Transforming a Danish Sole Proprietorship into an APS Enterprise
Converting a sole proprietorship to an ApS company is typically motivated by the desire for limited liability. Before making the switch, it's important to ensure that a limited liability structure is suitable for your business. If you do decide to convert, there are two options to choose from.
Option 1 – „tax-free” conversion
If your business has a significant value, it's recommended to opt for a "tax-free" conversion when converting a sole proprietorship to an ApS company. This involves treating the conversion as if the sole proprietorship (including machinery, goodwill, equipment, liabilities, etc.) had been sold to a new ApS. If the sole proprietorship has a high value, such as from high revenues and a large customer base, the resulting profit from the sale of the ApS business could be considerable. This profit may come from selling machinery and equipment as well as from selling customers. It's important to calculate the value of your customers to accurately determine the total profit from "selling" the sole proprietorship to the new ApS.
You need an auditor to make a tax-free conversion
The role of the auditor when converting a sole proprietorship to an ApS company is to determine the company's value and issue a statement to that effect. Additionally, the auditor will oversee the actual process of registering the ApS. Following the conversion, any future tax liability will be subtracted from the profit obtained from the "sale" of the ApS business, based on the goodwill value determined by the auditor. The fee charged by the auditor for a "tax-free" conversion typically ranges from DKK 5,000 to 20,000 plus VAT, depending on the complexity of the company.
So why is this type of conversion called „tax-free”?
The term "tax-free conversion" is not entirely accurate and a more appropriate term would be "tax deferred conversion". This is because taxes still need to be paid on the conversion to the IRS. However, by utilizing the tax-deferred conversion rules, taxes can be deferred until the date when shares in the new ApS are sold. Therefore, it is not completely "tax-free" in actuality, but rather a deferral of taxes.
Option 2 – Taxable conversion
If your business has little or no value, it's recommended to opt for a taxable conversion when converting a sole proprietorship to an ApS company. This is because there will be little or no gain as a result of the sale of the sole proprietorship to the ApS. Therefore, the tax on the sale will also be zero or very low. In the case of a small sole proprietorship, a taxable conversion is more beneficial than the tax-free conversion option, which can cost anywhere between DKK 5,000 to 20,000 plus VAT.
Sole proprietorship’ value
The value of a business is based on how much someone would be willing to pay for it, but since a buyer may not always be readily available, it's necessary to make certain assumptions. One approach is to consider the difference between the business's assets and liabilities. Assets may include goodwill, machinery, deposits, equipment, cash, receivables from customers, and bank deposits, while liabilities may include debts, loans, credits, and other obligations. Many of these components have a value that can be seen on the balance sheet, such as a debt owed to a supplier. For other items, such as machinery and equipment, it's necessary to determine their present value. Goodwill is often valued at zero on the balance sheet because it's not considered an asset until a customer base has been established over time. Therefore, when converting a sole proprietorship to an ApS, the value of the customer base is a key consideration. If the customer base is valued at zero on the balance sheet, the entire value of the customer base will be subject to taxation when converted to ApS, as it's considered to have been sold to the new ApS. If a customer base was acquired in the past, the difference between the current and previous value of the customer base is used. In any case, the current value of the customer base must be determined before converting to ApS.
How to determine the value of a company’s customer base?
When calculating the value of your company, it's important to take into account not only the value of assets such as machinery, equipment, and liabilities, but also the value of your company's customer base. There are no specific regulations for determining a business's value, so it's up to the business owner to make appropriate calculations. When converting a sole proprietorship into an ApS, the owner serves as both the seller and buyer, so it's important to document the sale price in some way.
In broad terms, there are five methods available for documenting the value of a business:
1. Use commonly used valuation methods in your industry.
2. Use the guidelines provided by the tax office.
3. Use your own method for calculating the value of your business.
4. Consider an offer from an unrelated party interested in buying the company.
5. Have a professional conduct a valuation of the business.
Option 1: Use the most commonly used valuation methods in your industry
In some industries, there may be commonly used valuation methods that can be used to determine the value of a business, including the value of the company's customer base. If such methods exist, they can be useful for calculating the value of a business, but it's important to ensure that everything is well-documented. This may be the case in professions such as doctors, law firms, dentists, auditors, and real estate agents. However, it's worth noting that not all industries have established valuation methods, and other methods may need to be considered.
