Close Corporations: The Good, the Bad, and the Ugly

Flexibility is a key to the popularity of LLCs. Unlike the rigid structure associated with corporations, where shareholders elect directors, and directors elect officers, who in turn run the company, the LLC provides the ultimate in flexible management structures. Sadly, though, the gross receipts fee imposed on LLCs has caused so many business owners to look for other solutions (See “What is the annual cost of maintaining a LLC?)

In a regular corporation or “general” corporation , failure to follow certain corporation formalities, like holding annual meetings of the shareholders and directors and not allowing the directors to make major business decisions, can result in personal liability for the shareholders for corporate obligations. Electing to function as a “statutory close corporation”, on the other hand, can provide the flexibility of the LLC without the gross receipts fee. In a statutory close corporation, the shareholders, not the board of directors, hold the power to manage the business. Even better, the failure of a close corporation to observe corporate formalities relating to meetings of directors or shareholders in connection with the management of its affairs is not considered as a factor tending to prove personal liability of the shareholders. Cal Corp Code Section 300 (e).

In the right situation, a statutory close corporation can be the magic ticket. In one situation, we represented a band that operated through a general corporation. The lead singer was a brilliant business man, and the rest of the shareholders were, well, … not. All of the other band members agreed that the lead singer needed greater management power than represented by his ownership percentage of the shares of the corporation to run the day-to-day business of the band.

The statutory close corporation worked nicely for the band, so why don’t we use it for every client? The answer lies in the requirement that a statutory close corporation have a detailed shareholder agreement. The provisions of this sort of shareholder agreement are far more extensive that a typical shareholders agreement, which contains buy-sell provisions. Substantively, the organizational documents of a statutory close corporation must satisfy several important requirements:

1. Cal. Corp. Code Sec. 158 (a) requires that the Articles of Incorporation include the statement “This Corporation is a close corporation and that the number of shareholders shall not exceed 35”. This language may be included in the Articles at the time of formation or by amendment, but if it is included in an amendment, the amendment must be adopted by the affirmative vote of all of the shareholders.
2. Additionally, the shareholders of a close corporation must unanimously adopt a shareholders agreement. The shareholders agreement must contain a detailed scheme by which the shareholders, rather than the board of directors, will manage the affairs of the corporation. This is typically a very detailed, highly customized agreement. Because of the expense associated with the shareholders agreement, a close corporation is not the inexpensive, flexible solution to the needs of most business owners. While many view a close corporation as a tool to avoid corporate formalities, as a practical matter, it usually far more cost effective to simply prepare annual minutes and follow corporate requirements.
3. The share certificates must contain the following conspicuous legend: “This corporation is a close corporation. The number of holders of record of its shares of all classes cannot exceed ____ [a number not in excess of 35]. Any attempted voluntary inter vivos transfer which would violate this requirement is void. Refer to the articles, bylaws and any agreements on file with the secretary of the corporation for further restrictions.” Corp. Code Section 418(c).