Transforming a Danish Sole Proprietorship into an APS Company

Deciding to convert your sole proprietorship into a Danish limited liability company (ApS) may have various reasons, but it’s often because you want to limit your liability. Before making the switch, it’s crucial to confirm that your business is suitable for a limited liability structure. If you choose to proceed, you have two options for the conversion process.

Option 1 – „tax-free” conversion

If your business has considerable value, it's advisable to opt for a tax-free conversion. This involves treating the conversion of a sole proprietorship into an ApS as a sale of the sole proprietorship's assets, including machinery, goodwill, equipment, and liabilities to a new ApS. If the sole proprietorship has a high value, such as significant revenue and a large customer base, the profit from the sale of the ApS business would be substantial. This profit may come from the sale of equipment, machinery, and customers. To calculate the total profit from "selling" the sole proprietorship to a new ApS, you must also assess the value of your customers.

You need an auditor to make a tax-free conversion

The primary responsibility of an auditor is to assess the value of the company and provide an appropriate statement. They will also handle the ApS registration process for the conversion of a sole proprietorship to a Danish Ltd. In the case of a tax-free conversion, your future tax liability will be deducted from the profit you obtained from the „sale” of the ApS business, which is based on the goodwill assessed by the auditor. The cost of hiring an 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" can be misleading because you are still required to pay taxes on the conversion to the IRS. Instead, it would be more accurate to describe it as a "tax-deferred conversion." By using the tax-free conversion rules, you can postpone paying taxes until the day you sell your shares in the new ApS. Therefore, in reality, the conversion is not truly "tax-free." Rather, it allows you to defer paying taxes until a later date.

Option 2 – Taxable conversion

If your business has minimal or no value, it would be more appropriate to choose a taxable conversion. When a sole proprietorship is sold to an ApS, there may be little to no gain from the sale. Consequently, the tax on the sale of a sole proprietorship to an ApS is likely to be zero or very low. For small sole proprietorships, a taxable conversion is more beneficial than a tax-free conversion option, which can be costly (usually ranging from DKK 5,000-20,000 + VAT).

Sole proprietorship’ value

The value of a business is the amount that someone would be willing to pay for it, but since buyers may not always be available, value assumptions need to be made. When evaluating the value of a business, the focus is usually on the difference between its assets and liabilities. Assets may include items such as machinery, deposits, equipment, cash, receivables from customers, and bank deposits, while liabilities may refer to debts, loans, credits, and other similar items. The value of most of these components is typically visible on the balance sheet. However, for items such as machinery and equipment, their present value needs to be evaluated.

Goodwill is usually not valued on the balance sheet. This is because when you started your sole proprietorship, there was no customer base initially. Over time, you built up goodwill in the context of a customer base that is not considered an asset on the balance sheet. Therefore, the value of the customer base is a significant factor when converting to an ApS. If a company’s customer base has zero value on the balance sheet, you will be taxed on the entire value of the customer base when converting to a Danish private limited company. This is because the customer base is considered to have been sold to the new ApS. In cases where a customer base was acquired in the past, the difference between the current value of the customer base and the value on the balance sheet may be considered. In any event, determining the current value of the customer base is critical before converting to an ApS.

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

When calculating the value of your company, it is necessary to include not only machinery, liabilities, and equipment, but also the value of your customer base. There are no specific regulations on how to calculate the value of a business. In the case of converting a sole proprietorship to an ApS, where you are both the seller and the buyer, the sale price needs to be documented in some manner.

There are five general methods available to document the value of your business:

1. Use the most commonly used valuation methods in your industry.
2. Use the tax office's guidelines.
3. Use your own method for determining the value.
4. Consider an offer from an unrelated person interested in buying the company.
5. Hire a professional to provide a valuation.

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

If your industry has commonly used valuation methods to determine the value of your business, including the value of your customer base, you may want to consider using them. However, it is essential to ensure that everything is documented appropriately. This option is often applicable for professionals such as doctors, law firms, dentists, auditors, and real estate agents. Nevertheless, it is important to note that not all industries have the appropriate valuation methods for determining business value.

