date | theme

21. August 2020 | Converting individual companies: GmbH versus GmbH & Co. KG

24. August 2020 | Conversion of a sole proprietorship: objectives and procedures (this contribution)

26. August 2020 | Other consideration for transfer to GmbH: valuation of assets

There are several reasons to carry out the conversion of a sole proprietorship. The goal of transformation also largely depends on this. If, for example, other partners who are not silent partners are to be accepted into the company, either an OHG or a limited partnership is possible as the goal of the conversion. However, if a sole proprietor wants to continue to manage the fortunes of his company, but considers this in another form, he benefits from the conversion into a GmbH or a GmbH & Co. KG, because there his private liability is limited to the company capital.

Depending on whether a partnership or a corporation emerges from the sole proprietorship, the path to this is fundamentally different. On the one hand, the transformation of the sole proprietorship into a partnership constitutes a new start-up. On the other hand, the conversion of a sole proprietorship into a limited company takes place by transfer. The tax implications are also very different. The conversion into a corporation is tax neutral only if the book values are maintained.

In the video we explain the tax advantages & disadvantages of converting a sole proprietorship into a GmbH or a GmbH & Co. KG.

1. reasons for the conversion of a sole proprietorship

As a sole proprietor you have many freedoms that are rare in a society. At the same time, a sole proprietor also bears all the obligations and risks associated with his company. However, there are ways to strike a balanced balance.

1.1. Conversion of a sole proprietorship through the acquisition of a partner

For example, accepting a trusted partner offers an opportunity to share some of the responsibility. Because many individual entrepreneurs know the meaning of the words leisure or even holiday only as a symbol of a utopia. On the other hand, a new partner can inspire the company with new ideas and thus enrich it. So the inclusion of a partner can be a good reason why you want to convert your individual company.

1.2. Higher reputation after conversion of the sole proprietorship

On the other hand, the transformation of a sole proprietorship may serve the goal of increasing the reputation of the company. Many banks and financial service providers prefer, among other things, companies that are obliged to account for their size and thus their economic power, but at least due to legal regulations. This has the consequence that balance sheets are published and thus the economic activity is transparent.

1.3 Limitation of liability as a goal of the transformation of the individual enterprise

And since all good things are three, here is another, in many cases crucial aspect that leads entrepreneurs to transform their individual business. Here, the question of the extent of private liability in connection with the management of the company plays a central role. For a sole proprietorship, the entrepreneur bears full responsibility for all decisions. In an emergency, the liability is correspondingly extensive. More specifically, a sole proprietor is liable both for the assets in his company and for his private assets. Therefore, the desire to separate these two spheres is understandable. For this purpose, companies are suitable in which the liability is limited to the company assets. This is the case for corporations

2. When the conversion of a sole proprietorship is not a conversion

When the present article refers to the conversion of a sole proprietorship, the word conversion is first to be understood in general terms as transformation. In fact, this is also a civil law term that describes the change in the legal form of a company. However, in the context of our article, this only applies to conversion into a corporation. The change that a sole proprietorship makes by giving rise to a partnership, on the other hand, is a simple start-up instead of a conversion in the sense of civil law.

However, in order to clearly use the meaning of the word conversion, we want to use the term in the further course of the text only in the civil sense. Henceforth we distinguish it from the general process of transformation in the formation of a partnership by calling it a transformation.

Two ways to transform the individual enterprise

In principle, the conversion or transformation of a sole proprietorship always leads to a company. Because a company is the only commercial alternative to the individual enterprise. There are two options to choose from, into which a sole proprietorship can be converted.

3.1. Option 1: the partnership

One acts as a partnership. Here, all shareholders as participants are each independent legal entities and thus individually taxable. The company, on the other hand, ultimately has no rights or obligations of its own, because these are borne solely by the shareholders, albeit to varying degrees. In this case, as partnerships operating commercially within the meaning of the Commercial Act, OHG and the limited partnership are defined as objectives. Although a GbR can also operate commercially, it is not a commercial partnership under the Commercial Code. Therefore, it remains out of consideration in our article.

In contrast, GmbH & Co. KG, as a special, albeit widely used partnership in the legal form of a limited partnership, holds a shareholder company. Thus, in order to transform a sole proprietorship into a GmbH & Co. KG, it is first necessary to establish this general partner GmbH. By contributing the sole proprietorship, the GmbH & Co. KG is founded.

3.2 Option 2: the corporation

In the second option, the main difference from the partnership is that the corporation is a separate legal entity. The technical term here is “legal person”. Accordingly, the limited liability company also pays its own taxes as a tax subject. It goes without saying that a corporation, which as a legal person is just such a construct, can only express its legal will through a natural person. This requires at least one managing director who represents the interests of the corporation externally.

However, since the GmbH is by far the most widespread capital company in Germany, we refer to it as a representative in the following.

When a sole proprietorship is transformed into a commercial partnership, the company is re-established, with the assets of the sole proprietorship flowing into the partnership. There it is assigned to the capital account of the former sole proprietor.

