Transforming a Danish Individual Business to an APS

If you're considering converting your sole proprietorship to an ApS company, there could be various reasons behind your decision, but most commonly, it is to enjoy limited liability protection. Before proceeding, it's essential to determine if a limited liability structure aligns with your business requirements. Once you've decided to convert, you have two options to choose from.

Option 1 – „tax-free” conversion

If your business has substantial value, it's advisable to consider a "tax-free" conversion when converting your sole proprietorship into an ApS company. This conversion process involves treating the sole proprietorship's assets (such as machinery, equipment, liabilities, goodwill, etc.) as if they were sold to a newly established ApS company. This approach is beneficial because it allows for high profits from the sale of the ApS business, which could include revenue from selling machinery and equipment or from selling customers. To accurately determine the profit gained from the sale of a sole proprietorship to a new ApS, you'll need to evaluate the value of your customers.

You need an auditor to make a tax-free conversion

The role of an auditor in converting a sole proprietorship to an ApS company is to determine the value of the business and issue a corresponding statement. Additionally, the auditor is responsible for managing the ApS registration process. During this conversion, your future tax liability will be deducted from the same profit earned from the "sale" of the ApS business, based on the goodwill assessed by the auditor. The cost of the auditor's services during a tax-free conversion is typically between 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”?

A more precise term for the conversion of a sole proprietorship into an ApS company would be "tax deferred conversion" since you're still required to pay taxes on the conversion to the IRS. However, by utilizing the tax-free conversion rules, you can defer the tax payment until the date you sell your shares in the newly established ApS company. Hence, in reality, it's not entirely tax-free, and you're merely deferring the payment of taxes.

Option 2 – Taxable conversion

If your business has zero or minimal value, it's best to opt for a taxable conversion when converting your sole proprietorship into an ApS company. When selling your sole proprietorship to an ApS company, the sale usually results in little or no gain, which means that the tax on the sale will be either zero or very low. As a result, a taxable conversion is more beneficial than a tax-free conversion option, which can be costly (typically DKK 5,000 to 20,000 plus VAT), especially for a small sole proprietorship.

Sole proprietorship’ value

The value of a business refers to the amount one would pay for it, but since buyers are not always readily available, we must make certain value assumptions. Typically, the difference between assets and liabilities is the key focus when evaluating a business's value. Assets include goodwill, machinery, equipment, deposits, cash, receivables from customers, and bank deposits, while liabilities consist of debts, loans, and credits. Most of these components have a visible value on the balance sheet, such as if you owe a supplier €1,000, the liability value is €1,000. For other items, like machinery and equipment, you'll need to assess the present value. Goodwill is usually valued at zero on the balance sheet because a sole proprietorship's customer base starts from zero and is gradually built up over time. However, the value of the customer base is considered significant when converting to an ApS company. If the customer base value is zero on the balance sheet, you'll be taxed on the entire customer base value when converting to an ApS because it's deemed to have been sold to the new ApS. In situations where you've acquired a customer base in the past, the difference between the current and balance sheet value is assessed. Therefore, determining the current value of the customer base is crucial before converting to an ApS.

How to determine the value of a company’s customer base?

When calculating your company's value, you must not only consider machinery, equipment, and liabilities but also take into account the value of the customer base. There are no established regulations on how to calculate a business's value. During the conversion of a sole proprietorship to an ApS, where you are both the seller and the buyer, you must document the price you plan to sell the business for in some way.

There are five methods you can employ to document the value of your business:

  1. Utilize the most commonly used valuation methods in your industry.
  2. Refer to the tax office's guidelines for determining the value of your business.
  3. Come up with your own approach to calculating the business's value.
  4. Consider an offer from an unrelated individual who is interested in purchasing your business.
  5. Hire a professional to conduct a formal valuation of your business.

