What is a Company?

What is a company? This may seem like an overly basic question to ask, but in my experience most people really don't understand what a company really is. It is such a basic question that it is a little like asking what is air. We all know what air is, but do we? Air is what we breathe. Or, air is an colorless, odorless, tasteless gas. Or, air is a gas made up of 78% nitrogen, 21% oxygen, and 1% other gases. In reality such basic questions are not so simple. And simple questions always raise more simple questions, and pretty soon the questions aren't so simple to answer anymore. So, what is a company? A company is an organization created to make money. This organization may or may not have employees. Most companies do have employees; however, they are not an essential ingredient. To be considered legal, a company must be registered with a government agency, usually a county or state. Note that companies are registered locally with counties and states, not with the Federal Government (except for tax purposes). The main purpose for registration is, you guessed it, to pay taxes. Companies must pay local, state, and federal taxes. As far as the government is concerned, companies look like people. They have names; they live and die (though they don't have to die); they make and loose money; they must obey laws; and most importantly, they pay taxes. In fact, from the governments viewpoint, there is not much difference between a company and a person. People have social security numbers and companies have tax id numbers, different names for the same thing. As far as the government is concerned, both people and companies are opportunities to collect taxes. More formally, a company is a legal entity with a name which is recognized by a state and given the right to do business. Of course, this forces us to ask another basic question, what is a business? A business is an entity created to make money, that is a profit, for its owners. This entity called a business must have a name, an owner, and a business purpose. Most importantly as far as the state is concerned, it must be registered for the purposes of legal liability and the payment of taxes. The terms company and business will be used synonymously, though the term business will also be used in the larger sense to refer to the type of actives that the company performs to make money. I don't want to go into an excessive amount of detail here, but I think we can gain a better understanding of companies placing them in appropriate categories. By Legal Type: Proprietorship Partnership Corporation By Type of Ownership: Private Public By IRS Taxing Status: C S Other attributes such as industry, size, profitability, and organization are discussed in other sections. Classification by Legal Type A proprietorship, also called a sole proprietorship, is a company with has a single owner. It does have a name, but as far as the government is concerned there is no separation the owner and the company. The company does not have a separate tax identity with the government. The owner's social security number identifies both the company and the person. Most home businesses are sole proprietorships. Also very important is that, legally, the owner is personally liable for the actions of the business. If someone sues the company, they are suing the owner. A new form of business called a limited liability company is gaining popularity. These companies protect the owners from personal liability. A partnership differs from a sole proprietorship in that more than one person owns the business. Like a sole proprietorship, individuals are personally responsible for the taxes of the partnership and the actions of the partnership. There are special forms of partnerships which limit the legal liability of partners called limited partnerships. These are frequently used in real estate and oil and gas exploration. Corporations are separate legal and tax paying identities. Corporations exist for the purpose of sharing ownership with many people and limiting the legal liability. In fact, you will often see the name Limited or LTD. after a company name. This just means it is a corporation. There are separate laws which govern the behavior of corporations, and as far as the government is concerned, corporations are separate identities from the owners of the corporation. For example, as a stock holer in General Motors, you can not be sued if they build a faulty car. The company can, but you can't. On the other hand, if it were a proprietorship you could be sued. So, the main reason for creating a corporation is to limit liability by separating the legal liability of the company from the owners of the company. The second major reason for creating a corporation is raise capital, another new word. Capital is the word for the money used to start and run a company. It is easier to raise the money needed to start a business, when many people contribute a small amount of money. Since most businesses do not make money on the first day of operation, there needs to be some capital or money to pay the bills until the company is profitable. Individuals would not invest in a company if they knew they had to accept personal liability for actions of the management. People would not want to own stock if they knew they could be sued for the actions of the company over which they have no control. So this issue of limited liability is key to the concept of a company and its ability to raise money. Capital can be in the form of debt or equity, which are discussed elsewhere. Classification by Type of Ownership Companies can be private or public. This discussion can get very complex, but the basics are pretty simple. Private companies have stock which cannot be bought and sold on public stock exchanges. Most corporations are private corporations. Public companies have stock which can be traded in the stock market. The most common characteristic of private companies is that they are small in size (that's a separate question for later), though this does not have to be the case. Most big companies are public companies, because it usually takes a lot of capitalization (money) to become big, and it is easier to get capital by being a public company. Two very large, well known private companies are Mars Candies and Hallmark Cards. You cannot buy stock in either of these companies; they are private not public. Other private companies are Wolfe Cameras and Carabou Coffee Shops. Another key characteristic of private companies is that there is a usually a small number of owners (share holders). A typical private company will have less than 20 owners and frequently only one owner, the founder. A typical public company will have thousands or millions of owners. The most common private companies are restaurants, cleaners, electricians, local banks, real estate agencies, and other local businesses. Classification by IRS Taxing Status When initially formed all corporations are regular of "C" corporations. Once formed, a corporation may make an election with the United States Internal Revenue Service (IRS) to be an "S" corporation. An S corporation allows a company to be taxed as if it were a sole proprietership but have the legal protection and characteristics of a corporation. Remember that the main reason for creating a corportion is create a legal entity which is separate from the owners. Also remember that the profit of a corporation is taxed separately from the owners. That is, if a corporation pays out some of its profit to the share holders in the form of a dividend, the money is taxed twice, one at the corporate level and once at the individual level. Congress recognized that this created an unfair situation for small corporations which were owned by one or a few people and operated like sole proprieterships and wanted the legal protection of being a corporation. Their income, which was the profit of the company, would be taxed twice, once as a company and once when it was paid to the owner. To avoid this double taxation issue, congress passed a law, which became known as "Sub Chapter S" of the IRS code, which allows a small corporation to be taxed as if it were a sole proprietership. That is the profit from the S corportion is added to the personal income of the owners, and tax is paid only once. There are many more details associated with C and S coporations, but this is the most important distinction and motivation for making what is called an "S" election with the IRS after a corporation is formed. Companies which intend to remain small, remain private, and have a small number of share holders are almost always S corporations. All public companies are C corporations, in fact, they must be. The biggest restriction on being a S corporaton is not have more than 75 share holders. We are taking some liberty with the terminology here since technically a C coporation does not exist. Corporations are just corporations, and some of them have made a special election with the IRS (filed a one page form with the IRS) to have special tax treatment. We use the term C corporation just to easily identify companies which have not made the S election with the IRS. When we are investing in stocks, we will always be dealing with C corporations. When we start a small private company in which we are the owner, we will almost always be dealing with S corporations. Public companies must be C; private companies can be either C or S, but are almost always S. More information on this subject can be found in books about how to start a business. Think Like an Owner The important point to keep in mind as an investor is that whether or not you own 100% of the company or .001% of the company, you are still an owner. The most successful investors, think like owners. They buy and hold stocks as if they owned the company, because they do. This is the Warren Buffett model of investing. When you own stock, you own the company. You may not own enough to control the activities of the company, but you do in a very real sense own the company. Thinking and acting like an owner will dramatically improve your investment success.

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