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The conversion of a sole proprietorship into a limited liability company

Are you a sole trader and wondering whether you can convert your company into a GmbH? You are certainly not alone in this, because the sole proprietorship is attractive with its uncomplicated foundation. On the other hand, you bear the entrepreneurial risk alone and have unlimited liability with your private assets. As your company grows, so does the entrepreneurial risk.

So you’re thinking about alternatives, but you’re not sure how the conversion to a GmbH works? In the following article we inform you about the conversion of a sole proprietorship into a GmbH.

General

The conversion of a sole proprietorship into a GmbH offers sole proprietorships the opportunity to change their corporate structure and benefit from the advantages of a GmbH. In practice, one of the following two approaches is usually chosen: either contribution or spin-off.

What is the difference between a contribution and a spin-off?

In the case of a contribution under general civil law, all assets, liabilities and rights of the sole proprietorship are contractually transferred to the GmbH.

In a spin-off under the German Reorganisation Act, all assets, liabilities and rights of the sole proprietorship are transferred by law to the GmbH by way of universal succession. This procedure is governed by the Transformation Act and is subject to certain formal requirements and special legal provisions.

Convert a sole proprietorship into a GmbH: What are the reasons?

There are various reasons for converting a sole proprietorship into a limited liability company, with two key aspects being the limitation of liability and the gain in reputation.

Limitation of liability: One of the main reasons for converting a sole proprietorship into a GmbH is the limitation of liability. As a sole proprietor, you are personally liable for all liabilities and risks of the company. In the event of debts or legal problems, this can lead to considerable financial burdens that jeopardise private assets. By converting to a GmbH, liability is limited to the company’s assets. This means that private assets are protected.

Reputational gain: The conversion into a GmbH can also lead to a reputational gain. The GmbH is an internationally recognised legal form with a professional image. By converting a sole proprietorship into a GmbH, the company can gain reputation and credibility, especially with business partners, customers, suppliers and investors.

Other reasons for a conversion may be

The desire to manage the company in the future as a team with other partners and no longer as the sole owner.

The intention to arrange a company succession.

The goal of attracting investors.

The tax-neutral treatment of the contribution or spin-off of your business or business unit

Both the contribution and the spin-off are generally treated as tax-neutral, as the entire business or at least a separable part of the business is transferred. This means that the transfer has no direct tax consequences and therefore no taxes are incurred.

Tax neutrality is based on the relevant legal provision of Section 20 of the German Reorganisation Tax Act (UmwStG). The transferred assets are transferred to the company assets of the GmbH at book value. This prevents hidden reserves from being disclosed and taxes from being incurred. The carrying amount can be carried forward if the given conditions are met. However, the taxpayer can also, if he wishes, choose an intermediate value or the market value with disclosure of the hidden reserves. Whether this makes sense or not depends on the individual case.

However, it should be noted that tax neutrality depends on certain factors. If this is not the case or if it ceases to apply later, taxes will be due. In addition, a GmbH is treated differently from a sole proprietorship for tax purposes. It is therefore always advisable to seek advice from a tax advisor or specialist expert in advance in order to create an individual tax plan.

Attention for married sole proprietors

Spouses living under the community of accrued gains regime require the consent of the other spouse to dispose of their significant assets. The business operations of the sole proprietorship will often be the main asset. This therefore affects sole proprietors who live under the statutory matrimonial property regime, i.e. who have not entered into a special marital property agreement. Therefore, if you are married, you should point this out. Your advisors can then work with you to find out whether or not your spouse’s consent is required.

The spin-off in accordance with the Transformation Act

A sole proprietorship can be transferred to an existing or newly founded GmbH by way of a spin-off. This process is a case of partial universal succession.

The prerequisite for the spin-off is that the sole proprietor is registered as a registered trader in the commercial register. Anyone who is not yet registered as a merchant in the commercial register must arrange for this.

What do you need to know about partial universal succession?

In the case of partial universal succession, all rights and obligations of the sole proprietorship are transferred to the GmbH. As a result of the spin-off, the GmbH assumes the legal position of the sole proprietorship and thus takes over its assets, contractual relationships and liabilities.

A spin-off in accordance with the German Reorganisation Act (UmwG ) can be particularly interesting if important contractual relationships exist and it is uncertain whether the contractual partners will agree to the transfer to the GmbH. In the case of a spin-off in accordance with the UmwG, the contractual relationships are transferred to the GmbH without the consent of the contractual partners.

The spin-off to form a new company

The spin-off can take place at the time of new formation. In this case, a new GmbH is formed and the spin-off is carried out in accordance with the UmwG upon formation.

The general regulations for the formation of a GmbH apply to a spin-off for new formation. However, the formation of the new GmbH is regarded as a non-cash formation. Therefore, the sole trader must prepare a non-cash formation report. This must contain certain formal details. In addition to the substantive formation report, the registry court may also require proof of the value of the sole proprietorship.

The spin-off to an existing GmbH

The spin-off can also be made to an existing GmbH. This can be founded specifically for this purpose or the GmbH already exists independently of the spin-off.

In the case of a spin-off for absorption, the sole trader receives shares in the absorbing GmbH in return for the transferred assets. The share capital of the absorbing GmbH is increased for this purpose.

The capital increase resolution must stipulate that the capital increase is to be carried out in order to implement the spin-off. At the same time as the capital increase, a corresponding amendment to the articles of association of the GmbH must be resolved.

The competent registry court may require a report on the increase in non-cash capital and further evidence of the value of the sole proprietorship.