Option 2: Use the tax office’s guidelines

The IRS has released a set of guidelines for determining the estimated value of your company's customer base. As a result, you can use the IRS estimate of your company's value and combine it with your other assets and liabilities to calculate your company's overall value.

Option 3: Use your own way

Estimating the value of your company's customer base using your own method can be problematic, particularly if your calculations differ significantly from the industry or IRS guidelines. In the worst-case scenario, you may be required to pay taxes on a value that the IRS later estimates, resulting in additional expenses. To mitigate the risk, you can apply to the tax office for approval of your valuation before the conversion process. However, this approach could increase the processing time by several months, even though it reduces the uncertainty.

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

If you have received an actual offer from an unrelated person who is interested in buying your company, you may use this offer to determine the value of your company.

Option 5: Get a valuation done by a professional

Another option to determine the value of your company is to engage a professional such as an auditor or company broker to provide a valuation. They can assist you in assessing the worth of your company's assets, liabilities, and customer base to determine the company's overall value.

Calculating goodwill according to tax office guidelines

To utilize the IRS's guidelines for calculating goodwill, you need to include the profit of the past three years for a sole proprietorship in the calculation.

It's important to keep in mind that there are two types of profits.

1. Profit calculated based on tax regulations: This type of profit is calculated in accordance with the tax regulations that apply in your country. It considers factors such as tax deductions, exemptions, and credits.
2. Profit calculated based on accounting principles: This type of profit is calculated in accordance with generally accepted accounting principles (GAAP). It considers factors such as revenue, expenses, and depreciation.

Typically, the profit calculated based on accounting principles should be used for determining goodwill. However, for smaller sole proprietorships that only prepare an annual report based on tax rules, the profit calculated based on tax regulations may be used instead. In either case, the calculation of goodwill is based on the profit of the last three years before interest and taxes, which is referred to as "Resultat før renter" in Danish.

If the calculations are being done in 2021, the following issues will need to be taken into consideration:

1. The profit before interest and taxes in 2020.
2. The profit before interest and taxes in 2019.
3. The profit before interest and taxes in 2018.

After obtaining the profit figures for the last three years, the next step is to adjust the profit in each year based on various factors. These factors may include:

1. Removing an associate's salary that is no longer included as an expense in the profit.
2. Removing the depreciation made on previously acquired assets.
3. Removing any extraordinary amount, such as large one-time losses or gains, that may have affected the profit figure.

After adjusting the profit figures for each of the three years, the result is referred to as the adjusted profit for each year. The next step is to calculate the average profit of these three regulated profits, with the most recent year being given more weight than the oldest year. This average profit figure is then used to determine the goodwill value of the business.

To calculate the weighted average profit, the three years of adjusted profit are multiplied by individual weighting factors and then divided by six. The weighting factors typically give more weight to the most recent year and less weight to the older years. This method ensures that the average profit reflects the current financial status of the business.

1. Regulated profit in 2020 x 3
2. Regulated profit in 2019 x 2
3. Regulated profit in 2018 x 1

To calculate the average profit for the year, we add up the profits from 2018, 2019, and 2020, and then divide the sum by 6. We will refer to this average profit as "profit" for the following calculations. If the profit grew from 2018 to 2019 and 2020, we add 50% of the growth to the result. Then, we deduct the salary for a sole proprietor, which is 50% of the remaining result, but not less than DKK 250,000 and not more than DKK 1,000,000. Next, we subtract 3% of the value of assets (excluding goodwill purchased in the past) from the remaining result. To arrive at the final result, we need to adjust for future expectations by considering the life expectancy of customers, which is usually 7 years. We multiply the remaining score by a factor of 2.83 to estimate the goodwill.

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

The tax-free conversion becomes effective on January 1 of the year. You are allowed to make a tax-free conversion up to six months before January 1, which means that you can make a tax-free conversion between January 1 and June 30 of each year, and it will be effective on January 1 of the same year, even retroactively.

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

Regardless of the results of the calculations, the actual price of the company must be used, which would be the price obtained if the company was sold to someone who is not related to the owner. It's important to consider whether the estimated value of the company is reasonable or not. If you are uncertain about the value, you can contact the tax office for further assistance.