Conversion of Sole-Proprietorship to a Private Limited Company
Shiriti Kumari
Co-Founder & COO at Compliance Calendar ® | Entrepreneurs trust CCL for Peace of Mind in Legal, Tax & Compliance of their business
Takeover of Sole Proprietorship by a Private Limited Company
The decision of whether to start a business as a Sole Proprietorship or a Private Limited Company often depends on the many reasons, situations, goals, and considerations at the time of inception and learn why individuals might initially opt for a Sole Proprietorship and later choose to convert to a Private Limited Company as their business grows by Registration of a Private Limited Company.
Operating initially as a sole proprietorship offers entrepreneurs a quick and straightforward way to establish their business. However, as the business experiences growth and expansion, the limitations of a sole proprietorship become apparent. To overcome these limitations and harness the benefits of a more robust corporate structure, many business owners decide to convert their proprietorship into a private limited company, conversion brings about several advantages, including access to higher capital, limited liability for owners, and enhanced credibility. Yet, the decision is not without its complexities, shift to a private limited company introduces a diffusion of power and a potential loss of independence for the business owner.
Converting a Sole Proprietorship to a Private Limited Company as a startup involves steps like Start with Slump Sale formalities and inform relevant authorities, surrendering registration certificates, apply for Private Limited Company Registration with MCA , get board approval for the takeover, and execute a takeover agreement and before conversion, Settle Sole Proprietorship debts or seek creditor NOC, Be aware of capital gains tax and explore exemptions.
Submit required documents to the Registrar (MCA/CRC) through Company Registration and Post Incorporation compliance of Private Limited Company by filing INC-20A etc., Sole Proprietor retains 50% voting rights for 5 years post-incorporation and No monetary consideration is involved in the conversion. Transition bank accounts, officially shut down the Sole Proprietorship, and discontinue licenses or tax registrations.
Starting as a Sole Proprietorship
Choosing to Convert to a Private Limited Company as the Business Grows:
1. Limited Liability & Member: As the business expands, the proprietor may seek the protection of limited liability provided by a Private Limited Company, shields personal assets from business liabilities.Requires a minimum of two members, up to a maximum of 200.
2. Attracting Investors: Private Limited Companies have greater potential to attract external investors by issuing shares, facilitating fundraising for expansion and development.
3. Enhanced Credibility: A Private Limited Company often carries greater credibility in the business world, fostering trust among clients, partners, and investors.
4. Scalability: The structure of a Private Limited Company is conducive to scaling operations and accommodating a larger workforce, facilitating business growth.
5. Transferability of Shares: Private Limited Companies offer flexibility in transferring ownership through the sale or transfer of shares, enabling changes in ownership structure.
6. Tax Planning Opportunities: Private Limited Companies may benefit from various tax planning strategies and potentially lower tax rates on profits, offering tax advantages as the business grows.Profits are taxed at a fixed rate of 30%, plus surcharges and cess.
7. Formalized Governance or Compliance: Private Limited Companies generally have more formal governance structures, which can enhance transparency and corporate governance practices.Annual returns and accounts must be filed with the Registrar of Companies.
Hence, in the case of a Sole Proprietorship, While starting provides simplicity and quick setup, the decision to convert to a Private Limited Company is often driven by the changing needs and ambitions of a growing business, lacking the formalities mandated by the Companies Act, 2013, for a Private Limited Company.
How to Register a Private Limited Company in India ?
For Business Registration, a minimum of 2 shareholders and 2 directors is required, or a single shareholder and director in the case of an OPC (One Person Company), where the proprietor can be both, minimum share capital is Rs 1 lakh and all directors must have a DIN (Director Identification Number), and if not, a fresh application is required during company incorporation only by filing Spice part-B.
In the case of a sole proprietor converting to a private limited company, a Share Allotment Agreement is essential, should ensure that the proprietor's shareholding/voting rights remain at least fifty per cent (50%) for the next five years.
Learn more here how to Register a Private Limited Company in India
How to Convert Sole Proprietorship ?
