A closed corporation, also known as a close corporation or privately held company, is a business entity where a small number of select individuals, often closely associated with the business, hold shares. Unlike publicly traded companies, closed corporations are not open to investment from the general public, offering more flexibility in operations and reduced reporting requirements. This article delves into the concept of closed corporations, their advantages and disadvantages, examples, and frequently asked questions.
Understanding closed corporations
A closed corporation, sometimes referred to as a close corporation, privately held company, or family corporation, is a business structure in which a limited number of individuals, usually owners, managers, or their families, hold shares. This structure provides several unique characteristics and advantages:
Here is a list of the benefits and the drawbacks to consider.
- Enhanced Privacy: Closed corporations enjoy a higher level of privacy compared to publicly traded companies.
- Long-Term Vision: Closed corporations can focus on long-term strategies rather than short-term goals.
- Pass-Through Taxation: Many closed corporations opt for pass-through taxation, simplifying the tax process.
- Reduced Corporate Taxation: Closed corporations that choose C corporation status may benefit from lower corporate tax rates.
- Flexible Ownership: Closed corporations offer more flexibility in ownership, often involving family members or close business partners.
- Limited Access to Capital: Closed corporations may face challenges accessing capital for expansion or operational needs.
- Lack of Liquidity: Shares in closed corporations are not publicly traded, which can result in limited liquidity for shareholders.
- Potential Shareholder Disputes: With a small number of shareholders, disputes can be more impactful and challenging to resolve.
- Succession Planning: Transitioning leadership and ownership within closed corporations, especially family-owned ones, can be complex.
- Restricted Market for Shares: Shareholders in closed corporations may find it difficult to sell their shares on an open market.
The legal structure of closed corporations
Understanding the legal framework of closed corporations is essential for business owners considering this structure. Closed corporations are formed under specific legal provisions that vary by jurisdiction. The legal structure dictates the rules and regulations that govern these entities. Here are some key aspects to consider:
Formation and ownership
Closed corporations are typically formed by a small group of individuals, often family members or business partners. The ownership structure is characterized by a limited number of shareholders, which can provide a more intimate and closely-knit business environment. This can be an advantage for family businesses or small enterprises where trust and close relationships are essential.
Flexibility in operations
One of the primary attractions of a closed corporation is the flexibility it offers in business operations. With fewer shareholders involved and reduced reporting requirements, these companies have more room to adapt quickly to changing market conditions, make strategic decisions, and innovate without the burden of meeting strict public reporting standards.
Succession planning in closed corporations
Succession planning is a critical aspect of closed corporations, especially those that are family-owned or have long-term management in place. It involves preparing for the transfer of leadership and ownership within the company, ensuring its continuity. Here are some key considerations:
Preserving family ownership
For family corporations, passing on the business to the next generation is a common goal. Succession planning helps in preserving the legacy and values of the company while ensuring a smooth transition of ownership. This may involve grooming the next generation of leaders and shareholders or considering external management if family members are not willing or capable of taking on these roles.
Closed corporations often use buy-sell agreements to establish a mechanism for the sale or transfer of shares among existing shareholders. These agreements define the process for handling situations such as a shareholder wanting to sell their stake, retiring, or passing away. It helps prevent conflicts and ensures a fair market value for the shares, protecting the interests of both the departing shareholder and the company.
Challenges in closed corporations
While closed corporations offer various advantages, they are not without challenges. Recognizing these difficulties is crucial for making informed business decisions:
Limited access to capital
One of the main challenges for closed corporations is accessing capital for expansion or operational needs. Publicly traded companies can raise funds through stock offerings and bond sales, but closed corporations have a more restricted set of options. They may rely on retained earnings, loans, or investments from existing shareholders.
Lack of liquidity
Shares in closed corporations are not publicly traded, which can result in limited liquidity. Shareholders may find it challenging to sell their shares or exit the company if they wish to do so. This can be a drawback, especially when shareholders need to access the value of their investment for personal reasons.
Closed corporations vs. publicly traded companies
Publicly traded companies, as the name suggests, offer shares to the public through stock exchanges, making them more accessible for investment. Closed corporations differ in several ways:
Publicly traded companies have a higher reporting burden, including annual reports, while closed corporations enjoy more privacy and flexibility in operations. Closed corporations do not answer to shareholder actions or quarterly profit targets, providing them with greater autonomy.
When it comes to raising funds, publicly traded companies have the advantage of selling shares or issuing bonds, which is not as accessible to private firms.
Examples of closed corporations
Closed corporations exist worldwide and span various industries. Here are some notable examples:
- Cargill: A multinational company with interests in manufacturing, trading, and investing, it reported $134.4 billion in revenue in 2022.
