Converting a danish sole proprietorship to an ApS
There may be several reasons behind your decision to convert your sole proprietorship into an ApS company. Usually it is related to the desire to have limited liability. It is important to first make sure that you are able to run your business in a limited liability structure. If you decide to convert a sole proprietorship to an ApS (private limited company in Denmark), you have two options to consider.
Option 1 - "tax-free" conversion
In a situation where your business has significant value, it is a good idea to do a "tax-free" conversion. The conversion of a sole proprietorship into an ApS should be treated as if the sole proprietorship (machinery, goodwill, equipment, liabilities, etc.) had been sold to a new ApS. Then if the sole proprietorship has a high value - for example, if your revenues are high and many customers - then the profit from the sale of the ApS business would also be high. This profit can come from the sale of machinery and equipment - as well as from the sale of customers. You also need to determine the value of your customers to understand the total profit from "selling" a sole proprietorship to a new ApS.
You need an auditor to make a tax-free conversion
The auditor’s role is to determine the value of the company and issue the appropriate statement. In addition, the auditor will also undertake the actual process of ApS registration. When a sole proprietorship is converted into an ApS, your future tax liability will be deducted from the same profit that you got from the "sale" of the ApS business - based on the goodwill that the auditor has determined. The auditor's fee during a "tax-free" conversion is usually DKK 5,000 - 20,000 + VAT, depending on the complexity of the company.
So why is this type of conversion called "tax-free"?
Well, a more accurate expression would actually be "tax deferred conversion" - because you still have to pay the tax on the conversion to the IRS. Using the tax-free conversion rules, on the other hand, you can defer tax to the date you sell your shares in the new ApS. Thus, it isn't really "tax-free" in reality - all you have to do is defer the tax.
Option 2 - Taxable conversion
In a reverse situation where your business has zero or little value, then a taxable conversion should be made. Even when selling sole proprietorship to ApS, there is only a little or no gain as a result of the sale. For the same reason, the tax on the sale of a sole proprietorship to ApS is also zero or at least very low. In comparison to the cost of a tax-free conversion option (often DKK 5,000-20,000 + VAT), a taxable conversion is more advantageous for a small sole proprietorship.
Sole proprietorship’ value
Business’ value is how much one would pay for it, but because the buyer is not always on our hand, we need to make some value assumptions. We usually pay attention to the difference between assets and liabilities. For example, in assets we include goodwill, machinery, deposits, equipment, cash ,receivables from customers and bank deposits. For liabilities, we talk about debts, loans, credits and others. Most of the components mentioned have a value visible on the balance sheet, for example, if you owe a supplier €1,000, the value of the liability is usually €1,000. For other things, such as machinery and equipment, you will have to evaluate the present value. Goodwill is usually valued at 0 on the balance sheet. This is because once you started a sole proprietorship, you did not have a customer base at the beginning. So over the years you built up increased goodwill in the context of a customer base that is not viewed as an asset on the balance sheet. Usually for this very reason, the point of interest in converting to ApS is the value of the customer base. If a company’s customer base value is zero on the balance sheet, you will be taxed on the entire value of the company’s customer base when converted to Danish Ltd (ApS), because the customer base is considered to have been sold to the new ApS. There might be situations in which you acquired a customer base somewhere in the past, we instead take the difference between the value of the customer base that exists on the balance sheet and value of the customer base that is current. Either way, before converting to ApS, the current value of the customer base must be determined.
How to determine the value of a company's customer base?
To calculate your company’s value, then in addition to machinery, liabilities, equipment, etc., we must also calculate the value of the company’s customer base. There are no regulations on how to calculate the value of a business. When you convert a sole proprietorship into a Danish private limited company (ApS), which you also own, you act as both seller and buyer. The price you plan to sell for must be documented in some way.
[infografika] In general, there are 5 methods you can use to document the value of your business:
- Use the most commonly used valuation methods in your industry.
