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Editorial 9 MIN READ

The close corporation in late 2021: a form outrun by two others

Twenty months after the Corporate Transparency Act became law, the statutory close corp is competing for a niche that barely exists

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 7 sections
  1. What the statute still says
  2. The Corporate Transparency Act pushed the last wavering users toward LLCs
  3. What founders actually pick now
  4. The § 1202 question has not changed, and it matters
  5. Failure modes the form still has
  6. When to still pick this form
  7. Sources

he Delaware close corporation, once the preferred vehicle for owner-operated businesses that wanted corporate form without corporate theater, is in 2021 a statutory form most lawyers quietly advise against. Twenty months after the Corporate Transparency Act was signed into law as part of the NDAA for Fiscal Year 2021, the case for picking a close corp over an LLC or a public benefit corporation has thinned to almost nothing.

This is the fourth time Incorporator.org has looked at this form, following pieces in 2016, 2018, and February 2020. The trajectory has been the same each time. Fewer filings, narrower use cases, and a growing list of alternatives that do the same job with less statutory friction.

What the statute still says

Subchapter XIV of the Delaware General Corporation Law, 8 Del. C. §§ 341 through 356, defines the statutory close corporation. The headline provisions have not moved in a generation. A close corporation is limited to 30 record holders under § 342(a)(1). Its shares must bear a restriction on transfer under § 342(a)(2). It cannot make a public offering of its stock under § 342(a)(3). And under § 351, the certificate of incorporation can dispense with the board of directors entirely and vest management in the stockholders, which is the feature close-corp advocates have always pointed to as the form's defining move.

Sections 343 and 344 govern how an existing Delaware corporation elects close-corporation status or terminates it. Section 350 authorizes stockholder agreements that restrict board discretion. Section 352 gives the Court of Chancery the power to appoint a custodian or provisional director when close-corporation deadlock occurs, which is the form's structural weakness made explicit in the statute itself.

California's close-corporation provision sits at Cal. Corp. Code § 158 and caps the form at 35 shareholders. The certificate must contain both the close-corp election and the transfer restriction on every share certificate. Texas uses Subchapter O of the Texas Business Organizations Code, §§ 21.701 through 21.732, which permits shareholder management agreements and a similar departure from conventional corporate governance. The Texas version is the most permissive of the three, but even Texas practitioners rarely reach for it when drafting for a new closely held business.

The short version is that the statute authorizes the form. It does not oblige anyone to use it.

The Corporate Transparency Act pushed the last wavering users toward LLCs

The CTA, enacted January 1, 2021 as Title LXIV of the William M. Thornberry National Defense Authorization Act for Fiscal Year 2021, added a new 31 U.S.C. § 5336 that requires most small entities to report their beneficial owners to FinCEN. The reporting obligation does not take effect until FinCEN issues final regulations, and as of this writing the rulemaking is still open under the Notice of Proposed Rulemaking published in the Federal Register on December 8, 2021. Reporting itself will begin on the effective date the Secretary sets after the final rule.

The important point for the close-corporation question is that § 5336 applies to corporations and LLCs equally. A close corporation is a reporting company. An LLC is a reporting company. There is no CTA arbitrage between the two forms. Whatever privacy value the close corporation once carried has been neutralized at the federal level, and the neutralization lands at the same time state-level disclosure is tightening.

What that means in practice is that the group most likely to prefer a close corp in prior eras (family-owned operating businesses that wanted a fixed-identity ownership roster with no outside capital and minimal formalities) now faces the same beneficial-owner filing as every other small entity. The close-corp option survives, but the privacy argument that sometimes tipped the choice no longer tips anything.

What founders actually pick now

When a single-owner or small-group operating business walks in the door in late 2021, the choice tree almost always runs LLC first, then PBC, then (rarely) close corporation.

The LLC wins on flexibility. Delaware charges $90 to form and $300 a year in flat franchise tax under 6 Del. C. § 18-1107. There is no board requirement, no shareholder record, no stock certificate machinery, and the default tax treatment is pass-through. A family business that would once have elected a close corporation can now achieve the same practical governance (unanimous-consent management, transfer restrictions, pre-agreed buy-sell mechanics) entirely inside an operating agreement, without invoking Subchapter XIV or its California or Texas analogues at all.

The PBC is the form that has eaten a surprisingly large share of the closely held C-corp niche. Delaware amended 8 Del. C. § 362 in August 2020 to reduce the stockholder vote needed to become a PBC from two-thirds to a simple majority, and in the same amendment dropped the statutory appraisal right that used to attach to PBC conversions. The effect was to make PBC formation a near-default option for founders who want a corporate form and who have any mission-driven framing. PBCs post-August 2020 are easier to form, easier to convert into, and carry less litigation overhang than they did in the 2013-to-2019 window. Kickstarter, Allbirds, Warby Parker, and a long tail of smaller issuers have used the form. Some of that traffic would, in a prior decade, have been close-corp traffic.

