When should a sole proprietorship become a limited company – and can the conversion be tax-free?
The move becomes relevant when the business takes on more risk, earns more than the owner needs privately, gets employees, needs capital, or plans co-owners and a sale. The conversion can be carried out without immediate tax under section 11-20 of the Taxation Act, but it requires a newly formed company, tax continuity – and that the company is formed and the registration notice sent before 1 July if it is to take effect from 1 January the same year.
Five reasons that actually matter
1. The business earns more than you need privately. In a sole proprietorship the profit is taxed on the owner in the year it is earned. A limited company pays 22% corporation tax, and the personal tax only comes when value is taken out. The advantage is a tax credit, not necessarily lower final tax. 2. The risk has grown. Employees, larger contracts, bank loans, leasing, inventory, guarantee obligations or substantial liability risk all make the separation between private finances and the business more important. 3. You want to be an employee of the business. The owner of a sole proprietorship cannot be an employee – withdrawals are private, not salary. 4. You are taking on co-owners or investors. A sole proprietorship can have only one owner. 5. You want a holding structure or are planning a sale. A sole proprietorship cannot be owned by a holding company. The background to the choice is in Sole proprietorship or limited company
A tax-free conversion is possible – but means deferred tax
The general rule on moving from one form to another is that the assets are treated as realised. That could give tax on the increase in value in fixed assets, goodwill and other accumulated value. Section 11-20 of the Taxation Act and its regulations make a tax-free conversion possible where the conditions are met. «Tax-free» does not mean the latent tax disappears. The principle is tax continuity: the new company takes over the tax values and relevant tax positions from the sole proprietorship – tax bases, balance values, acquisition dates, the gain and loss account, negative balances and certain carried-forward losses connected to the business.
You have to actually carry on a business
The rules apply to converting a business. A registered organisation number is not enough on its own. The activity has to meet the tax definition of a business: a certain duration and scale, capable of producing a profit, and carried on for the owner's account and risk.
The company has to be newly formed
This is one of the most important rules, and it is often overlooked. A tax-free conversion under section 11-20 has to be to a newly formed limited company. That can be done by using the business as a contribution in kind to the new company, or by forming the company with cash first and transferring the business afterwards. In the latter case the company must not have carried on any activity before the business is transferred. An existing company that has already traded normally cannot be used as the receiving company. If you have an old dormant company lying around, it is not automatically a shortcut. The owner also has to hold 100% of the shares after the conversion. New investors should therefore come in later, through a separate transaction.
What has to – and does not have to – be transferred?
The general rule is that the business continues in the company, and that the activity and the essential part of the relevant assets and obligations go with it. But for a sole proprietorship there are important special rules: Real property does not necessarily have to be transferred. The owner can in some cases keep the property privately and let it to the company. Financial assets such as shares do not necessarily have to go with it. Monetary debt does not necessarily have to be transferred either. The bank's consent, the security and the loan agreement can still impose practical limits. Private assets – a home, a holiday property and anything mainly private – cannot be included merely to move them into the company tax-free. The conversion covers the business, not the owner's wealth.
The deadline: before 1 July
For the conversion to take tax effect from 1 January the same year, the company has to be formed and the registration notice sent to the Register of Business Enterprises by 1 July – in practice by 30 June. Where the owner takes salary from the company, the regulations also require the company to have made tax deductions and calculated employer's contributions on salary payments from 1 July at the latest. Miss the deadline and you can still set up a company later in the year – but not use 1 January of that year as the effective date. The conversion then has to be planned afresh, often with effect from the next 1 January.
An auditor normally gets involved
Even where the new company is otherwise to opt out of an audit, the regulations require among other things an auditor's statement that the assets taken over are not carried in the balance sheet at more than fair value. Where the business is used as a contribution in kind at formation, the Companies Act's rules on contributions in kind and the accompanying statement also apply. Whether the company can then opt out of an audit is in Statutory audit
The share capital cannot be set arbitrarily
The nominal share capital cannot be set higher than the positive net equity arrived at using tax values, including any cash contribution. At the same time the Companies Act's minimum of NOK 30,000 has to be met. Where the sole proprietorship has low or negative tax net values, a cash contribution may therefore be necessary. The shares' tax base is set at the tax net values transferred – not at the market value of the business. Where the business has large latent gains, they carry forward into the structure. A warning: do not take the difference between a calculated business value and NOK 30,000 and book the rest as «tax-free debt to the owner». Where a receivable arises, its size and treatment have to be calculated from the specific conversion.
VAT, document duty and employees
VAT: a transfer as part of a transfer of a business to a new owner is exempt under section 6-14 of the VAT Act where the conditions are met. But where the business has capital items – machinery and fixtures where the input VAT on cost was at least NOK 50,000, or construction measures where it was at least NOK 100,000 – the adjustment obligation has to be handled and can on conditions be transferred. See The adjustment rules and VAT on winding up and business transfers Document duty: where real property is transferred as part of a reorganisation that can be carried out with continuity under section 11-20, a specific exemption applies. The property should still not always be transferred. Employees: where the transfer meets the conditions for a transfer of an undertaking under chapter 16 of the Working Environment Act, the employees have particular rights. Payroll, the a-melding and the employer registration also have to move to the new organisation number from the right date.
A new company means a new organisation number
A tax-free conversion does not simply add «AS» to the sole proprietorship's name. A new legal person with a new organisation number is created. So the bank account, the invoicing set-up, agreements, insurance, customer and supplier records, the domain and subscriptions, employees, VAT registration, authorisations and system access all have to be dealt with. That is the same practical job as in a triangular merger, and it is consistently underestimated – see Can I put a holding company above an AS I already own?
Do not confuse a conversion with an ordinary sale
If you form a company and then sell the assets from the sole proprietorship to it without following the conditions in section 11-20, the general rule on realisation applies. Latent gains can then be taxable on the owner. A tax-free conversion and an ordinary sale of assets are two different transactions. When should you start planning? Not on 29 June. The more fixed assets, vehicles, employees, inventory, real property, debt, VAT adjustment positions, carried-forward losses and larger contracts the business has, the earlier. Greenleaf can map the tax positions and values, handle the accounting basis and the reporting, and coordinate the conversion with the auditor. The assessment of the conditions in section 11-20 should be quality-assured by a tax adviser.
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This is general guidance, not advice on your specific case. Deadlines, rates and amounts change – always check the current rules, or get in touch with us.
More on starting up and choosing a company form
- Sole proprietorship or limited company – which should you choose?
- How to start a limited company – step by step
- Share capital – what can the NOK 30,000 be used for?
- Contributions in kind – can a car, equipment or a business be used as share capital?
- NUF – what is it, and when does it make sense?
- ANS or DA – what is the difference, and how large is the personal liability?
- Your first year with a limited company – which deadlines and tasks matter?
- The shareholders' agreement – what should it contain, and when do you need one?
- When do you need an accountant – and when can you manage yourself?
- Winding up a limited company – how to dissolve and delete it
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