Converting a sole proprietorship into a GmbH is a popular topic for entrepreneurs in Germany, particularly when the business is growing. There are many benefits to converting your business into a GmbH. This article explores the options for conversion via a spin-off or an incorporation. You will also learn the process for carrying out the conversion and the consequences of becoming a GmbH.

What's in this article?

• What are the advantages of a GmbH compared to a sole proprietorship?
  
• Which businesses can be converted into a GmbH?
  
• What are the options for converting a sole proprietorship?
  
• What are the practical steps for converting a sole proprietorship into a GmbH?
  
• What are the costs involved in the conversion?
  
• What are the tax implications and potential benefits?
  
• Checklists for converting a sole proprietorship into a GmbH
  

What are the advantages of a GmbH compared to a sole proprietorship?

A GmbH is a form of corporation that normally involves several shareholders. However, this form of business is also an option for sole proprietors. A key advantage of a GmbH – "Gesellschaft mit beschränkter Haftung" in German or "limited liability company" in English – is that business owners cannot be held personally liable. Personal liability is only a factor for a GmbH where a personal guarantee has been provided or the management breaches its obligations.

In a GmbH, other people can quickly and easily get involved in the business. A further advantage is the low level of taxation if the GmbH's profits are not distributed but remain in the business's assets. Additionally, a GmbH enjoys greater prestige among customers, business partners, banks and investors.

Which businesses can be converted into a GmbH?

In Germany, the complex task of converting a sole proprietorship into a GmbH is regulated by the German Conversion Act. Any business that is run by an entrepreneur can be converted into a GmbH. A sole proprietorship in Germany is commonly also referred to as an individual company, individual operation, small business or Ich-AG (Me Inc.). However, for legal and tax purposes, it is the same type of entity. Any of these businesses can be converted into a GmbH.

What are the options for converting a sole proprietorship?

Converting a sole proprietorship to a GmbH usually happens in one of the following two ways:

• Creating a spin-off of the sole proprietorship via the German Conversion Act
  
• Incorporating the sole proprietorship through contributions in kind or non-cash capital increase
  

Let's explore these two processes below.

What are the practical steps for converting a sole proprietorship into a GmbH?

The exact process for converting a sole proprietorship into a GmbH depends on your chosen method: spin-off or incorporation. In practice, a spin-off is the most popular option. The term "spin-off" in this context comes from the process of the sole proprietor "spinning off" their business from the assets of the sole proprietorship to the GmbH. The assets of the sole proprietorship are transferred to the GmbH. This offers a significant advantage of conversion by spin-off compared to incorporation.

Converting a sole proprietorship via spin-off

When spinning off a sole proprietorship via the process outlined in the German Conversion Act, sole proprietorships can convert their business into a GmbH following the regulations laid out in transformation law. There are two options: the first involves the creation of a new GmbH; the second uses an existing GmbH as the target business. When setting up a GmbH, you must follow the regulations for setting up a new business. In particular, you need to consider the requirement to raise share capital (at least €25,000) as a cash contribution or contribution in kind. Generally, a sole proprietorship's existing assets are invested as contributions in kind. When it comes to spinning off to a pre-existing GmbH, you must follow the requirements for increased capital, including an increase of the in-kind contribution.

Converting a sole proprietorship via incorporation

The second option for converting a sole proprietorship into a GmbH is incorporation – either via contributions in kind or via non-cash capital increase. This conversion of a sole proprietorship into a GmbH according to the GmbHG (Law on Limited Liability Companies) takes place outside the regulations of the German Conversion Act. For this reason, the process is also referred to as the civil law conversion method.

Incorporation via non-cash capital increase or contributions in kind

A sole proprietorship can be converted into a GmbH by incorporating it into an existing GmbH or a newly founded GmbH. The first option will involve transferring ongoing operations into the GmbH via a non-cash capital increase. This must be certified by a notary. The sole proprietorship is transferred to the existing GmbH as a contribution, thereby increasing the share capital of the GmbH. If the value of the contributed sole proprietorship exceeds €10,000, the surplus can be defined as capital reserves or a shareholder loan. After screening by the Commercial Register Court, the capital increase is recorded in the Commercial Register. This means that the sole proprietorship falls under the complete ownership of the GmbH.

If a GmbH does not yet exist as a target business, the sole proprietorship can be converted into a GmbH via contributions in kind. The sole proprietorship is the capital stock used to set up the GmbH. After the Commercial Register Court has examined the report on formation by contributions in kind, the newly founded GmbH is registered.

Are there other forms of conversion?

In addition to spinning off or incorporating a sole proprietorship into a GmbH, there are forms of conversion that require particular framework conditions and can be advantageous in certain scenarios:

• Selling the business to your GmbH: Sole proprietors usually choose this option to avoid the contributions-in-kind processes and the report on formation by contributions in kind. However, this solution comes with risks: if an entrepreneur sets up a new GmbH using cash and then sells the sole proprietorship to the GmbH, there may be concealed contributions in kind for which the entrepreneur can be held liable.