For the easy conversion of a sole proprietorship into a private limited company, certain pre-conditions must be met to ensure a proper compliance sound and well-structured process. The conversion or takeover of a Sole Proprietorship into a Private Limited Company involves a structured process, given that there are no specific provisions in the Companies Act, 2013 for such a transition:
1. Sale or Takeover Agreement:
- A formal sale agreement or takeover agreement must be documented between the sole proprietor and the private limited company post Company Registration as Private Limited Company, agreement outlines the terms and conditions of the transition and how to transfer the Capital or funds in the way of subscriber to MOA in case of the company, agreement should also specify the effective transition date for clarity and understanding for smooth conversion.
2. Inclusion in MOA:
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- The Memorandum of Association (MOA) of the Private Limited Company needs to explicitly include the object of 'The takeover of a sole proprietorship M/S-----------------having PAN-------------------.' inclusion ensures clarity and legality in the conversion process.
3. Transfer of Assets and Liabilities:
- All properties, assets, and liabilities of the sole proprietorship must be meticulously transferred to the private limited company subject to agreement terms along with cash at Bank/Hand, includes a comprehensive transfer of ownership and control.
4. Shareholding Structure:
- The shareholding structure is a critical aspect. The proprietor's shareholding in the private limited company should not be less than 50% of the voting power, and this ownership structure must be maintained for a stipulated period, typically 5 years.
5. No Additional Advantages:
- The proprietor or owner involved in the conversion should not receive any additional advantage, either directly or indirectly, beyond the extent of shares held. This ensures fairness and transparency in the process.
6. Incorporation of New Private Limited Company:
- A new private limited company must be incorporated, indicating its purpose to "take over the business of the Existing sole proprietorship ---------------".
Why to surrender all associated Registration Certificates by Proprietor?
As part of the conversion process from a sole proprietorship to a private limited company, it is important for the owner or proprietor to intimate all relevant authorities where the business has been registered and subsequently surrender all associated Registration Certificates, ensures transparency, compliance, and a seamless transition in the eyes of regulatory bodies. The proprietor should proactively communicate with government departments, licensing bodies, and any other entities where the sole proprietorship is registered like GST, Income Tax, ESIC, EPFO etc., providing them with the necessary information about the conversion and adhering to any formal procedures for surrendering certificates.
How to Transfer transfer assets from your existing sole proprietorship ?
1. Sole proprietorship Bank Accounts Closure
Close old accounts tied to the sole proprietorship and open new ones in the Private Limited company's name. Redirect all financial transactions to these new accounts.
2. Assets Transfer and clear Liability
- Convert net assets from the sole proprietorship into paid-up capital for the Private Limited company in the form of either in Cash or Kind.
The debts of a Sole Proprietorship pose a unique challenge during a transfer process. These debts cannot be automatically transferred to another entity, owner is left with two options: settle all existing debts independently or seek the consent of creditors for a transfer to new company. In the latter case, it's difficult to obtain explicit agreement from creditors, allowing the Sole Proprietorship to be transferred to a new entity. Importantly, no new bills or obligations should be incurred in the name of the Sole Proprietorship during this process, ensures transparency and compliance while managing the financial transition to a new business structure.
3. Contracts/Leases:
- Update or re-sign contracts, service agreements, and leases under the Private Limited company.
4. Licences/Permits:
- Reapply for licenses and permits under the new company's name, as they are typically non-transferable.
This swift and systematic process aligns with the three-month closure requirement for the sole proprietorship.
More importantly, transfer of a Sole Proprietorship to a Company triggers capital gains tax in the hands of the Sole Proprietorship owner for the transfer of assets. However, there is a specific provision outlined in Section 47(xiv) of the Income Tax Act that provides a pathway to avail tax exemption on such transfers from a Sole Proprietorship to a Company, aims to offer a tax benefit during the transition, underlining the importance of understanding and utilizing the relevant sections of tax law when undergoing business structure changes.