You can’t turn on the news these days without hearing about pending or threatened “trade wars” between the United States and various foreign nations, particularly China, Mexico and Canada. But what exactly is a trade war? The typical “weapon” of a trade war is a tariff on imports from the targeted country. You may have also noticed that commentators have stated that trade wars can have a greater impact on small businesses and family owned businesses; large corporations have the wherewithal to withstand what is typically a short term war.
Tariffs can have an impact on your small businesses and family owned business in a variety of ways: you may sell imported products; you may manufacture products that use components made abroad; you may be in a purely service business but use products that are made abroad, for example, printer paper from Canada.
What is a Tariff?
There is often some confusion here, but simply put a tariff is a tax on imported goods. Before the advent of the federal income tax, tariffs were the federal government’s major source of revenue. Here’s a key point: the tariff or tax is not paid by the foreign exporter, it is paid by the American importer. Because there is so much confusion, let us explain it as clearly as possible.
A Simple Example
Let’s assume you are a small business selling, among other things, widgets. (What are widgets? Widgets are a fictional product beloved by law professors; they represent a generic consumer good or product.) Let’s also assume that the widgets you sell are manufactured in China and imported by your small business or family business. We are going to make up some numbers here so bear with us.
As things stand today, you import the Chinese-made widgets at a wholesale cost of $800 each. Based on your overhead costs and what you feel to be a fair profit, you sell the widgets to the public for $1,000 each. Thus, your profit is $200 (minus overhead costs).
Now let’s assume that the threatened trade war takes place, and the United States imposes a twenty percent tariff on Chinese-made widgets. As we explained earlier, this means that the United States will collect $160 on each widget at the port of entry. As we explained, this tax is not paid by the Chinese exporter; it is paid by the purchaser: you. Now your cost for each widget is $960 instead of $800.
Now you are faced with a dilemma. If you continue to sell the widgets for $1,000, you will only make a profit of $40 per widget instead of the $200 you are accustomed to. With your overhead factored in, that might actually mean you are selling at a loss. Alternatively, you can start selling the widgets for $1160 each to maintain your desired profit level of $200. But will your customers balk at the price hike?
How can you Prepare for a Trade War?
As we discussed, a trade war can be particularly damaging to a small business or family owned business. What can you do to prepare if a tariff is imposed? Here are some suggestions.
- Stock up on pre-tariff inventory. If a tariff is definitely on the way and the date it will be imposed is set, stock up on pre-tariff inventory. Of course, this can have a negative impact on your cash reserves.
- Look for alternative sources for your widgets. Tariff threats are currently pending against China, Mexico and Canada. (Side note: if your small business sells wine, a tariff on French wines is also threatened.)
- Buy American! One of the purposes of a tariff which makes imported goods more expensive is to protect and encourage American manufacturing. Using our earlier example, your Chinese-made widgets went from $800 a piece to $960 a piece; perhaps that $900 a piece American-made widget now makes economic sense. The less your small business or family business depends on a single product or the products of a single nation the more a trade war puts you at risk. The more you can diversify the better you are protected when the tariffs hit.
- Ride out the storm. Trade wars are not meant to be permanent, but rather to force the other side to the negotiating table. Can you take a short-term hit on your bottom line if you hold the price steady despite your increased cost?
- Finally, be transparent with your customers. Make sure they understand that they aren’t being gouged if you’ve had to raise the price. They watch the news too, so they should understand what is going on.
Some Final Thoughts
Naturally, as small business and family business accounting and tax experts we thought of a number of accounting and tax issues that are raised by the effects of a trade war. For example, if you have pre-tariff widgets that cost you $800 and post-tariff widgets that cost you $960, and you sell a widget for $1000, did you make a $400 profit or a $2000 profit? Let’s not get into a long dissertation on FIFO (first in first out) and LIFO (last in first out) accounting, but should the need arise, we can work you through it.
If you’d like to learn more about tax laws and your business, we at Akif CPA are here to help. Learn about our services here.
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