In contrast to an ordinary capital increase, the sole proprietor does not have to submit a separate takeover declaration in the case of a spin-off to an existing GmbH. In addition, the entry of the capital increase is applied for in the commercial register before the contribution is made. This is because the spin-off only becomes effective upon registration.

The spin-off agreement and the spin-off plan

The terms of the spin-off into an existing GmbH are defined in a spin-off agreement between the sole trader and the absorbing GmbH. The absorbing GmbH does not yet exist at the time of the spin-off to form a new company. The spin-off agreement is therefore replaced by the spin-off plan. In the spin-off plan, only the sole trader makes a unilateral declaration.

Both the spin-off agreement and the spin-off plan require notarisation. In the case of a spin-off into an existing GmbH, the spin-off agreement can be concluded at the same time as the capital increase resolution. However, it is also possible to graduate at different times.

What essential content must be included in the spin-off agreement or spin-off plan?

The spin-off agreement or the spin-off plan must contain the following information in particular:

Name/company and registered office of the parties involved;

The agreement on the transfer of the sole proprietorship in return for the granting of GmbH shares;

The key date for the profit participation right (in the case of spin-off for inclusion);

The spin-off date;

Special rights granted in connection with the spin-off;

Special benefits granted in connection with the spin-off;

The exact designation of the assets to be transferred;

The consequences of the spin-off for employees.

If there are any other agreements between the parties regarding the spin-off, these must also be included in the spin-off agreement or spin-off plan.

The spin-off date

From the spin-off date, the actions of the sole trader are deemed to have been carried out for the account of the absorbing GmbH.

The spin-off date is therefore used for clear allocation, particularly for tax purposes. The spin-off date can be up to 8 months in the past. It can therefore also lie in the past.

A closing balance sheet for the sole proprietorship must be prepared on the day before the spin-off date.

December 31: Closing balance sheet of the sole proprietorship

January 01: Spin-off date

Tip: If January 1 is selected as the spin-off date, the annual financial statements as of December 31 of the previous year can be used as the closing balance sheet.

The impairment test

As the spin-off is a non-cash formation or non-cash capital increase, the commercial register may require proof of the value of the contributed company for the registration of the GmbH or the capital increase. Evidence can be provided, for example, by an impairment certificate from an auditor. The certificate confirms the value of the contributed company. It is associated with additional costs.

The subsequent liability of the sole trader

In the external relationship, i.e. vis-à-vis third parties, the sole trader and the absorbing GmbH remain jointly and severally liable for liabilities that arose before the spin-off was entered in the commercial register. This joint and several liability for old liabilities is called subsequent liability. The subsequent liability of the sole trader is quite complicated. In simple terms, the extended liability applies for 5 years after the spin-off has been entered in the commercial register. The sole trader is only released from joint and several liability after these 5 years have expired. It can then no longer be held liable for old liabilities alongside the GmbH.

In the internal relationship between the sole trader and the absorbing GmbH, the absorbing GmbH must indemnify the sole trader against existing liabilities. This does not change the liability of the sole trader towards third parties.

The absorbing GmbH is exclusively liable for all new liabilities that arise after the spin-off has been entered in the commercial register.

Contribution under general civil law

An alternative method of converting a sole proprietorship into a GmbH is to contribute the sole proprietorship to the GmbH in accordance with general civil law.

All assets are transferred individually. The contribution can be made either when the GmbH is founded or later by means of a capital increase.

Contribution through contribution in kind

One way of transferring the sole proprietorship to the GmbH is the non-cash foundation or non-cash capital increase. However, the special regulations for contributions in kind must be observed.

The impairment test

As with the spin-off, the commercial register may require a certificate of value from a tax advisor or auditor for the registration of the GmbH or the capital increase. The preparation of an impairment test involves considerable effort and costs.

Cash contribution and premium in kind

In order to avoid the regulations on contributions in kind, the formation or capital increase can be carried out in cash. This means that the contribution must actually be made in cash. The provisions on contributions in kind are not applicable. A non-cash formation report or non-cash capital increase report is therefore not required.

The assets of the sole proprietorship are treated as a voluntary additional payment to the capital reserve. This is also known as contribution in-kind.

Advantages and disadvantages of contribution under general civil law

Lower formal requirements

Compared to the spin-off under the German Reorganisation Act, the contribution under general civil law is less formalistic. It is true that the formation of the GmbH or the capital increase must also be notarised in the case of a contribution under general civil law. However, a spin-off agreement or spin-off plan is not required.

The assets of the sole proprietorship to be transferred must be precisely described and listed in both cases.

No subsequent liability

In the case of contribution under general civil law, there is no subsequent liability for the sole trader. This means that the personal liability of the sole trader ends with the transfer of the respective contractual relationships of the sole proprietorship to the GmbH, including for old liabilities.

Consent requirement

However, you need the consent of your contractual partners to transfer existing contractual relationships to the GmbH. This means that the transfer must be discussed and, if necessary, negotiated with each individual. Depending on the number of contracts, this can be difficult.

If one of your contractual partners is opposed and refuses to give their consent, the entire conversion does not necessarily have to fail. The situation can be saved by excluding the contract from the takeover and exempting you internally.

Conclusion:

The conversion of a sole proprietorship into a GmbH offers clear advantages such as limited liability and tax neutrality. This can be done either by contribution or by spin-off. The main reasons for the conversion are the personal limitation of liability and the improvement of the company's image.However, it should be noted that there may be subsequent liability for old liabilities in the external relationship. The choice between contribution and spin-off should be carefully weighed up depending on the individual objectives and circumstances of the entrepreneur. Legal and tax advice is advisable in order to find the best solution for you and your company.

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