Tax efficient conversion of sole proprietorship businesses to a private limited company by Startups

A sole proprietorship is the simplest and most common structure chosen to start a business . It’s an unincorporated business owned and run by one individual with no distinction between the business and you, the owner. You are entitled to all the profits and are responsible for all your business debts, losses and liabilities. This is because you aren’t really planning the business. Sometimes, you do not want the efforts of incorporating until the business is profitable. In a sole proprietorship, the owner of the business and the business are a single entity. Only one person owns the company and instead of paying corporate taxes, the owner pays personal income tax on any profit. This type of business has some advantages because there is less paperwork—for example simpler tax returns—and there are fewer regulations. After some years when the sole proprietorship business becomes big and there is a need to limit the liability,  the best option is, Tax efficient conversion of sole proprietorship businesses to a private limited company by Startups.  The timing of the conversion depends on the nature of business and the financial and growth goals. CASE STUDY (Example) Mr. Bharat is a sole proprietor business. He wants to convert the sole proprietorship business to a private limited company. First he needs to prepare a balance sheet as on the date of Conversion and then transfer all the business assets and liabilities in exchange of Share allotment in the new company which should be more than 50% holding and which needs to hold till 5years. The conversion date is 31.07.2013. Mr. Bharat has drawn the following balance sheet as on 31.07.2013.

Liabilities Amount( in Lacs)  Assets Amount (In Lacs)
Capital 20 Building 6
Creditor   2 Plant 10
    Stock 6
Total 22 Total 22

      The Balance Sheet as on 31.07.2013 is as follows:- Transfer Values: Building – Rs. 6L Plant   -      Rs. 10L SIT  -           Rs. 6L As all the conditions mentioned in the section are met so no Capital Gain will be there on conversion from Sole Proprietor to Private Ltd Company.   If any of the conditions is breached:- (For example : If the sole proprietor sells away his shares  another individual before 5 years) then the exemption granted earlier will be taxable. LEGAL ISSUES Transfer of capital assets or intangible asset by a sole proprietorship concern to a company where the sole proprietorship is succeeded by a company in the business carried on by it, shall not be regarded as transfer, subject to the following conditions: i)        All the assets and liabilities of the sole proprietary concern relating to the business immediately before the succession became the assets and liabilities of the company. ii)      The shareholding of the sole proprietor in the company is not less than 50%  of the total voting power in the Company and his shareholding continues to remain as such for a period of 5 years from the date of succession. iii)    The Sole proprietor does not receive any consideration or benefit, directly or indirectly, in any form or manner, other than by way of allotment of shares in the company. Where any of the above conditions laid down above are not complied with, the Capital Gain not charged to tax u/s 45 shall be deemed to be capital gain of the successor company for the previous year in which infringement takes place. ANALYSIS OF THE SECTION The section says that the sole proprietorship was carrying on the business and the same is succeeded by the Company. This is to say that the company should carry on the business but for how many years is not prescribed. The above would lead to a conclusion that this exemption would not be available if sole proprietorship had carried on no business or would have carried on profession. 1)      All asset or liabilities are to be transferred relating to the business. As result investments which are not relating to business may not be transferred. The section does not prescribe the transfer has to be at book value. That means it can be at any value. 2)     Stock in trade should be transferred at book value. If it is transferred at a higher value then exemption would not be available and business income would be taxable in hands of sole proprietor. 3)     Sole proprietor should not receive any consideration (money or kind) or benefit, directly or indirectly other than share allotment. (To be seen only at the time of conversion & not past conversion) ISSUES OF SOLE PROPRIETORSHIP BUSINESS 1)      There is always unlimited liability in Sole Proprietorship business which extend to private assets of the individual also. 2)      There is no separate legal entity in the eyes of law 3)      No Corporate tax benefits or incentives. Hence with increasing profits you will have to pay more taxes at a higher rate. 4)      The business comes to an end with the retirement or demise of the sole proprietor. 5)      Only one person operates the whole business. So outsiders don’t have much role to play. Outside people considers it as a small business. BENEFITS OF CONVERSION 1)      The Company will be having its own separate legal entity. The personal assets will not be targeted as the company would be having its own assets. 2)      The Outside people feel easier to transact with a Company which will ultimately help the company to grow. 3)      The Company enjoys some tax benefits also. 4)      There will be no worries for raising the Capital anymore. The shareholders will be providing you the required capital. PROCESS OF CONVERSION 1)      Incorporating a new private limited company, indicating that this company will take over the business of the sole proprietorship, as well as the date of termination of the sole proprietorship 2)      Formally transfer all business assets from the sole proprietorship to the newly registered company. 3)      Terminating the sole proprietorship business. Thanks for reading for this article. Please feel free to write to us, We want to hear it all!Suggestions? Complaints? Feedback? Requests?  at [] or call us at +91 88208208 11. We would be more than happy to assist you.