Option 2: Use the tax office’s guidelines
The IRS provides guidelines for calculating the estimated value of a company's customer base. It's possible to use the IRS estimate of the customer base's value and add it to the value of other assets and liabilities in order to arrive at the calculated value of the company.
Option 3: Use your own way
It's generally not recommended to use your own method to estimate the value of a company's customer base, especially if your calculations differ significantly from industry or IRS guidelines. This approach can result in having to pay tax on a value that the IRS later determines to be higher than your own estimate. To minimize this risk, it's advisable to apply to the tax office for approval of the valuation before the conversion. This procedure can help remove uncertainty, but it also increases the processing time by several months.
Option 4: Use an offer from an unrelated person who wants to buy your company
If you have received an offer from an unrelated party interested in buying your business, you can use this offer to determine the value of your company. This can be a useful approach, as the offer provides a tangible and external benchmark for the value of the business.
Option 5: Get a valuation done by a professional
Another option for determining the value of your company is to engage a professional, such as an auditor or a company broker, to conduct a valuation. These professionals can provide an objective assessment of the value of your business, taking into account various factors such as its assets, liabilities, and customer base. Using a professional to conduct a valuation can be a reliable and accurate way to determine the value of your company.
Calculating goodwill according to tax office guidelines
If you're calculating goodwill using the IRS guidelines and dealing with a sole proprietorship, you should factor in the profit of the past three years in your calculation.
Remember that there are 2 types of profits:
1. There are two ways to calculate profit in Denmark: The first method is based on tax regulations, and the second method is based on accounting principles.
2. When profit is calculated according to tax regulations, it takes into account various tax deductions and credits. This can result in a lower taxable profit for the company.
In general, profit calculated based on accounting principles should be used. However, for smaller sole proprietorships that prepare annual reports based on tax rules, profit calculated based on tax rules may be used. Goodwill is calculated based on the profit of the last three years before interest and taxes, which in Danish is referred to as "Resultat før renter."
If the calculations are being carried out in the year 2021, then we will examine matters such as:
1. Profit in 2020 before interest and taxes
2. Profit in 2019 before interest and taxes
3. Profit in 2018 before interest and taxes
After that, make modifications to the profit for each year based on factors such as:
1. Excluding the salary of an associate that is no longer considered an expense in profit.
2. Eliminating the depreciation recorded on assets that were acquired in the past.
3. Removing any extraordinary amounts that could skew the profit calculation, such as significant one-time losses.
After making the necessary adjustments, the outcome is referred to as the adjusted profit for each of the three years. The next step is to calculate the average profit of these three adjusted profits, giving more weight to the most recent year compared to the oldest year.
This is done by multiplying the years by the individual factor and dividing by 6:
- Regulated profit in 2020 x 3
- Regulated profit in 2019 x 2
- Regulated profit in 2018 x 1
The sum of the three-year average profits is divided by 6 to obtain the annual average profit, referred to as "profit" for the subsequent calculations. If profit has increased in each year from 2018 to 2019 and 2020, 50% of the profit growth from 2018 to 2020 is added to the outcome. The salary for a sole proprietor is then subtracted, which is 50% of the remaining result, with a minimum of DKK 250,000 and a maximum of DKK 1,000,000. Following that, 3% of the value of assets, excluding goodwill purchased in the past, is deducted from the remaining result. Next, the remaining result is adjusted for future expectations by assessing the life expectancy of customers. As a rule, the customer life expectancy should be seven years. If a customer life expectancy of seven years can be established (which is typically recommended), then multiply the remaining score by a factor of 2.83. This will give you the calculated estimated goodwill.
When can a „tax-free” conversion be made?
When converting to a "tax-free" status, the conversion becomes effective on January 1st of the year. However, it is possible to carry out a "tax-free" conversion six months before the effective date. This implies that the conversion can be done between January 1st and June 30th of a given year, with a retroactive effect from January 1st of the same year.
What happens if the value of the company is zero or even negative?
Regardless of the results obtained from the calculations, the actual price for the company must still be used, just as it would be if the company were being sold to an unrelated third party. It's essential to consider whether the estimated value of the company is realistic. If you have doubts about the value, it's advisable to seek guidance from the tax office.