- Koch Industries: A conglomerate with revenues of $115 billion in 2022 and 122,000 employees.
- Publix: A Florida-based supermarket chain with 227,000 workers and $45 billion in sales.
- Mars, Inc.: A global candy and food product manufacturer that earned approximately $40 billion in 2022 and employed 130,000 people.
Well-known U.S. closed corporations include Ernst & Young, PricewaterhouseCoopers, SC Johnson, Hearst Corporation, Chick-Fil-A, and Hobby Lobby. Internationally, examples include IKEA, ALDI, Bosch, and LEGO.
Can I invest in a closed company?
Ordinary investors typically do not have access to shares of closed corporations. These shares are typically held by insiders such as top managers, co-founders, early investors, or their immediate family members. However, closely held stock can be gifted, allowing control to remain within the company or donated to organizations like hospitals, universities, or foundations.
Do closed companies pay dividends?
Closed corporations have the option to pay dividends to shareholders. However, most choose not to pay dividends to avoid potential double taxation.
Is a closed company the same as a closed fund?
No, a closed company and a closed fund are not the same. A closed company refers to a privately-held business entity with a limited number of shareholders. On the other hand, a closed fund or ETF (Exchange-Traded Fund) is a type of investment vehicle that is no longer accepting new capital inflows. Closed-end funds issue a fixed number of shares at the start and may trade on the secondary market, but new shares cannot be created.
The advantages of closed corporations
Understanding the benefits of operating as a closed corporation is essential for business owners. While we’ve discussed some pros, here are more advantages to consider:
Closed corporations enjoy a higher level of privacy compared to their publicly traded counterparts. They are not required to disclose financial information or business strategies to the public or competitors. This secrecy can be a significant advantage for businesses with proprietary technology or sensitive operations.
Closed corporations can focus on long-term strategies rather than short-term goals driven by quarterly profit expectations. This allows them to make strategic decisions that may take years to yield results, contributing to their sustained success.
Tax benefits in closed corporations
The tax implications of operating as a closed corporation can be advantageous. Here’s what you need to know:
Many closed corporations opt for pass-through taxation, which means the company itself does not pay taxes. Instead, profits and losses pass through to the individual shareholders who report them on their personal tax returns. This can result in significant tax savings and simplifies the taxation process.
Reduced corporate taxation
For closed corporations that choose to be taxed as C corporations, they may benefit from lower corporate tax rates and deductions. These savings can be reinvested in the business or distributed to shareholders as dividends.
The role of shareholder agreements
Shareholder agreements are crucial in the operation of a closed corporation. Here’s why:
Shareholder agreements outline procedures for resolving disputes among shareholders. This can prevent conflicts from escalating and ensure that the company continues to operate smoothly in case of disagreements.
Transfer of ownership
These agreements also detail the process for transferring shares when a shareholder wishes to sell, retire, or pass away. Having a clear plan for ownership changes ensures the company remains stable during these transitions.
Closed corporations offer a compelling business structure with numerous advantages, including enhanced privacy, long-term strategic vision, and potential tax benefits. Understanding the role of shareholder agreements and the legal aspects is vital for those considering this business model. While they come with some challenges, closed corporations have proven to be a successful choice for many businesses, offering flexibility and a unique approach to ownership and operations.
Frequently asked questions
What are other names for a closed corporation?
Closed corporations are also known as close corporations, privately held companies, private companies, family corporations, or incorporated partnerships. They may also be referred to as closely held, unlisted, or unquoted.
What distinguishes closed corporations from publicly traded companies?
Closed corporations have a limited number of shareholders, are not publicly traded, and enjoy greater operational flexibility and reduced reporting requirements compared to publicly traded companies.
Are there disadvantages to closed corporations?
Yes, closed corporations may face challenges related to limited liquidity, potential shareholder disputes, and difficulties in raising funds compared to publicly traded counterparts.
Can ordinary investors invest in closed corporations?
Ordinary investors typically cannot invest in closed corporations, as these shares are usually held by insiders and their immediate family members.
Do closed companies pay dividends?
Closed corporations have the option to pay dividends to shareholders, but many choose not to do so to avoid potential double taxation.
- Closed corporations, also known as close corporations or privately held companies, have a limited number of shareholders and are not publicly traded, offering operational flexibility and reduced reporting requirements.
- Examples of closed corporations include Cargill, Koch Industries, Publix, Mars, Inc., and several well-known U.S. and international businesses.
- Ordinary investors usually do not have access to shares of closed corporations, as they are typically held by insiders.
- Closed corporations can elect to pay dividends, but many choose not to do so to avoid potential double taxation.
- Closed companies should not be confused with closed funds or ETFs, which are investment vehicles that have stopped accepting new inflows of capital.