Delaware Close Corporation: Things You Should Know

A Delaware close corporation places restrictions on the buying, selling, and transferring of its stock.

A Close Corporation may have no more than thirty stockholders in Delaware.

To obtain and preserve “S-Corporation” tax status from the Delaware | Internal Revenue Service and/or to simplify administration for a small firm, typically a family business, are two common reasons for forming a Close Corporation.

To maintain S-Corporation tax status, restrictions on stock transfers are frequently used. For instance, a typical restriction forbids the transfer of restricted shares to non-resident foreigners.

A common limitation called “First Refusal” forces a potential seller to first offer the stock shares to the Company and its current shareholders before making the offer to anyone else. First refusal may be able to prevent the sale of shares in a family firm to non-family members or the sale of shares in an S-Corporation to an entity that would result in the loss of the corporation’s “S” status.

In terms of management, profit distribution, official decisions, and partner/shareholder recruitment, one can set up and operate a close corporation similar to an LLC or a limited partnership.

FEATURES OF A DELAWARE CLOSE CORPORATION

• Designed for a small, cohesive group – A close corporation is specifically structured for a small group of individuals who have a close relationship, such as family members or a tight-knit group of business partners. It allows for a more personalized and closely controlled business environment.
• Restricted to no more than 30 shareholders – Close corporations have limitations on the number of shareholders they can have, typically capped at 30 individuals. This restriction ensures that the company remains small and maintains the desired level of close involvement and control among shareholders.
• Corporations cannot become publicly traded – Unlike regular corporations, close corporations are prohibited from becoming publicly traded entities. This restriction helps to preserve the close-knit nature of the company and prevents outside investors from buying shares on public stock exchanges.
• Eliminates management by a Board of Directors – In close corporations, the traditional management structure of a Board of Directors is eliminated. Instead, the shareholders themselves assume the responsibilities of the directors and directly manage the company’s operations and decision-making.
• Shareholders assume the responsibilities of the directors and directly manage the company – In a close corporation, the shareholders actively participate in managing the company’s affairs, including making strategic decisions, overseeing day-to-day operations, and assuming executive responsibilities. This direct involvement allows for a more hands-on approach to management.
• Restrictions on the sale and transfer of stock – Close corporations often have restrictions in place regarding the sale and transfer of shares. These restrictions can include the requirement for shareholder approval before a transfer can take place or the right of first refusal, where existing shareholders have the first opportunity to purchase shares being sold.
• A provisional director may be appointed by the Delaware Chancery Court to settle disputes – In the state of Delaware, which is a popular jurisdiction for close corporations, the Delaware Chancery Court has the authority to appoint a provisional director to settle disputes among shareholders. This provision helps resolve conflicts and maintain the stability of the company.
• May elect Subchapter S if all qualifications are met – A close corporation may elect to be taxed under Subchapter S of the Internal Revenue Code if it meets the eligibility requirements. Subchapter S taxation allows the company to avoid double taxation by passing profits and losses through to the shareholders’ personal tax returns.

MANAGEMENT OF A DELAWARE CLOSE CORPORATION

1. Close Corporations are exempt from the requirement of conducting an annual meeting of the Board of Directors; instead, decisions affecting shareholders may be regulated by a “Shareholder Agreement” rather than a Board of Directors.
2. A shareholder agreement, which outlines the specifics of the regulation of the company’s business, is similar to an operating agreement or a limited partnership agreement.
3. The Certificate of Incorporation of a Close Corporation will contain the following details:
   •  The corporation’s name
   • The Delaware Registered Agent’s full name and address
   • The proposed Corporation’s General Purpose
   • A statement of the number of shares that have been authorized, either with or without a par value.
   • The names and addresses of the Incorporator and the Initial Director. Unless the Certificate is intended to be private, in which case the fifth article will only include the Incorporator’s name and address, a clause stating that there may be no more than 30 shareholders
   • a declaration that the shares of stock are bound by one or more restrictions on stock transfers
   • A statement that the company won’t offer its shares for sale to the public.
   • The incorporator’s signature

