be the basis for piercing the corporate veil or imposing shareholder liability for company debts.

On the other hand, there are certain disadvantages to statutory close corporations. They cannot have more than 35 shareholders. This is not an issue for many small businesses, but for those that wish to grow by bringing in outside investors or incentivizing employees with stock compensation, that limitation may be unworkable. Also, banks often require that a borrower have a board of directors and observe formalities, whether or not required by law. Thus, if a business depends on bank financing, there might not be much practical benefit to this form of entity. And if shareholders of a close corporation agree to financial rights disproportionate to share ownership, as the form allows, it might not be possible to be taxed as a pass-through “S Corp,” because federal law requires that S corps have only one class of equity, and the IRS sometimes views disproportionate financial rights as effectively creating two classes of stock. Of course, all tax-related questions should be directed to an accountant or other tax advisor before choosing the form of an entity.

There are several technical requirements to forming a statutory close corporation. The articles of incorporation must include an express election to be treated as such and a provision limiting stockholders to 35 or fewer. Each share certificate must include a legend with language specified in the California Corporations Code. And the shareholders’ agreement must be in writing and executed by all shareholders.

Whether a statutory close corporation is the right choice depends on the needs of a business, the relationships among its owners, tax considerations and future plans for expansion. It should be considered only upon the advice of experienced corporate counsel.