Conversion of a sole proprietorship

In the case of rapid business growth, in addition to profit, the risk of the extent of liability incurred by the entrepreneur also increases. It is then necessary to consider taking appropriate measures to safeguard the interests of the entrepreneur against possible business failures.

Activities conducted in the form of a sole proprietorship determine the entrepreneur’s full and unlimited liability for the obligations that have been incurred in the course of the business. Can this liability be limited? Deciding to convert can solve the above problems – however, an in-depth analysis of the legal and tax consequences should be made in advance to avoid future problems.

Conversion of a sole proprietorship can be done, for example, by:

  • converting into a sole proprietor limited liability company,
  • contributing the sole proprietorship to a new company – a limited liability company or, for example, a limited partnership.

In the case of a one-person limited liability company, however, it should be pointed out that there is some semblance of an advantage associated with the limitation of liability – the sole shareholder, in principle, is appointed as the sole member of the board of directors, and thus continues to bear full and unlimited liability for the company’s obligations. A member of the board of directors may exempt himself from this liability only if he proves that he timely filed a bankruptcy petition against the company, or if he proves that the failure to file the petition was through no fault of his own.

The Tax Ordinance also regulates that in the event of transformation, a limited liability company will be jointly and severally liable for debts related to its business̨ activities for 3 years, counting from the date of transformation. Double taxation of limited liability companies can also be a problem for entrepreneurs. – both at the level of the company itself and at the level of profit distribution to shareholders. Income tax on the company’s side can be 19% or 9% – depending on a number of factors. Tax on the shareholders’ side is another 19%.

A shareholder of a limited liability company will also be required to pay a health contribution. The health contribution is calculated on the basis of the amount of the average monthly salary announced by the Central Statistical Office for the fourth quarter of the previous year, and in 2023 amounts to PLN 626.93.

An alternative is to make an in-kind contribution of the run JDG to a new company – a limited liability company in which more than one person is a partner, or to a limited partnership in which the contributing entrepreneur serves as a limited partner. As a rule, permits, licenses and other administrative decisions held by a sole proprietor are not transferred to the company to which the enterprise is contributed.

The primary contribution of an enterprise to a company consists of an in-kind contribution by the entrepreneur to cover his shares in the share capital. Secondary contribution takes place after the company is formed, through an increase in share capital. In exchange for the in-kind contribution, the entrepreneur receives shares in the share capital. When an in-kind contribution is made to a limited liability company, the subject of the contribution and the person of the shareholder making the contribution should be specified in detail, as well as the number and nominal value of the shares taken up in exchange.

As a rule, such a transaction is tax-neutral and is not subject to VAT. No income tax liability also arises as of the date of the in-kind contribution, which may occur upon the sale of shares.

In the case of a limited partner, making a contribution in kind (in-kind contribution) requires that the limited partnership agreement specify the subject of the contribution, its value and the person of the limited partner. The company to which the in-kind contribution is made is jointly and severally liable with the partner making the in-kind contribution in the form of an enterprise for arrears related to the business activities of the seller, until the date of disposal of the enterprise. It is also necessary to analyze the issues related to the taxation of each company in the course of its current operations, as well as the need for the partners to pay Social Security contributions.

As of 2021, the limited partnership has become a CIT taxpayer, which means that the limited partnership pays CIT at a rate of 9% or 19%, and when distributing profits, the partners, both limited partners and general partners, pay a 19% tax. The general partner deducts the CIT paid by the limited partnership from its tax on the distribution of profits. In the case of a profit distribution to a limited partner, 50% of this amount is exempt from taxation, with the proviso that the maximum amount of exemption cannot exceed PLN 60,000. However, it should be borne in mind that this exemption is not available to a limited partner who is a member of the board of directors of a limited liability company that is the general partner of that limited partnership, holds at least 5% of the shares in such limited liability company directly or indirectly, or is a related entity (e.g., a spouse) of a person who is a member of the board of directors or holds at least 5% of the shares in a limited liability company that is the general partner of the limited partnership.

The above considerations indicate that the decision to convert should be preceded by an in-depth legal and tax analysis in order to choose the most favorable business model. However, limiting the liability of a sole proprietor – so important from the point of view of business activity – may be associated with an increase in the public and legal burdens that the entrepreneur will be obliged to pay.