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Editorial 10 MIN READ

The close corporation, revisited after TCJA

A 21% corporate rate changes the shareholder math; the governance pitch is the same as it ever was

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 6 sections
  1. What TCJA did and did not do to the form
  2. The statutes have not moved
  3. QSBS is the interesting footnote
  4. Where the form still earns its keep in 2018
  5. Failure modes, same as they were
  6. Sources

he close corporation statutes did not change when the Tax Cuts and Jobs Act moved the federal corporate rate to a flat 21 percent. The tax math behind the form did. Eighteen months after we last wrote about the close corporation, the statutory mechanics in Delaware, California, and Texas are exactly where they were; the shareholder-level arithmetic has shifted enough to be worth reopening the file.

This is a form that survives, in 2018, for reasons the TCJA mostly did not touch. Estate and legacy planning still drives most of the elections we see. Active operating businesses still belong in an LLC.

What TCJA did and did not do to the form

TCJA did three things that matter to anyone weighing a close corporation.

First, it replaced the graduated corporate rate schedule with a single 21 percent rate under IRC § 11, effective for tax years beginning after December 31, 2017. The IRS confirmed the transition mechanics in its fiscal-year blended-rate guidance: a corporation whose tax year bridged January 1, 2018 prorates, and everyone else pays 21 percent from the first day of their first 2018 year.

Second, it left the shareholder side of the double tax alone. Qualified dividend rates remain 0, 15, and 20 percent under IRC § 1(h)(11), and the 3.8 percent net investment income tax under IRC § 1411 still rides on top for high earners. A close-corp shareholder in the top bracket therefore pays a combined federal rate on distributed earnings of roughly 39.8 percent (21 percent at the entity, then 20 percent plus 3.8 percent on what comes out). That is down from the pre-TCJA combined rate closer to 50 percent, which is a real change, but it is still meaningfully above the roughly 37 percent top rate a single-layer pass-through shareholder sees on distributed profit after § 199A, and the § 199A deduction does not help a C-corp shareholder at all.

Third, it left every provision that makes the close corporation peculiar exactly where it was. The accumulated earnings tax under IRC § 531 still imposes an additional 20 percent on unreasonable accumulations. The personal holding company tax under IRC § 541 still applies. Subchapter C still taxes liquidating distributions as sales at the shareholder level. The close corporation is still a C-corp (or, if the shareholders elect, an S-corp) with LLC-flavored governance. The only thing TCJA did on the entity side was cut the headline rate.

The effect on the close-corp shareholder calculus is smaller than the 21 percent headline suggests. If the company retains earnings, 21 percent is the whole federal bill and compound growth happens on the after-corporate-tax number; the double tax only lands when cash comes out. For a family business that reinvests for a generation, that is a meaningful improvement on 35 percent. For an operating business whose owners expect to take most of the profit home every year, the second layer still eats the spread, and an LLC taxed as a partnership (or an S-corp) remains cheaper on an all-in basis.

The statutes have not moved

The close-corporation subchapters in the three states that matter most have not changed in any way relevant to the form since we wrote about them in October 2016.

Delaware's Subchapter XIV of the DGCL still requires the certificate of incorporation to state that the corporation is a close corporation, cap the number of record holders at a specified number not exceeding 30 under 8 Del. C. § 342(a)(1), subject all issued stock to one or more of the transfer restrictions permitted by § 202, and prohibit any public offering under the Securities Act of 1933. Joint tenancy or tenancy by the entireties still counts as a single holder for the 30-shareholder cap. Sections 350 and 351 still validate shareholder agreements that manage the business without a board, imposing director-level fiduciary liability on the shareholders who sign. Section 354 still preserves agreements that cause the corporation to be treated "as if it were a partnership" for governance purposes. Section 355 still lets the certificate grant a dissolution option.

California Corporations Code § 158 still defines a close corporation as a corporation whose articles state that the corporation is a close corporation and that all issued shares of all classes are held of record by not more than a specified number of persons, not exceeding 35. Adding the close-corp designation to an existing corporation still requires unanimous written consent after issuance under § 158(c); removing or changing the cap still requires two-thirds of each class unless the articles set a lower threshold. Spouses, single trusts, and single business entities still count as one shareholder for the cap. Exceeding the cap still flips the corporation out of close-corp status by operation of the statute.

Texas uses a different architecture. Subchapter O of Chapter 21 of the Texas Business Organizations Code (§§ 21.701 through 21.732) defines a close corporation as a for-profit corporation formed under or governed by that subchapter. Unlike Delaware and California, Texas imposes no statutory cap on the number of shareholders. Formation happens under Chapter 3 with the certificate of formation stating that the corporation elects close-corporation status (§§ 21.703 and 21.718), and the shareholders' agreement under § 21.714 can cover fifteen categories of governance matter, from buy-sell mechanics and dividend policy to management structure and dispute resolution. Section 21.713 lets the agreement dispense with a board; §§ 21.725 and 21.726 allocate the director-level duties to whoever actually runs the company under the agreement.

None of this moved in 2017 or 2018. The Texas subchapter has been stable since the BOC's mandatory application in 2010. The DGCL's Subchapter XIV is older still. California's § 158 has been in place since 1977 and has been amended only at the edges.