- Use the tax office's guidelines
- Use your own way
- Use an offer from an unrelated person who wants to buy the company
- Use a valuation done by a professional
Option 1: Use the most commonly used valuation methods in your industry
If there are most commonly used valuation methods in your industry that make it possible to determine the value of your business, including the value of the company's customer base, you could consider using this type of valuation. However, make sure that everything is well documented. This is often the case for professions such as doctors, law firms, dentists, auditors and real estate agents. Keep in mind that definitely not all industries have the right valuation methods.
Option 2: Use the tax office's guidelines
The IRS has issued a set of guidelines to calculate your company’s customer base estimated value - so it’s possible to use the IRS' estimate of your company's value and add that to your other assets and liabilities. This will give you your company’s calculated value.
Option 3: Use your own way
Using your own way to estimate the value of a company's customer base can be a really bad idea if your own calculations differ significantly from industry or IRS guidelines. In the worst case scenario, you will be obliged to pay tax on the value of the company, which the IRS later estimates. To reduce the risk, you have the option of applying to the tax office for approval of the valuation before the conversion. Such a procedure will remove the uncertainty however, at the same time it will increase the processing time by several months.
Option 4: Use an offer from an unrelated person who wants to buy your company
If you received an actual offer from an unrelated person, you can also use it to determine the value of your company.
Option 5: Get a valuation done by a professional
You can also use a professional - such as an auditor or company broker - to evaluate your company.
Calculating goodwill according to tax office guidelines
To use the IRS's guidelines for calculating goodwill, include in the calculation the profit of the last 3 years for a sole proprietorship.
Remember that there are 2 types of profits
- Profit calculated on the basis of tax regulations
- Profit calculated on the basis of accounting principles
As a rule, you must use profit calculated on the basis of accounting principles. When your company prepares an annual report only on the basis of tax rules (this is very common for smaller sole proprietorships), then profit calculated on the basis of tax rules can be used. The calculation of goodwill is based on the profit of the last 3 years before interest and taxes (in Danish called "Resultat før renter").
If the calculations are done in 2021, we will look at issues such as:
- Profit in 2020 before interest and taxes
- Profit in 2019 before interest and taxes
- Profit in 2018 before interest and taxes
Then adjust the profit in each year according to such things as:
- Removing an associate's salary that is no longer included as an expense in profit
- Removing depreciation made on previously acquired assets
- Removing the extraordinary amount (large one-time losses, etc.)
The result we get is called the adjusted profit for each one of the 3 years. Next step is calculating the average profit of these 3 regulated profits, with the most recent year being more important than the oldest.
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 this is divided by 6, which gives us the average profit for the year. Let's call this amount "profit" for the purposes of the following calculations. If profit grew from year to year from 2018 to 2019 and 2020, we add 50% of the profit growth from 2018 to 2020 to the result. Then we have to deduct the salary for a sole proprietor, which is 50% of the remaining result - but a minimum of DKK 250,000 and a maximum of DKK 1,000,000. We then subtract 3% of the value of assets (excluding goodwill purchased in the past) from the remaining result. To get the remaining result, we then need to adjust for future expectations. This is done by looking at the life expectancy for customers. As a rule of thumb, this should be 7 years. If the customer life expectancy can be set to 7 years (this is usually recommended), then use a factor of 2.83 to multiply the remaining score. This will give you the calculated estimated goodwill.
When can a "tax-free" conversion be made?
The "tax-free" conversion always takes effect on January 1 of a given year. You can make a "tax-free" conversion 6 months back. This means that it’s possible to make a "tax-free" conversion between January 1 and June 30 of each year - it will take effect on January 1 of the same year (retroactive too).
What happens if the value of the company is zero or even negative?
However the results of calculations come out, the actual price for the company still has to be used, just as you would get if you sold it to someone not related to you. Think about whether the estimated value of the company is realistic. If you don't feel confident about the value, ask the tax office.