A California Close Corporation is a corporation designed to give its shareholders more control over the operation of their business. Instead of sitting back and letting others run the company, the owners of a Close Corporation typically act as the company’s managers. By complying with specific statutory requirements, Close Corporations can forego many of the corporate formalities other corporations are required to comply with. This in turn reduces the risk that others will be able to pierce the corporate veil and reach the owners’ personal assets. 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 sudivision (b), shall not be considered a factor tending to establish that the shareholders have personal liability for corporate obligations”. However, shareholders who manage the Close Corporation are subject to the same fiduciary duties any director of officer of a corporation has.
The California Corporations Code imposes the following requirements for qualification as a Statutory Close Corporation:
1. The Corporation cannot have more than 35 shareholders. However, for the purposes of satisfying this requirement, spouses are considered to be a single shareholder as are corporations, trusts, partnerships or other business associations unless the primary purpose of the entity was to acquire the close corporation’s shares.
2. The Articles of Incorporation must include a provision that the corporation cannot have more than 35 shareholders and specifically state that the corporation is a close corporation.
3. The corporation’s share certificates must contain a conspicuous legend stating: “This corporation is a close corporation. The number of holders of record of its shares of all classes cannot exceed 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.”
4. The Shareholders must enter into a written agreement setting forth the matters upon which the shareholders, rather than the board, will exercise control. The shareholders’ agreement must be lodged with the Secretary of the Corporation and available for inspection by prospective purchasers. It is common for Shareholders’ agreements to include buy-sell provisions limiting transferability of shares providing existing shareholders with a right of first refusal. Moreover, close corporations may provide for greater control by minority shareholders and disproportionate distributions of profit.
In addition to these statutory requirements, Close Corporations cannot go public.
Ultimately, the Statutory Close Corporation is run much like a partnership providing its owners greater latitude in the management of the corporation’s day to day operations. Small business owners often look to the Statutory Close Corporation as a practical business entity option, one that provides them the liability protections of a corporation while simultaneously providing flexibility and control. It should be noted, however, that Limited Liability Companies (LLCs) offer similar benefits and should be considered.
California’s Statutory Close Corporation is not without its drawbacks. As stated above, shareholder managers remain potentially liable for breaches of fiduciary duties held by directors and officers of general corporations. In addition, the shareholders’ agreement and statutory requirements of a Close Corporation typically make outside investment less appealing. The limitation on the number of shares sold and other transferability restrictions typically included in shareholders’ agreements naturally reduce the corporate shares’ marketability.
While corporate formalities are relaxed for the California Close Corporation, they remain important in many ways. First, these formalities can only be dispensed with to the extent the shareholders’ agreements and by-laws specifically allow for it. Any ambiguities are likely to be resolved in favor of normal corporate procedures. Second, from practical standpoint, banks and other lending institutions usually require certified copies of resolutions to open accounts and take out loans. Maintaining corporate formalities makes good business sense. It keeps managers, officers and directors on their toes. In addition, personal guarantees are usually required by banks for corporate loans, and this is more common for Close Corporations. Personally guaranteed loans are counter-productive to the idea of limiting personal liability.
Finally, opting for disproportionate allocation of profits or other financial rights are likely to be deemed as giving preferential rights to certain shareholders thereby disqualifying the Close Corporation from electing to be taxed as an S Corporation.
Forming a California Close Corporation is generally more expensive than forming a general corporation due to the increased attorney’s fees associated with preparing the shareholder’s agreement. Shareholders’ agreements are usually detailed and look much like partnership agreements. The ultimate decision on which business entity is right for your business should be made with the guidance of a San Diego Corporation Attorney.