Converting a Sole Proprietorship (Einzelunternehmen) into a GmbH: When It Pays Off and How It Proceeds

• When a sole proprietorship (Einzelunternehmen) is converted into a GmbH, the existing business is transferred into a corporation (Kapitalgesellschaft) – common motives are limitation of liability, growth and tax optimisation in the case of retained profits.
• For startups, the GmbH is often even a precondition: investors as a rule invest only in corporations, so that external financing rounds are practically impossible with a sole proprietorship.
• In favour of the GmbH are a lower tax burden on retained profits and the limitation of liability, while a higher administrative burden and additional ongoing costs constitute the drawbacks.
• The most common routes are a contribution under the Reorganisation Tax Act (Umwandlungssteuergesetz) and a spin-off (Ausgliederung) under the Reorganisation Act (Umwandlungsgesetz) – both can be carried out tax-neutrally where certain conditions are met

What does converting a sole proprietorship (Einzelunternehmen) into a GmbH involve?

The conversion of a sole proprietorship into a GmbH describes the process by which an existing business, together with its assets, contracts and employees, is transferred to a newly formed or already existing GmbH without the business operations as such being interrupted. The identity of the undertaking in economic terms is preserved in the process – customers, contracts and day-to-day operations continue unchanged, and only the legal entity changes from the sole trader to a corporation (Kapitalgesellschaft).

The most frequent motives for this step lie in the limitation of liability, since in the case of a GmbH it is in principle only the company's assets and not the entrepreneur's private assets (Privatvermögen) that are liable, as well as in tax considerations where profits are to remain in the business and be reinvested. In the case of startups, a further and often decisive reason regularly comes into play: business angels, venture capital funds and other institutional investors participate almost exclusively in corporations, since only the GmbH can properly reflect in legal terms the shares, voting rights and preferential rights (such as liquidation preferences) required for this purpose. A financing round with a sole proprietorship is simply not feasible in practice – anyone dependent on external growth capital therefore usually cannot avoid the GmbH (or a comparable corporation). Further reasons are the more professional external image vis-à-vis business partners and banks as well as clearer succession arrangements, since shares in a GmbH are more easily transferable than a sole proprietorship as a whole.

What are the advantages and disadvantages of converting into a GmbH?

Whether the conversion is worthwhile depends decisively on the interplay of tax burden, liability risk, financing requirements and the additional administrative burden.

• Tax: Whereas the profit of a sole proprietorship is charged directly at the personal income tax (Einkommensteuer) rate of up to 45% plus the solidarity surcharge (Solidaritätszuschlag), the profit of a GmbH is initially subject only to corporation tax (Körperschaftsteuer) and trade tax (Gewerbesteuer) at a current combined rate of around 30% (the corporation tax rate is to be reduced from 15% to 10% by 2031). Only upon an actual distribution to the shareholders does withholding tax on investment income (Kapitalertragsteuer) additionally arise, so that the tax advantage of the GmbH shows itself above all where profits are retained in the business rather than being withdrawn in full.
• Liability: In the case of a GmbH, in principle only the company's assets are liable, while the sole trader is answerable for business liabilities without limitation, including with his or her private assets. In practice, however, this advantage is frequently qualified by the fact that banks regularly require personal guarantees from the shareholders when granting credit to young GmbHs.
• Ability to raise finance: For growth-oriented startups this point is often the actual trigger for the conversion: investors need shares that they can subscribe for, endow with preferential rights and later sell again – all of which can only be reflected with legal certainty in a corporation. Anyone planning a financing round should therefore address the conversion at an early stage and not only immediately before the round is closed, since investors regularly presuppose the GmbH structure as early as the term sheet.
• Administration: A GmbH entails a noticeably higher administrative burden: double-entry bookkeeping and annual financial statements (Jahresabschluss) under commercial law must be prepared, with a disclosure obligation vis-à-vis the Federal Gazette (Bundesanzeiger); in addition, shareholders' meetings must be minuted and company-law formalities such as capital maintenance rules must be observed. A sole proprietorship, by contrast, where its size permits, regularly makes do with a simple cash-basis income statement (Einnahmen-Überschuss-Rechnung).
• Costs: In addition to the one-off formation costs for the notary and the commercial register, a GmbH incurs higher ongoing costs for tax advice, preparation of the annual financial statements and, where applicable, a statutory audit, which depending on the size of the business can amount to a mid to high four-figure sum per year – considerably more than for a comparable sole proprietorship.

The upshot is this: the higher the retained profit, the greater the liability risk of the operating business and the more concrete the plans for external financing, the more the advantages of the GmbH outweigh the additional administrative burden. For smaller, low-risk businesses with no financing requirements and with profits withdrawn in full, by contrast, the change is often not worthwhile.

