Converting from a sole proprietorship to a limited company – Need-to-knows + Checklist

Many entrepreneurs, driven by their enthusiasm for their business idea, start out as self-employed sole proprietors –  a swift, inexpensive and relatively straightforward way of getting their business up and running.  Later, when they start to see a good level of success and increasing revenues, many consider converting from a sole proprietorship to a limited company.

Changing legal structure from sole proprietorship to limited company – what are the advantages?

As a sole proprietor (also referred to as a “sole trader”), you are held personally liable if your company runs into liquidity problems or sustains bad debt losses. There is no limit on the extent of your liability and, in the worst-case scenario, your business and your livelihood are at risk. This personal liability on the part of the sole proprietor is usually the main reason behind the decision to convert to a limited company as business and profits grow. Unlike with a sole proprietorship, the liability of a limited company is limited to the company’s assets (see Section 13(2) of the Limited Liability Companies Act (“Gesetz betreffend die Gesellschaften mit beschränkter Haftung”)).

Another reason can be the decision to bring investors on board, which is much simpler with a limited company. If a sole proprietor is doing well in terms of earnings, trade tax (“Gewerbesteuer”) can also be an incentive for conversion – especially in regions with high trade tax rates. The trade tax actually paid tends not to be adequately credited against the sole proprietor’s income tax, which is why it is not uncommon for tax advisers to suggest converting from a sole proprietorship to a limited company.

Converting to a limited company: when’s the right time to do it?

There’s no one-size-fits-all answer to this question because it always depends on numerous factors, especially tax, legal and business aspects. Your tax adviser can provide some good suggestions regarding timing because he or she should have a precise knowledge of your business’s needs. Changing between the two legal forms is not always easy so it is also advisable to consult a lawyer with relevant expertise.

Conversion methods – an outline

There are different methods for converting from a sole proprietorship to a limited company, each with its own pros and cons for the business owner.

1. Hive-down as per the Conversion Act (“Umwandlungsgesetz”)

The rules concerning conversion of sole proprietorships into limited companies are set out in Germany’s Conversion Act. However, to convert this way the sole proprietor must be listed in the commercial register (as stipulated by Section 152, Sentence 1 of the Conversion Act) and must not have liabilities that exceed its assets (see Section 152, Sentence 2 of the Conversion Act). This is a type of splitting-up method and is referred to as “hiving down” (or “Ausgliederung” in German, see Section 123 ff. of the Conversion Act) which is tax-neutral in accordance with Section 20 of the Conversion Tax Act (“Umwandlungssteuergesetz”).

There is no realisation of hidden reserves since the book values are continued in the sole proprietorship.  The entire proprietorship (or parts thereof) is (are) transferred to a newly founded or existing limited company, with all of the assets and liabilities, by way of universal succession. This transfer process does not require any further legal acts. Once the hive-down has been registered in the commercial register, the transferred assets of the sole proprietorship are considered to have been transferred. This also includes liabilities and contracts with third parties.

2. Incorporation into the limited company by means of formation based on contributions in kind/capital increase through contributions in kind

This method is not subject to the provisions of the Conversion Act and is thus also known as the “conversion method under civil law”. Here too, the sole proprietorship can be converted into a limited company by means of forming a new company or by transfer to an existing limited company. In the latter case, the incorporation takes the form of a capital increase through contributions in kind. The sole proprietorship serves as the capital contributed to the existing limited company in the form of a capital increase. The “Registergericht” (registry court) checks the required “Report on capital increase through contributions in kind” and then the capital increase is entered in the commercial register. This entry marks the completion of the transfer from sole proprietorship to limited company.

If it is necessary to establish a new limited company, the conversion takes the form of a company formation based on contributions in kind. In this case, the sole proprietorship is added to the limited company’s business assets in the form of capital stock when the limited company is created. The company is entered in the commercial register once the report on the formation based on contributions in kind has been checked by the court. This entry marks the completion of the conversion from sole proprietorship to limited company. The original sole proprietor usually assumes the role of manager.

Incorporating a sole proprietorship into a limited company

Besides hiving off, there are several other ways to convert from a sole proprietorship to a limited company, as described in the following.

Disposal

Parts of the sole proprietorship (or the entire proprietorship) are transferred to the new limited company in return for payment. However, this course of action is not advisable for legal reasons we will be happy to explain.

Formation by cash subscription

Once the limited company has been created, the sole proprietorship (or parts thereof) is incorporated into the company in the form of a constructive contribution. The sole proprietorship is not granted any shares, nor is any purchase price paid. Another possibility is formation by cash subscription followed by an increase in capital by incorporating the sole proprietorship into the limited company (at book values).

Leasing

There are two possibilities here, which are clearly defined in the legislation and have different consequences. If, for example, you have decided to set up a limited company in order to limit your liability, you should not do so before consulting a tax adviser and an experienced lawyer specialised in this area.

Downloadable checklist

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Checklist: Converting from a sole proprietorship to a limited company