DIFFERENCE BETWEEN DELAWARE CLOSE CORPORATION VS GENERAL CORPORATION

• Ownership and Shareholders – In a general corporation, there are no restrictions on the number of shareholders, and ownership can be widely dispersed among the public through the sale of shares on public stock exchanges. On the other hand, a close corporation is designed for a small, cohesive group and typically limits the number of shareholders to no more than 30 individuals.
• Transfer of Shares – In a general corporation, shares can be freely transferred or sold without significant restrictions. However, in a closed corporation, there are often restrictions on the sale and transfer of shares. These restrictions can include requirements for shareholder approval or the right of first refusal, which gives existing shareholders the first opportunity to purchase shares being sold.
• Governance and Management – A general corporation typically follows a traditional management structure where shareholders elect a board of directors, who are responsible for making strategic decisions and overseeing the company’s operations. In contrast, a closed corporation eliminates the board of directors and allows shareholders to directly manage the company. Shareholders in a close corporation assume the responsibilities of the directors and actively participate in decision-making and day-to-day operations. If you wish to know more about forming a company here, refer to Delaware company registration for non-residents.
• Public Trading – A general corporation has the option to become publicly traded by listing its shares on a stock exchange. This allows the general public to buy and sell shares in the company. In contrast, a close corporation is prohibited from becoming publicly traded. Its shares are not publicly available, and ownership remains within the limited group of shareholders.
• Size and Scale – General corporations can vary in size and scale, ranging from small businesses to large multinational corporations. Close corporations, however, are specifically designed for small groups of shareholders and are often associated with closely-held family businesses or small partnerships.
• Regulatory Requirements – General corporations are subject to more extensive regulatory requirements and reporting obligations due to their potential impact on the public and financial markets. Close corporations, especially those registered in Delaware, often have more flexibility and fewer regulatory burdens, allowing for greater autonomy and privacy.

ADVANTAGES & DISADVANTAGES OF A DELAWARE CLOSE CORPORATION

ADVANTAGES

• Simpler overall operation – In a close corporation, the owners or shareholders are actively involved in the day-to-day operations of the business. This leads to a closer alignment of business goals and quicker decision-making.
• Fewer formalities – Close corporations have fewer regulatory requirements and formalities compared to larger corporations. While there are still rules for incorporating the business, the ongoing compliance obligations and reporting requirements are generally less burdensome.
• Restricted liability – The limited liability of shareholders in a close corporation shields their personal assets from the debts and liabilities of the company. There might be exceptions, such as when a shareholder has personally guaranteed a debt.
• Greater freedom – Compared to regular organizations, owners of close corporations have more freedom to manage their businesses. Without the oversight and bureaucracy frequently associated with larger firms, they have more influence over strategic decisions and can react rapidly to market developments.
• More control over shares – Shareholders have greater power over how and when shares are sold or transferred to outside investors in a close organization. This makes it possible to have more control and to safeguard ownership interests.

DISADVANTAGES

• Costs – Establishing a Delaware close corporation can be more expensive compared to other jurisdictions. Costs incurred by them include filing fees, annual franchise taxes, and additional administrative costs.
• Delaware-Specific Laws – Delaware has its own specific corporate laws and requirements, which may be unfamiliar or burdensome to businesses operating outside of the state. This can lead to additional compliance efforts and potential complexities for companies based in other jurisdictions.
• Limited Number of Shareholders – Delaware close corporations are restricted to no more than 30 shareholders. This limitation may not be suitable for businesses that intend to have a larger number of shareholders or seek external investment.
• Compliance Obligations – While Delaware provides flexibility, close corporations must still fulfill ongoing compliance obligations, such as filing annual reports and paying annual franchise taxes. Failure to meet these requirements can result in penalties and potential loss of good standing.
• Close Shareholder Involvement – While some may consider close shareholder involvement an advantage, it can also pose challenges. Decision-making and management responsibilities may be more time-consuming and complex due to the direct involvement of shareholders.

Reach out to us at Relin Consultants – Leading Global Business Set Up Partners for further assistance with your Delaware close corporation.