One of the most important decisions entrepreneurs face when starting a new business is how to organize the new venture. Although the flexibility provided by a limited liability company (LLC) is enticing, California’s gross receipts tax is distasteful to many business owners. Moreover, the rigidity and formality of the standard corporate structure can prove cumbersome for young businesses. California’s statutory Close Corporate (meaning that the form of business entity was created and governed by statute) provides entrepreneurs a third option offering much of the same flexibility LLC’s provide while simultaneously avoiding California’s gross receipts tax. Because the ultimate choice will vary from business to business, it’s important to consult with a San Diego business attorney and a tax professional such as a C.P.A. before moving forward.
A close corporation is one in which the shares of the corporation are not freely traded and are held by a limited number of individuals. Significantly, the shareholders of a close corporation can authorize the elimination of the board of directors and run the corporation themselves, actively managing and operating the company’s day-to-day affairs. Most states have statutes specifically limiting the number of shareholders (generally between 30 and 50),and requiring that certain transfer restrictions appear on the stock certificates. California’s Corporation Code Sec. 158(a) requires that a close corporation’s Articles of Incorporation state, “This Corporation is a close corporation and that the number of shareholders shall not exceed 35.” In order to properly establish the corporation as closely held, the shareholders must prepare a written agreement (shareholder’s agreement) outlining the method by which management decisions are to be made and determining what, if any, restrictions are applicable to the sale of the ownership shares.
Because the shareholders manage a close corporation, they owe greater fiduciary duties to each other, and the controlling shareholders owe minority owners the highest duty not to oppress them. In the normal corporate structure, if a minority shareholder disagrees with the manner in which the company is conducting its business, typically his only recourse is to sell the stock (assuming the company’s officers or directors are not violating the law or the corporation’s bylaws). In a close corporation, however, sale of the stock is generally not an option. As such, the law allows minority shareholders to sue the majority shareholder(s) and seek court intervention in the management of the company
The proper operation of a traditional corporation requires the formation of a board of directors, appointment of officers, holding of regular
shareholder meetings, and compliance with corporate bylaws. Further,
shareholders of any corporation generally enjoy legal protection from
personal liability for the debts of the company (known as the “corporate veil”). The failure to comply with corporate formalities can establish a basis for litigants to pierce the corporate veil. However, because
close corporations often do away with or reduce such formalities, the
likelihood of successfully piercing the veil of a closely held
corporation is much lower.
Forming a California close
corporation provides shareholders a number of benefits not available to
other business entities. In order to properly form a close corporation,
however, compliance with applicable California law and the careful
drafting of a shareholders’ agreement are imperative. In addition, it’s important to carefully analyze all of the different forms of business
entities available including an LLC, S Corporation or C Corporation. It is advisable to consult with a business attorney before and during the process.