• Leasing the sole proprietorship to your GmbH: An entrepreneur can also lease a business to their GmbH. This conversion method is primarily used when business assets need to be split. The issue of concealed contributions in kind, as seen in the sale of the business, can also arise here. Furthermore, many advantages of a GmbH (third-party involvement, succession planning, etc.) cannot be fully used in this scenario.

If you wish to explore these options for converting a sole proprietorship into a GmbH, it is advisable to seek advice from a tax consultancy, law firm or auditor. This is particularly prudent if the exact market value of the sole proprietorship needs to be confirmed or if the business is saddled with debts.

What are the costs involved in the conversion?

The costs of converting a sole proprietorship into a GmbH can vary significantly depending on the circumstances. In essence, the conversion costs comprise the costs for tax and legal advice, notary costs, as well as costs for the Commercial Register Court. The required share capital of €25,000 is usually raised when setting up a new GmbH by ensuring the sole proprietorship's assets are valued at €25,000 minimum and are transferred to the GmbH. Therefore, in this scenario, the share capital is not a real cost factor.

The costs for the notary and Commercial Register Court are set by law. The costs for the certification by the notary depend on the size of the individual business, and are somewhere between €1,500 and €7,000. The conversion must be entered in the Commercial Register. The costs for this are around €300. Overall, the costs for converting into a GmbH can reach several thousand euros, depending on the size of the business and the chosen method for converting the sole proprietorship.

What are the tax implications and potential benefits?

Converting a sole proprietorship into a GmbH also comes with tax implications. In most cases, a GmbH enjoys tax advantages compared to a sole proprietorship. Due to its legal structure as a corporation, the GmbH is subject to corporation tax instead of the income tax that applies to sole proprietorships. This often results in lower taxes. Additionally, the managing directors of a GmbH can claim their salaries as business expenses, thereby further reducing the tax burden.

However, converting a sole proprietorship into a GmbH can also have tax implications that may lead to additional costs. For example, this could include the taxation of concealed reserves or the transfer of assets. In particular, if property forms part of the sole proprietorship's assets, make sure that you seek detailed tax advice: we advise caution when transferring a sole proprietorship into a GmbH, as contributions are subject to land transfer tax due to the change of ownership.

Tax implications can vary significantly depending on the conversion method and the individual circumstances. Only qualified tax advice can determine whether a conversion makes sense from a tax perspective and how you can make full use of any possible tax advantages.

Checklists for converting a sole proprietorship into a GmbH

Depending on the chosen conversion method, whether spin-off or incorporation, there are certain tasks that must be completed. These are listed in the following checklists. In both cases, registration of the sole proprietorship as such in the Commercial Register is a prerequisite for conversion.

Checklists for conversion via spin-off

• Create a spin-off plan: This must list all of the sole proprietorship's assets, debts and contracts that are to be transferred to the GmbH. If there is a works council, it must be consulted on the spin-off plan.
  
• Obtain consent from contractual partners: If the conversion does not involve universal succession, you must obtain the consent of the business's contractual partners.
  
• Inform employees: All employees must be informed about the incorporation due to possible impacts on employment contracts.
  
• Update contracts: Contracts and agreements must be updated.
  
• Have the process notarised: The articles of incorporation and memorandum of association, which can already form a part of the spin-off plan, must be notarised.
  
• Invest share capital: At least €25,000 must be invested via cash contributions or contributions in kind.
  
• Ensure that the Commercial Register Court performs its checks: Finally, checks are carried out by the Commercial Register Court, which then completes the entry into the Commercial Register.
  

Checklists for conversion via incorporation

• Create a contribution agreement: This must contain information on the valuation of the business being contributed, along with the type and amount of the contribution and any compensatory payment.
  
• Create a report on formation by contributions in kind. You must list the assets due to be transferred to the GmbH via the contribution. Alternatively, the sole proprietorship can also be converted into an existing GmbH in return for a non-cash capital increase.
  
• Update contracts: Contracts and agreements must be updated.
  
• Have the process notarised: The contribution agreement and the report on formation by contributions in kind, as well as the contract for the non-cash capital increase, must be notarised.
  
• Inform employees: All employees must be informed about the incorporation due to possible impacts on employment contracts.
  
• Invest share capital: At least €25,000 must be invested via non-cash capital increase or contributions in kind.
  
• Ensure that the Commercial Register Court performs its checks: Finally, checks are carried out by the Commercial Register Court, which then completes the entry into the Commercial Register.
  

All documentation for the conversion should be prepared by the sole proprietorship in cooperation with tax and legal advisers. The legal professional will also support the final notarial process and entry into the Commercial Register.

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