Converting a Sole Proprietorship into a UG or GmbH: What You Need to Consider from a Tax Perspective

Are you operating as a sole trader and considering whether to establish a limited company instead? It is generally possible to transfer your existing business into a newly incorporated or already existing company. Most people interested in this step focus on the Unternehmergesellschaft (UG), which is a simplified form of the GmbH (Gesellschaft mit beschränkter Haftung — private limited company).

A word of caution at the outset: in theory, the UG is not suited for this purpose. This is because the underlying legislation does not provide for non-cash contributions in this particular type of company. In practice, the transfer can nonetheless be implemented. Alternatively, it is worth considering a GmbH, even though the hurdles are higher. Bear in mind that converting a sole proprietorship into a UG or GmbH is a complex undertaking. Make use of the expertise of an established tax advisory firm!

Converting your sole proprietorship into a limited company involves a certain amount of effort. Accordingly, there should be sound reasons for taking this step. Take time to compare the advantages and disadvantages of the sole proprietorship, UG, and GmbH legal forms!

The most important advantage of UGs and GmbHs relates to liability. As a sole trader, you are personally liable with your entire business and private assets for third-party claims. In the event of insolvency and with large outstanding claims, this liability mechanism can prove devastating. You may lose a large proportion of your private assets and be forced to declare personal insolvency. With a limited company, you avoid this risk — liability is confined to the company's assets.

This raises an important question: how significant is this financial risk? This cannot be answered in general terms; the specific risk depends on the nature of your business activities, your financial prudence, and your insurance cover. It is best to discuss this aspect with your tax and business adviser!

Furthermore, converting a sole proprietorship into a limited company may be worthwhile for tax reasons. Here too, the answer depends on your individual circumstances. Additional advantages of limited companies include their strong reputation and high creditworthiness — this applies especially to GmbHs. The higher creditworthiness is based, amongst other things, on the share capital, which serves as security.

Also factor the disadvantages of UGs and GmbHs into your deliberations. These include:

- Administrative burden: limited companies are subject to an obligation to prepare statutory financial statements (Bilanzpflicht). Establishing and administering a UG or GmbH also entails a significantly greater administrative burden.

- Share capital: establishing a GmbH requires share capital of 25,000 euros. This financial hurdle can be off-putting. The UG is recommended as an alternative, serving as a starter model for a GmbH. For UGs, the required share capital is only 1 euro, but in return there is a statutory obligation to accumulate reserves ("Ansparpflicht").

Sole proprietorships and limited companies are subject to different tax rules. Let us look at the taxes you must pay under each of these two legal forms:

As a sole trader, you pay income tax on your profit. You declare the profit arising from your business activity in your income tax return. To do this, you complete the relevant form — for traders, Schedule G is the relevant schedule. Are you working as a freelancer? Then complete Schedule S. If you are permitted to calculate your profit using a cash-basis income statement (EUER), your tax office will also require the EUER schedule. Otherwise, you must attach a balance sheet and possibly further documents to your tax return. Your tax adviser will handle these tasks for you!

What does this mean in financial terms? The tax authority taxes your income as a sole trader at your personal tax rate. The top tax rate is 42%; the so-called high-income tax rate for very high incomes is 45%. The problem is clear: many business owners find themselves in the range of the top or high-income tax rate, while simultaneously bearing significant entrepreneurial risks.

In addition, many sole traders are subject to trade tax (Gewerbesteuer): this tax, set by local authorities, applies directly to your business.

With limited companies, taxation works largely differently: the tax obligation falls on the company, not on you as the owner. The state levies the following profit-based taxes:

- Corporation tax (Körperschaftssteuer): 15% of profit

- Solidarity surcharge (Solidaritätszuschlag): 5.5% on corporation tax

- Trade tax (Gewerbesteuer): locally varying trade tax rates (as with sole proprietorships)

In general, the tax burden is lower than for many sole proprietorships. Bear in mind, however, that in a limited company the post-tax profit remains within the company. As a shareholder, you may not use this capital for private purposes. When the funds are transferred to your private assets, a further round of taxation takes place. Two methods are commonly used:

- Profit distribution: limited companies may distribute profits in full or in part to their shareholders; this requires a corresponding resolution by the shareholders' meeting. These profit distributions are subject to capital gains tax (Kapitalertragssteuer, or Abgeltungssteuer — final withholding tax) and the solidarity surcharge. The company withholds these taxes and remits them to the tax office.

- Income tax on employment income: many shareholders also work as employees of their company — often as managing directors. This arrangement is frequently found in limited companies that have emerged from sole proprietorships. In this case, the company pays its managing director or other employees a salary, which is subject to payroll tax (Lohnsteuer). Social security obligations also apply.

If you decide on a GmbH as your future legal form, you can implement the conversion in one of the following ways:

- Transfer into an existing GmbH: this constitutes an increase in share capital by way of a non-cash contribution (Sachkapitalerhöhung). You contribute your sole proprietorship as a non-cash asset, thereby increasing the GmbH's share capital. In practice, sole traders join forces with another company: they become shareholders of an established GmbH and bring their existing business as a non-cash contribution.

- Transfer into a newly incorporated GmbH: with this option, you first incorporate a GmbH. You then transfer your existing business as a non-cash contribution. The advantage with a GmbH is that you can reach the required minimum capital of 25,000 euros using such non-cash contributions.

Do you prefer a UG? Here you must proceed differently, as the legislation does not provide for non-cash contributions. Discuss this with your Guhr Steuerberatung advisers!

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When considering the possible conversion of your sole proprietorship into a limited company, you will be confronted with numerous questions. These include whether this step is advisable for tax reasons. Many further aspects — such as liability risks and the administrative burden — also deserve your attention. Have you decided in principle to proceed with a conversion? The next question is which legal form you should aim for and how to implement your plan professionally.

Your Guhr Steuerberatung advisers will provide you with detailed information on the advantages and disadvantages of converting your business and will accompany you through this challenging process. Looking to convert a sole proprietorship into a UG or GmbH? Arrange a consultation!

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