The close corporation in 2016: a form the LLC mostly replaced
Subchapter XIV is still on the books, and a small number of filers still use it on purpose
Contents 3 sections
elaware has roughly five thousand close corporations on its rolls. That is not a lot of entities for a form that, forty years ago, was supposed to solve the governance problems of the small, closely held business. The LLC ate that lunch, and most of the close corporations still filed today are either grandfathered structures from the 1970s through the 1990s or the product of a specific tax or estate-planning choice the LLC cannot quite replicate.
The form is not obsolete. It is narrow.
When the close-corporation election still earns its keep
A close corporation is a regular corporation that has elected, in its certificate of incorporation, to operate under the close-corporation subchapter of its state's corporate code — Subchapter XIV of the DGCL in Delaware, with parallel provisions in California, Texas, and a handful of other states. Once elected, the corporation may dispense with a board of directors, govern itself by shareholder agreement, restrict share transfers as a matter of the charter rather than a side contract, and generally behave like a partnership in everything but tax character.
That last clause is the point. A close corporation is a C-corp (or an S-corp, if the shareholders so elect) with LLC-flavored governance. In 2016, the places where that combination is actually useful are few and specific.
The clearest is estate planning around a closely held operating business where the family wants C-corp treatment — typically because of fringe-benefit rules, or because the company is accumulating earnings that would blow an S-corp election, or because the shareholders include a trust or entity type that cannot hold S-corp stock. In those cases, the planner wants the charter-level transfer restrictions the close-corporation subchapter provides, because they survive a shareholder's death without relying on a separate agreement the executor might contest.
A second is certain legacy S-corp structures where the S-election has accumulated tax baggage — built-in gains, accumulated adjustments account issues, a history of basis questions — and the shareholders prefer to keep the existing corporate shell and its S-election rather than unwind and re-form as an LLC. Electing close-corporation status mid-stream lets them switch to a shareholder-agreement governance model without dissolving the corporation.
A third is the long tail of state-tax quirks. A few states treat corporations and LLCs differently for franchise, gross-receipts, or local business-license purposes, and in isolated cases the close corporation comes out ahead. These are worth checking with a local tax adviser; they are not worth chasing as a general matter.
For almost everything else — the two-founder startup, the single-owner consulting practice, the real-estate holding vehicle, the family investment partnership — the LLC reaches the same destination without double taxation and without the filing theater.
Mechanics: the election has to be in the certificate
The close-corporation election is not a post-formation filing. It has to appear in the certificate of incorporation at the moment of formation, using the specific statutory language. In Delaware, the certificate must state that the corporation is a close corporation, must cap the number of record holders (thirty is the statutory maximum), must provide that all issued stock of all classes is subject to one or more of the permitted transfer restrictions, and must declare that the corporation will not make any public offering of its stock. Miss any of those and the election does not take.
Amending an existing corporation into close-corporation status is possible but awkward: it requires the same charter language and, in Delaware, a two-thirds vote of each class of outstanding stock. In practice, if a corporation is going to be a close corporation, it is almost always cleaner to form it that way from the start.
Governance is where the form earns its reputation for flexibility. The shareholders may, by unanimous written agreement, dispense with the board of directors entirely and manage the corporation themselves. The agreement may allocate voting, dividends, and officer positions in ways that would, in a conventional corporation, draw a challenge as an improper restraint on the board's fiduciary discretion. Under the close-corporation subchapter, those allocations are expressly permitted, and the shareholders are treated, for fiduciary-duty purposes, as if they were the directors.
Transfer restrictions are the other load-bearing feature. The charter may condition every transfer on the corporation's or the other shareholders' consent, or on a right of first refusal, or on a bona-fide-offer procedure. Because the restriction lives in the certificate, it binds every share from issuance and is enforceable against transferees who, on inspection of the certificate and the stock legend, are charged with notice of it.
Tax treatment is no different from any other corporation. A close corporation is a C-corp by default and may elect S-corp status if it meets the S-corporation eligibility rules — which, notably, include their own hundred-shareholder cap and their own restrictions on who may hold the stock. The two sets of restrictions do not align perfectly; a close corporation can be ineligible for S status (trust shareholder, nonresident alien) and still be a valid close corporation.
Failure modes
The close-corporation subchapter has two sharp edges, and most of the trouble with the form comes from one of them.
The first is the shareholder cap. A Delaware close corporation may have no more than thirty record holders. Exceed that number — by issuing to an additional investor, by a shareholder's estate distributing shares to multiple beneficiaries, by a divorce decree transferring half a block to a spouse — and the close-corporation status is lost automatically. The corporation becomes a regular corporation, the charter provisions that assumed close-corporation status become dead letter, and whatever governance arrangement the shareholders were running by agreement has to be reconciled with the default corporate rules. Thirty sounds like a lot until a second or third generation of family shareholders is in the mix.
The second is the transfer restriction. Restrictions on transfer are enforceable only if they are reasonable and if the transferee has notice. In the close-corporation context, notice is built in through the charter and the stock legend, but reasonableness is not. A restriction that amounts to an absolute prohibition on transfer, or that conditions transfer on a party's unfettered discretion with no cure, can be struck down. When that happens, the corporation has a shareholder it did not expect, the other holders have a dilution they did not plan for, and any shareholder agreement that assumed the original roster is now operating on stale facts.
A related failure mode is simple inattention. A close corporation run by shareholder agreement, with no board and no annual meeting, tends to drift. Minutes are not kept. Officer elections lapse. The certificate language that was so carefully drafted at formation is not looked at again for a decade, and when it is, no one can find the counterpart. The form rewards discipline, and small companies are not always disciplined.
If you are choosing an entity this quarter and someone suggests a close corporation, ask why not an LLC. The honest answer is usually an estate-planning constraint, a legacy S-election, or a state-tax artifact. If it is none of those, form the LLC and keep moving.