Option 1: Use the most commonly used valuation methods in your industry

If there are established and commonly used valuation methods in your industry that can help you calculate your business's value, including the value of the customer base, you may want to consider using this type of valuation. However, it's crucial to ensure that all the documentation is well-maintained. Certain professions, such as doctors, law firms, dentists, auditors, and real estate agents, typically have such valuation methods in place. However, it's essential to note that not all industries have the appropriate valuation methods available.

Option 2: Use the tax office’s guidelines

The IRS has provided a set of guidelines that you can use to estimate the value of your company's customer base. You can use the estimated value provided by the IRS along with the value of your other assets and liabilities to calculate your company's total value. This approach will give you the calculated value of your business.

Option 3: Use your own way

It's not advisable to use your own method to determine the value of your company's customer base if your calculations differ significantly from established industry or IRS guidelines. Doing so could result in unfavorable tax consequences if the IRS later estimates the value of your business differently. To mitigate the risk, you can request approval of your valuation from the tax office before proceeding with the conversion. While this procedure will reduce uncertainty, it will also increase the processing time by several months.

Option 4: Use an offer from an unrelated person who wants to buy your company

If you've received an offer from an unrelated individual to purchase your business, you can use it to determine the value of your company. The offer price can serve as a starting point for the valuation process, and you can adjust it based on other factors, such as the value of your customer base and other assets and liabilities.

Option 5: Get a valuation done by a professional

Another option to determine the value of your company is to engage the services of a professional, such as an auditor or a company broker. These professionals can provide you with a formal valuation of your business based on various factors, including the value of your customer base, assets, liabilities, and industry-specific trends. A professional valuation can offer more accuracy and reliability, and may also help you to identify areas of your business that require improvement.

Calculating goodwill according to tax office guidelines

To utilize the IRS's guidelines for calculating goodwill, you'll need to factor in the profits earned by your business during the last three years for a sole proprietorship. The calculation of goodwill involves assessing the overall value of the business based on factors like customer base, reputation, and other intangible assets. By including the profit earned over the last three years in the calculation, you can get a better idea of the value of your business's goodwill.

Remember that there are 2 types of profits:

  1. Profit calculated based on tax regulations: This method involves using the net taxable income of the business to determine the profits earned. This amount is typically calculated based on the tax regulations applicable in the region.
  2. Profit calculated based on accounting principles: This method involves calculating the profits earned by the business based on accounting principles. This may include the use of financial statements, such as balance sheets and income statements, to determine the net income generated by the business.

In general, it's recommended that you use the profit calculated based on accounting principles when determining the value of your business. However, if your company only prepares annual reports based on tax rules (which is common for smaller sole proprietorships), then you can use the profit calculated based on tax regulations. When calculating goodwill, you'll need to consider the profits earned by your business over the last three years before accounting for interest and taxes (known as "Resultat før renter" in Danish). This calculation provides an estimate of the value of your business's goodwill.

If the calculations are done in 2021, we will look at issues 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

The text outlines a series of calculations to determine the estimated goodwill for a business. First, the sum of the profits from the years in question is divided by 6 to determine the average profit for the year, which is referred to as "profit" for the calculations. If profit grew from year to year, then 50% of the profit growth from 2018 to 2020 is added to the result. Next, the salary for a sole proprietor is deducted from the remaining result, which is 50% of the result after the profit growth adjustment, but a minimum of DKK 250,000 and a maximum of DKK 1,000,000. The remaining result is further reduced by 3% of the value of assets (excluding goodwill purchased in the past). Finally, the estimated goodwill is adjusted for future expectations by multiplying the remaining score by a factor of 2.83 if the customer life expectancy is set to 7 years.

When can a „tax-free” conversion be made?

The option to convert tax-free is available from January 1 of a given year, and can be made up to 6 months in advance. This means that you can convert tax-free between January 1 and June 30 of each year, and it will take effect retroactively from January 1 of the same year.

What happens if the value of the company is zero or even negative?

Regardless of the outcome of the calculations, the company's actual price must be used, as it would be if it were sold to an unrelated party. It is important to assess the accuracy of the estimated value of the company, and if there are any doubts, it's advisable to seek advice from the tax office.

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