Regardless of the legal form in which the newly founded person trading company is to operate, the requirements for establishing an OHG must be observed. For example, in the case of an OHG or a KG, registration in the commercial register is required at the time of establishment. Further legal provisions either go back to the Civil Code on Company Law, or are part of the special laws in the Commercial Code. In particular, the transfer of real estate can pose special requirements. On the one hand, a notary is to be consulted and the change in the land register entered. On the other hand, this can lead to a real estate transfer tax.

5 Conversion of a sole proprietorship into a corporation

5.1 Civil law aspects of the transformation of a sole proprietorship into a GmbH

The conversion of a sole proprietorship into a GmbH takes place by transfer. This means that the sole proprietor transfers his company to the GmbH. From a civil-law point of view, the transfer is a special form of merger (§ 2 UmwG). However, in the event of a contribution, the contributor receives a participation in the company which takes over his company. In a regular merger, on the other hand, at least one previously existing shareholding relationship will expire.

The transfer of a sole proprietorship to a GmbH by way of individual legal succession is to be understood as material foundation. This means that, in this case, the company will be re-established by the former sole proprietor raising the share capital through his contribution. For this purpose, a memorandum of understanding must also be drawn up, which shows that all legal criteria regarding the share capital are met.

Incidentally, the conversion of a sole proprietorship into a GmbH is a process that requires a notarization. Of course, the GmbH must then also be registered in the commercial register.

Tax aspects of the transformation of a sole proprietorship into a limited liability company

The conversion tax law provides information on the tax consequences that a conversion of a sole proprietorship by transfer into a newly founded GmbH.

5.2.1. Valuation of the transferred individual enterprise

In particular, the valuation approaches of the transferred assets fall under this category. So there is a certain freedom in the evaluation of assets. On the one hand, one can choose a value approach that corresponds to the book values of the individual enterprise contributed. In this case, the conversion is fiscally neutral. On the other hand, you can also deviate from the book values. If the GmbH values the transferred assets at a higher value than the book value of the sole proprietorship, this also means that the transferring entrepreneur receives a higher value for his sole proprietorship in the form of shares in the GmbH. However, from a tax point of view, this represents a gain, which is therefore subject to the taxation of the entrepreneur.

If the choice falls on a value approach deviating from the book value at the acquiring GmbH, this also has consequences in the valuation of the shares granted in exchange. These values are then fixed as acquisition costs. The value approach deviating from the book value may be used at most with the actual market value, the so-called common value.

Especially in the taxation of the profit on a future sale of the shares, the acquisition costs are therefore of considerable importance. Because if you sell the shares at a later date above the book value at a market price, of course a taxable profit on the share of the hidden reserves. However, it is possible to tax this profit using legal relief. On the other hand, one can also choose a value approach corresponding to the current market instead of the book value directly during the conversion. This, however, directly reveals the hidden reserves, which leads to immediate taxation without the shareholder actually having received any real profit. However, this increases the probability that the amount of the tax in a later sale will be low due to the anticipated taxation of the hidden reserves.

5.2.2. Special features of the book value approach

Incidentally, the contribution to book values is only made at the special request of the GmbH. This application must be made in the case of a new establishment with the establishment of the opening balance. Otherwise, this is necessary when drawing up the next balance sheet. However, an application at a later date is excluded. In addition, the request shall be irrevocable once it has been submitted.

5.2.3. Avoidance of loss carry forward

If a sole proprietorship shows a loss carry forward, the conversion into a GmbH leads to the loss carry forward being cancelled. However, this can be avoided by using the transferred assets with a higher value instead of the book value. Because the profit from the realization of the hidden reserves can be offset against the carried forward losses. You can also choose an intermediate value between the book value and the actual value of the company in order to neutralize the tax with the losses.

5.2.4. Continuation of depreciation after conversion of a sole proprietorship

Another advantage in recognising the common value instead of the book value is future depreciation. Because this can also be depreciated on the hidden reserves. Although one initially has to expect a tax expense of the difference and the chosen asset, the depreciation actually leads to a refund of this tax. At the same time, however, the tax on a possible sale of the shares in the future is basically compensated for.

5.2.5. Seven-year blocking period after submission

If the shareholder of a GmbH created by the conversion of his sole proprietorship sells shares in that company within seven years after the conversion, this has an impact on the taxation of the resulting profit. Because without conversion, the entrepreneur would tax the profit from the sale of his sole proprietorship at 100% (§ 16 EStG). However, the sale of shares in a GmbH takes place by partial income procedure and is thus 40 % tax-free. In order to prevent entrepreneurs from exploiting this circumstance, the legislature has introduced a blocking period of seven years (§ 22 paragraph 2 UmwStG).

However, the sale of shares within the blocking period does not trigger taxation on the entire transferred assets. Rather, it is based on a pro rata taxation. In such a case, taxation is tax-free for one-seventh of the assets for each year elapsed after the transfer. For example, the sale of a total of EUR 700,000 in assets within four years leads to a tax approach of only EUR 400,000.

5.2.6. Retroactive effect of the contribution

An important aspect that may be relevant for a contribution is the possibility to make the conversion retroactively. A period of eight months shall apply. This option offers the advantage that the balance sheet to be submitted for conversion may also be the last balance sheet of the individual enterprise. This saves the costs that a balance sheet made specifically for the conversion causes.