Optimizing taxes: Conversion of a sole proprietorship into a GmbH
To save on taxes, a sole proprietorship can be converted into a limited liability company (GmbH). This is possible for up to 8 months retroactively and tax-neutral. This article explains the advantages and disadvantages of a GmbH and the conversion of a sole proprietorship into a GmbH.
Background
Entrepreneur A founded his sole proprietorship at the beginning of 2020. The company is more successful than expected. After just 2 years, it is already making an annual pre-tax profit of EUR 200,000. Euro.
The EBT does not include the entrepreneur’s salary, as the company is a sole proprietorship.
Entrepreneur A is single and his personal income tax rate is 42%. This means that the tax burden (income and trade tax) is EUR 84,000. Entrepreneur A would like to continue to grow his company, i.e. he would like to have as much liquidity available in the company as possible.
Entrepreneur A receives a salary as managing director of EUR 80,000 gross per year. The trade tax rate in his city is 420.
Entrepreneur A is considering the advantages and disadvantages of converting a sole proprietorship into a GmbH.
Advantages and disadvantages of the GmbH
Tax advantages of the GmbH
The tax advantages of the GmbH clearly lie in the stable tax burden. Taxes on the GmbH’s income average between 30-32%. As a corporation, the GmbH is subject to the following income taxes:
- Corporation tax in the amount of 15%
- Solidarity surcharge of 5.5% on corporation tax
- Trade tax of approx. 15% (depending on the municipality)
In this case, this would mean a tax burden of between EUR 36,000 and EUR 38,400.
In this case, the managing director would also have to pay around EUR 24,000 in personal income tax.
The tax burden is between 60,000 and 62,400 euros and is lower than for a sole proprietorship at 84,000 euros.
For tax reasons, however, a GmbH is only worthwhile from a pre-tax profit of around 100,000. Only above this amount are the GmbH’s income taxes lower than the average income tax rate.
Further advantages of the GmbH
In addition to tax advantages, there are other advantages of the GmbH compared to the sole proprietorship:
- Shareholders are only liable with the capital invested and therefore assume no personal liability.
- The shareholder of a GmbH does not necessarily have to be the managing director.
- Higher reputation compared to a sole proprietorship.
Tax disadvantages of the GmbH
The GmbH is obliged to pay trade tax by virtue of its legal form. There are no allowances for trade tax as there are for sole proprietorships.
Further disadvantages of the GmbH
The GmbH essentially has the following additional disadvantages:
- The formation of the GmbH and changes to the GmbH require notarization and therefore incur costs. The company must also be entered in the commercial register.
- The annual financial statements of the GmbH must be published or at least filed in the company register (formerly: Federal Gazette) and are therefore available to business partners.
- In the event of insolvency, incomplete capital contributions must be paid from the shareholder’s private assets.
- The dissolution of a GmbH takes at least 1 year and is more complicated than the termination of a sole proprietorship.
Conversion of a sole proprietorship into a limited liability company
Spin-off of the sole proprietorship into the GmbH
Universal succession
Through the spin-off, the sole proprietor can transfer his entire business to a GmbH as part of the so-called universal succession in accordance with § 152 UmwG. The German Reorganization Act enables universal succession. As a result, the sole proprietor’s assets, including all liabilities and contracts, are automatically transferred to the GmbH.
In contrast to civil law conversion processes, the consent of the contractual partners is not required. As with inheritance, contracts are transferred to the heirs without any action on their part. Similarly, in the case of universal succession, contracts are transferred to the new company without the consent of the contractual partners.
The automatic transfer of assets of the sole proprietorship is an advantage of the spin-off under the German Reorganization Act. This advantage exists in comparison to a contribution to a GmbH.
Steps of the spin-off
A spin-off to form a new GmbH requires the creation of a new company. The regulations for the formation of a new GmbH must also be taken into account.
The share capital (EUR 25,000) can generally be provided by a cash contribution or a contribution in kind, whereby the assets of the sole proprietorship are normally used as a contribution in kind. In the case of a spin-off into an already established GmbH, the regulations on a capital increase with a premium in kind apply.
Important steps for the spin-off of a sole proprietorship:
- Declaration of the sole proprietor on the spin-off
- Determination of the spin-off date
- Balance sheet of the sole proprietorship on the spin-off date(balance sheet must not be older than 8 months)
- Statement of the sole proprietor on the establishment of the GmbH
- Articles of association of the GmbH
- Shareholder resolutions on the formation and appointment of the managing director
- Managing director contract (taking tax aspects into account)
- List of shareholders
- Notary/commercial register
In the case of a spin-off into an existing GmbH, certain points are not applicable. A lawyer usually prepares the documents together with the sole trader and his tax expert. After detailed consultation and preparation of the documents, the lawyer accompanies the notary process and the registration procedure with the commercial register.
Note: Before the spin-off, the sole proprietor must be entered in the commercial register as a registered trader (e.K.). The transformation law enables a registered merchant to spin off and register in the commercial register in the event of a transformation.
Tax aspects of the spin-off
The spin-off is regulated for tax purposes in accordance with sections 20 et seq. of the German Reorganization Act. UmwStG if the sole proprietor transfers his entire business or a “partial business” as defined for tax purposes. Another prerequisite is that the sole proprietor receives new shares in the company in return.
The contribution in accordance with §§ 20 ff. UmwG offers the advantage of a valuation option for the entrepreneur.
Upon request, the GmbH can recognize the transferred assets at book value instead of fair market value. This means that hidden reserves do not have to be disclosed, which avoids taxable profits for the sole proprietor. However, the retroactive tax effect of the spin-off must be taken into account.
The transfer of assets in a spin-off is normally not taxable in accordance with §1 (1a) UStG. The spin-off therefore usually has no VAT implications. If land is transferred to the GmbH, real estate transfer tax aspects and exemption options must also be taken into account.
Contribution of the sole proprietorship to a GmbH
The sole proprietorship can also be transferred to a GmbH outside the scope of the Transformation Act. The ongoing operations of the registered merchant (e.K.) are transferred to the GmbH by means of a notarized capital increase in kind.
If there is no GmbH, the sole proprietorship can be converted into a GmbH through a so-called non-cash formation. When a GmbH is founded, the sole proprietorship of the e.K. is contributed as share capital.
A significant disadvantage of transferring a sole proprietorship to a GmbH is that all contractual partners must agree to the transfer of the contract. This is due to the fact that this is a singular succession.
Alternatives
It is not advisable to set up a GmbH with the same business model as the sole proprietorship. It is also not advisable to continue the sole proprietorship at the same time.
It is also not advisable to sell the assets of the sole proprietorship to your own GmbH. This can lead to a so-called hidden contribution in kind pursuant to Section 8 (3) sentence 3 KStG (German only), to the disclosure of hidden reserves and thus to a significant tax burden.
There is also the option of leasing the sole proprietorship to your own GmbH. We will look at the advantages and disadvantages of this option in a future blog article.
By the way: You can find information on tax optimization through a holding structure in our blog article here.
The s&w team will be happy to assist you with tax advice on conversions. We work closely with our law firm partners in corporate law. Contact us now or schedule a free online appointment.
Source: s&w, Haufe
Photo: Kelly Sikkema (Unsplash)
Disclaimer: We assume no liability for the accuracy and completeness of the information. The information provided here does not constitute recommendations for action.
