California Close Corporation
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In California, you may form both a corporation or a close corporation. While many elements between these two entities remain the same, there are distinct differences that are critical for business owners to understand if they are considering one entity or the other.
Forming a close corporation is done in the same way you would form a California corporation. You file Articles of Incorporation with the Secretary of State and pay the appropriate fee. The main difference at the incorporation stage is that your Articles of Incorporation must state that you intend to form a close corporation. As well, there are restrictions on the number of shareholders allowed by law for close corporations, which could play a role during formation.
How is a California Close Corporation Different?
California law sets specific restrictions on close corporations, while also allowing them greater leeway in certain areas. Understanding these unique qualities should help you determine if a California close corporation is the right choice for your business or if a traditional California corporation is a better choice.
Number of Shareholders
A California close corporation can have no more than 35 shareholders. This restriction speaks to the law’s design. The close corporation is intended for small, family-run businesses. Since the law also curtails certain corporate formality requirements, it makes up for this leniency by ensuring that close corporations are necessarily small.
If spouses form a close corporation together, the law allows the two to be counted as a single shareholder. In addition, corporations, trusts and other partnerships can also be counted as a single shareholder.
The California close corporation statutes allow the corporation to operate essentially like a partnership. A partnership is governed by whatever agreement the partners sign, and a close corporation is alike in this way. In a practical sense, shareholders are allowed to operate the corporation how they want, 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. In fact, a shareholder agreement may do away with a board of directors altogether (although it would be prudent to then outline the duties and obligations of the shareholders).
Ultimately, the shareholder agreement is the final word on how a close corporation operates.
A close corporation cannot go public. This clearly arises from the restriction on the number of shareholders of a close corporation. You cannot have a public corporation that limits the number of people who can purchase the stock. Even if such a scenario were possible, no underwriting bank would allow it (how would they make a profit?).
While publicly-traded stock is not possible for a California close corporation, it is worth noting that shareholders may set whatever restrictions they desire on ownership. This is one of the advantages of a close corporation: that shareholders have great control over the sale of stock to other investors.
Advantages of a California Close Corporation
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.
This allows a California close corporation to operate more like a partnership or California LLC, with a greater degree of flexibility than a classic corporation.
In a traditional corporation, profits are distributed depending upon the amount of shares of stock one holds. If you own twice as much stock as Joe, then you receive twice as much of the profit. A close corporation, however, is allowed to distribute profit disproportionately from the amount of stock each shareholder possesses.
This more flexible approach to distributing profits is also akin to how partnerships and LLCs operate.
Since a California close corporation operates primarily like a partnership, this elevates the position of the shareholder. In a classic corporation, shareholders may vote for members of the board of directors, but there are limits on the amount of direct control a shareholder may have.
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.
Disadvantages of a California Close Corporation
In a traditional corporation, shareholders are generally shielded from liability because fiduciary duties are fulfilled by directors. In a close corporation, however, shareholders may be held liable for fulfilling these duties if they take on management roles.
Shareholders should be made aware of the duties they are required to uphold to ensure that they do not unwittingly breach a fiduciary duty.
Formalities May Be Necessary
It may appeal to shareholders to simply do away with a board of directors, annual shareholder meetings, and keeping meeting minutes. This certainly simplifies management. However, many third parties will not conduct business with a corporation that does not fulfill these corporate formalities.
Investors, in particular, are attracted to the stability that is inherent in the formal structure of a traditional corporation. Boards of directors, corporate officers, regular meetings, minutes and records all provide layers of protection for an investor’s assets. A close corporation that forgoes these formalities may find itself limited in its business partners.
Possible Loss of S-Corp Status
Many companies take advantage of applying for S-corp status with the IRS. A close corporation can apply for S-corp status, but only if it distributes profits proportionately. If shareholders choose to distribute profits disproportionately, then the close corporation cannot opt for S-corp status.
California Close Corporation Formation
To form a California close corporation, file Articles of Incorporation of a Close Corporation with the Secretary of State. Through June 2023, there is no filing fee. Previously the fee was $100.
You can mail the filing to:
Secretary of State
PO Box 944260
Sacramento, CA 94244-2600
Filings can also be delivered in-person, but there is an additional $15 drop-off fee.
A close corporation will need to appoint a California registered agent.