Archives for October 2010

The Snowball: Warren Buffet

I recently read  “The Snowball: Warren Buffet and the business of life.”  It is an 838 page biography, along with another 91 pages of endnotes, of Warren Buffet – “the Oracle of Omaha.” 

In the event you have never heard of Warren Buffet his significance is that he started with nothing and went on to become the world’s wealthiest individual [worth over $60 billion] by investing in the stock market. 

The book is not only a biography on his life, but it is also, as would be expected, filled with the pearls of investing wisdom – foundational and inviolable principles that guided Buffett throughout his life. 

And there is one piece of advice that struck me as particularly profound that I would like to leave with you.  Its weight and significance comes from the fact that it is found on page 761 of an 838 page book – in the the 73rd year of his life.  Warren Buffett is addressing a group of students at Georgia Tech.   He was asked what had been his greatest success and greatest failure.  Here is his response:

“Basically, when you get to my age, you’ll really measure your success in life by how many of the people you want to have love you actually love you.

“I know people who have a lot of money, and they get testimonial dinners and they get hospital wings named after them.  But the truth is that nobody in the world loves them.  If you get to my age in life and nobody thinks well of you, I don’t care how big your bank account is, your life is a disaster. 

“That’s the ultimate test of how you have lived your life.  The trouble with love is that you can’t buy it.  You can buy sex.  You can buy testimonial dinners.  You can buy pamphlets that say how wonderful you are.  But the only way to get love is to be lovable.  It’s very irritating if you have a lot of money.  You’d like to think you could write a check: I’ll buy a million dollars’ worth of love.  But it doesn’t work that way.  The more you give love away, the more you get.” 


The Decision to Incorporate [Part 1]

Advantages of Incorporation

Income Tax Deferral

When a person chooses to begin a new business venture one of the first decisions that will have to made is how to structure the business.  Will it be operated as a sole proprietorship or as a corporation?  There are many significant advantages to be gained from operating a business in a corporation (which will be addressed at a later date).    Perhaps the most significant benefit is the ability to defer the payment of income tax.

A Canadian Controlled Private Corporation [CCPC] is entitled to a  small business deduction [SBD] on the first $500,000 of income.  In 2009, a CCPC operating in Ontario would be subject to a corporate income tax rate of 16.5%.  As of July 1, 2010 the rate is further reduced to 15.5%.  Consider that for a moment.  The first $500,000 of income is taxed at only 16.5%.  

 See the graph below:

What would be the tax rate if that income was earned through an unincorporated business?  To answer that, we need to consider two important tax rates that come into play in calculating the amount of taxes owed when you file your tax return. 

The Average or Effective Tax Rate

The first rate to consider is the “average tax rate”.  Canada Revenue Agency [CRA] uses different rates of income tax depending on how much income you have.  Basically, the more you make, the more they [CRA]take.   For example, in 2009, CRA taxed you at 15% if you made $40,726 or less.  If you made more than that you end up in another tax bracket. The rate increases to 22% on any amount over $40,726 until you get to $81,452.  After that you enter another tax bracket where the tax rate goes up to 26%, and so on, all the way up to 29%.  The Ontario government does something similar.  The result of  this is that when you calculate the amount of taxes owed on your tax return, the tax rate is really a combination of several rates of tax — taken together they represent your “average tax rate”.  

The Marginal Tax Rate

The second rate to consider is the “marginal tax rate”.   Remember what I said above about how CRA calculates your taxes: “The more you make the more they [CRA] take.”  This is referred to as a progressive tax system [It gets progressively worse].  What this means is that your marginal tax rate is higher than your average tax rate.  Let me give you an illustration, as this will be easier to grasp.  If you earn $50,000 in salary you will have to pay $7,980 in taxes.  Thus your average tax rate is 15.96% [$7,980/$50,000].  But let’s say you decide to get a part-time job to earn a little extra money.  Say you earn $1,000 from this part-time job.  How much tax will you have to pay on that extra $1,000?  If you said $159.60, which is $1,000 multiplied by your average tax rate — not only are you wrong, you are also in for a big surprise.  The correct answer is $312 – nearly double your average tax rate.  That is because that $1,000 of part time income is added to your $50,000 salary.  That extra $1,000 of income is taxed according to your highest tax bracket, with the result that it is taxed at a higher rate of tax.

And it only gets worse.  If you have a salary of $100,000, you will  have to pay $26,356 in taxes.  Thus, your average tax rate is 26.36% [$26,356/$100,000].  How much tax will you have to pay if you earn $1,000 from a part-time job.  You had better sit down — 43.4% – yes $434.00.   [I always wondered why my dad declined to work on Saturdays when he was given the opportunity to work over-time.  His answer was always that it wasn’t worth it.  Now I understand what he means.]

Back to our topic – Income Tax Deferral

What would be the tax rate if that income was earned through an unincorporated business?  Once you start making around $150,000, your marginal tax rate would be more than 46%!  Now compare that to the rate of corporate income tax of 16.5% — that is a difference of 30%.  The graph below shows the amount of taxes payable at various levels of income, depending on whether it is earned personally through an unincorporated business or through a corporation.

The next graph compares the percentage of income tax paid on income earned personally through an unincorporated business with income earned through a corporation.  The personal tax rate is the marginal tax rate.

I’ll continue with this topic in Part 2.

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