QSBS is the interesting footnote

IRC § 1202, the qualified small business stock exclusion, is where the close-corporation form still has a genuinely distinctive tax angle in 2018, and it is an angle TCJA did not touch.

Section 1202 allows a non-corporate taxpayer to exclude up to 100 percent of the gain on the sale of qualified small business stock held more than five years, subject to a per-issuer cap of the greater of $10 million or ten times the taxpayer's adjusted basis. The 100 percent exclusion applies to stock acquired after September 27, 2010. The issuing corporation must be a domestic C corporation with aggregate gross assets not exceeding $50 million before and immediately after issuance, must meet the active-business requirement for substantially all of the holding period, and must not be engaged in the excluded service trades or farming, banking, insurance, financing, leasing, investing, hotels, restaurants, and a handful of other listed fields.

The statute says nothing about close corporations as such. It asks whether the issuer is a C corporation, not whether the state charter bears Subchapter XIV markings. A Delaware close corporation that has not elected S status, and that meets the § 1202(c) and (e) tests, is a qualified small business for purposes of the exclusion. A California close corporation that issues stock directly to a founder, meets the gross-assets cap, and runs a qualified trade or business is likewise eligible.

The practical consequence is that a planner designing a family-held operating business with a possible exit horizon can, in principle, pair close-corporation governance (charter-level transfer restrictions, shareholder-agreement management, no board) with § 1202 treatment on founder stock. That combination is narrow. It requires the discipline of a C-corp, the patience of a five-year holding period, and the willingness to live with the 21 percent corporate layer in the meantime. When the fact pattern fits, no LLC structure reaches the same place; the § 1202 exclusion is a C-corp benefit and the check-the-box conversion resets the holding-period clock. Most close corporations will not exit and will never use § 1202, but for the ones that do, the form is a defensible wrapper.

Where the form still earns its keep in 2018

The narrow-use cases we described in 2016 are still the narrow-use cases.

Estate and legacy planning around a closely held operating business whose family wants C-corp character is the clearest. The charter-level transfer restrictions under Delaware's Subchapter XIV, California's § 158, or Texas's § 21.714 survive a shareholder's death without relying on a separate agreement that an executor might contest. At post-TCJA rates, the C-corp side of the pitch is cheaper than it used to be, and the estate-planning side is unchanged. Trusts and entities that cannot hold S-corp stock remain the most common reason a planner reaches for this form instead of a simpler pass-through.

Legacy S-corporations with accumulated-adjustments-account baggage or built-in gains, where the shareholders prefer to keep the existing corporate shell, still use close-corp status to switch to a shareholder-agreement governance model without dissolving. TCJA added one new reason to sit still: an S-corp conversion to a partnership or LLC today may surface § 1371(f) issues that did not exist before, and the cleanest path for many older S-corps is to retain the corporate shell and tighten the governance, not restructure.

State-tax quirks still exist and still deserve local advice. In a handful of jurisdictions, a close corporation gets better franchise, gross-receipts, or business-license treatment than an LLC doing the same activity. Those pockets have not grown since 2016, but they have not shrunk either.

For everything else, the LLC still wins. A two-founder startup, a single-owner consulting practice, a real-estate holding vehicle, a family investment partnership: the LLC reaches the same governance destination under an operating agreement, stays a single-layer pass-through, and never has to worry about blowing a 30- or 35-shareholder cap when a second-generation inheritance arrives.

Failure modes, same as they were

The sharp edges have not moved either, and the 21 percent rate does not dull them.

The Delaware 30-holder cap and the California 35-holder cap still flip the corporation out of close-corp status automatically when they are exceeded. The failure mode is silent: no filing, no notice, just a corporation whose charter language assumes close-corp status and whose actual status, as of whatever transfer pushed the count over, is a conventional corporation with stranded governance provisions. Texas does not share the cap, but it has its own version of this problem: § 21.708 lets the shareholders' agreement specify events that terminate close-corp status, and a drafting error or an outdated agreement can trigger termination without anyone intending it.

Transfer restrictions still have to be reasonable to be enforceable. The charter-level notice solves the notice half of the enforceability test; it does not solve the reasonableness half. Restrictions that amount to an absolute prohibition, or that give one party unfettered discretion with no cure, can be struck. The risk has not changed since 2016 and the case law has not meaningfully developed.

Inattention remains the most common way the form fails. A close corporation run by shareholder agreement, with no board and no annual meeting, tends to drift. Minutes lapse. Officer elections are forgotten. The carefully drafted 1998 certificate sits in a drawer until a 2018 buyer's counsel asks for it, and no one can find the counterpart to the shareholders' agreement. The form rewards discipline, and small companies are not always disciplined.

If you are choosing an entity this month and someone suggests a close corporation, ask why not an LLC. The answer will still usually be an estate-planning constraint, a legacy S-election, or a state-tax artifact. TCJA added one new reason to hear out a close-corp answer, which is § 1202 eligibility on a possible exit. It did not change the base rate. For the family business that has been a Delaware close corporation since 1984, the 21 percent rate is a quiet gift. For everyone else, the form is still narrow, and the answer is still usually the LLC.

Sources

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