What that leaves for the close corporation is a narrow strip of situations where founders want the specific § 351 feature of director-free management, inside a C-corporation tax shell, and are not well served by either an LLC (too much flexibility, in the sense of less-familiar litigation precedent) or a PBC (because there is no benefit purpose and no appetite to invent one). That strip is real, but it is small, and most of the founders in it are being steered by counsel toward a standard C-corp with a well-drafted stockholder agreement under 8 Del. C. § 218, which is available to any corporation and does not carry the 30-holder cap or the transfer-restriction-on-every-certificate requirement.

The § 1202 question has not changed, and it matters

Section 1202 of the Internal Revenue Code gives a non-corporate taxpayer a 100% exclusion on gain from the sale of qualified small business stock held more than five years, up to the greater of $10 million or 10 times basis, provided the issuer was a domestic C-corporation with aggregate gross assets under $50 million at the time of issuance. A close corporation that has properly elected under § 341 et seq. is still a C-corporation for federal tax purposes. Its stock can qualify as QSBS under § 1202(c) on the same terms as any other C-corp's stock.

This is the tax reason a closely held operating business might still pick a corporate form rather than an LLC. An LLC can elect to be taxed as a C-corp, but § 1202(c)(1)(A) requires the issuer to have been a C-corporation at the time the stock was issued and to have remained one throughout the holding period, and the conversion mechanics are not clean. For a founder who expects to sell in five to ten years and who wants the § 1202 exclusion available on exit, starting in corporate form is the safer path.

Whether that corporate form needs to be a close corporation rather than a plain vanilla C-corp is a separate question. The answer in 2021 is usually no. Section 1202 does not distinguish between Subchapter XIV corporations and any other Delaware C-corp. The exclusion attaches to the tax status, not the corporate-law subspecies.

Failure modes the form still has

The close-corporation statute was written on the premise that a small, cohesive group of owners could run a business without the formalities of a board. The statute's own § 352 remedy (custodians and provisional directors in deadlock) is the confession that this premise fails often enough to require a cleanup mechanism.

Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993), remains the leading Delaware authority on minority-stockholder rights in a closely held corporation, and its holding (that controlling stockholders owe the same fiduciary duties in a close corp as in any other Delaware corporation, with no special judicial doctrine of minority protection) is still the governing rule. Courts have not softened it. A close corp does not give minority holders a stronger set of rights than a standard corporation, and in many circumstances it gives them fewer, because the shareholder-agreement provisions that supplant the board also constrain what a dissatisfied minority can do.

California's analogue under Cal. Corp. Code § 158 and the derivative-and-direct claims doctrine laid out in Jones v. H. F. Ahmanson & Co., 1 Cal. 3d 93 (1969), produces a different balance for California close corporations, where controlling-shareholder duties are framed more protectively. A California closely held family business has reasons to consider § 158 election that a Delaware family business does not. Outside California, the close-corporation election buys less than the marketing suggests.

Texas's shareholder-management-agreement provisions at Subchapter O give wide drafting latitude but have generated far less case law, which cuts both ways. A well-drafted agreement in Texas can do almost anything. A poorly drafted one can leave disputes to be worked out in a jurisdiction that has not yet seen the question litigated.

When to still pick this form

A close corporation is the right answer in 2021 in a few specific circumstances. A California operating business with three to six family stockholders, a long-term hold intention, and a meaningful concern about minority-squeeze fact patterns is a real use case for § 158 election, because California's case law gives minority holders protections they would not otherwise have. A Delaware holding vehicle that wants to run without a board and has strong reasons to sit in corporate form rather than LLC form (most often because of § 1202 planning and a preference for Delaware case law over Delaware LLC Act interpretation) can reasonably elect close-corp status. A Texas family business where the drafting attorney is comfortable with Subchapter O and wants shareholder-management-agreement flexibility inside a corporation has a defensible reason to pick this form.

Outside those pockets, the close corporation in late 2021 is a form that answers questions most founders are no longer asking. The LLC does its informality job better. The PBC does its corporate-form job with less statutory overhead and a mission-language option that resonates with both staff and investors. The standard C-corp with a § 218 stockholder agreement does its governance-flexibility job without the 30-holder cap.

The statute is not going anywhere. Subchapter XIV was written to solve a 1960s-era drafting problem, and it still solves that problem for anyone who wants exactly the solution it offers. What has changed is that almost no one wants exactly that solution anymore, and the two forms that have absorbed the demand (LLC below, PBC above) have spent the last five years getting better at it.

Sources

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