How can a sole proprietorship be converted into a GmbH?

Various legal routes are available for converting a sole proprietorship into a GmbH, differing above all in terms of effort and flexibility.

• Contribution under the Reorganisation Tax Act (Umwandlungssteuergesetz): Under this classic variant, the sole proprietorship is contributed to a newly formed or existing GmbH by way of singular succession in title (Einzelrechtsnachfolge) in exchange for the granting of shares. Where the conditions of § 20 UmwStG are met, this route is possible tax-neutrally at book value (Buchwert), but it requires the transfer of every individual asset and contractual relationship, which can be time-consuming in the case of extensive businesses.
• Spin-off under the Reorganisation Act (Umwandlungsgesetz): The spin-off takes place by way of partial universal succession (partielle Gesamtrechtsnachfolge) under § 152 UmwG, as a result of which contracts, permits and liabilities pass to the GmbH automatically, without each contractual partner having to consent individually. This route is more complex in legal terms and requires a notarised spin-off plan, but in implementation it frequently saves time compared with singular succession in title.
• Cash formation followed by a transfer of the business: Alternatively, a new GmbH can be formed with a cash contribution and subsequently acquire the assets of the sole proprietorship by way of a purchase agreement. This route is simpler in legal terms, but because the reorganisation tax provisions do not apply it regularly leads to the realisation of hidden reserves (stille Reserven) and hence to immediate taxation, which is why it is usually the least favourable variant from a tax perspective.

In practice, the spin-off is usually the more efficient route for larger businesses with complex contractual arrangements, while the contribution route lends itself to manageable structures with few contractual relationships. Cash formation with a transfer of the business should be chosen only in well-founded exceptional cases, given the tax disadvantages.

How does the conversion proceed?

The course of a conversion depends on which of the above alternatives is chosen. First, the assets to be contributed or spun off are as a rule valued and documented on the basis of a balance sheet drawn up as at a reference date, for which an up-to-date interim balance sheet (Zwischenbilanz) as well as a schedule of all assets, contracts and liabilities are generally required. The GmbH is then formed or – where it already exists – the capital increase for taking up the contribution in kind (Sacheinlage) is prepared, with the articles of association and the contribution agreement having to be notarised.

Following notarisation, the application to the commercial register is made, frequently coupled with evidence of the value of the contribution in kind by means of a formation report on contributions in kind (Sachgründungsbericht). In parallel, ongoing contracts, permits, insurance policies and, where applicable, employment relationships must be transferred to the new GmbH or at least adjusted. Depending on the complexity of the business, the entire process from initial planning to entry in the commercial register takes between six and twelve weeks; the total costs for the notary, the commercial register and tax support usually come to a mid four-figure sum.

Is a retroactive conversion possible?

Yes, reorganisation tax law permits, upon application, retroactive tax effect of the conversion as at a reference date up to eight months prior to the application to the commercial register. In practice this means that the GmbH is treated as the sole proprietorship's successor in title for tax purposes as from an earlier point in time, even though registration under civil law only takes place later. This scope for structuring is frequently used in order to align the conversion in time with the beginning of a financial year, even where the legal implementation is only completed in the course of that year.

What alternatives are there to converting into a GmbH?

Besides the classic GmbH, other legal forms may also be considered depending on the objective, offering individual advantages of the GmbH without entailing its full administrative burden.

• GmbH & Co. KG: This hybrid form combines the limitation of liability of the GmbH as general partner with the tax transparency of a partnership (Personengesellschaft), but it requires the formation and administration of two legal entities and is thus administratively even more burdensome than a straightforward GmbH. For startups with planned financing rounds it is moreover usually unsuitable, since here too investors as a rule prefer a classic GmbH structure.
• Entrepreneurial company (Unternehmergesellschaft, UG): The UG is a variant of the GmbH with a lower minimum capital, but it is subject to the same ongoing obligations and is suited above all to founders with limited start-up capital who nevertheless wish to make use of the limitation of liability of a corporation. For later financing rounds it is in principle just as capable of accommodating investors as the GmbH, but it is viewed more critically by some investors on account of its lower share capital (Stammkapital).
• Continuation as a sole proprietorship with insurance solutions: Anyone whose main concern is to limit the liability risk without accepting the tax and administrative consequences of a GmbH can partly cushion that risk through public liability and financial loss liability insurance, even though this is no full substitute for the separation of liability under company law and offers no solution where financing is required.

Which variant is appropriate in an individual case depends above all on the planned growth, the capital requirements and the desired succession arrangements – anyone already contemplating a financing round, however, as a rule cannot avoid a classic GmbH.