About the types and procedures for converting a sole proprietorship to a corporation

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When a sole proprietorship grows beyond a certain size, they begin to consider incorporating their business. However, tax risks can vary depending on the method of incorporation and whether the requirements are met. Therefore, it's important to thoroughly review tax implications before incorporating. Therefore, we'll focus on the key methods and procedures for incorporating a business.

1. Types of corporate conversion

(1) Establishment of a corporation after simple closure of business

The simplest method is to close the sole proprietorship and establish a new corporation. This is suitable for businesses in their early stages or with minimal assets and liabilities to inherit. However, the new corporation cannot inherit existing tax benefits, such as tax breaks for small and medium-sized businesses (SMEs) that were available to the sole proprietor. Therefore, this method is often chosen when a business no longer meets the requirements for starting a business or is not in an industry that qualifies for such benefits.

(2) Comprehensive transfer system

A comprehensive transfer of business rights and obligations is the most commonly used method of incorporation in practice. This involves the comprehensive transfer of all rights and obligations related to a business operated by an individual business owner to a corporation. For this to be recognized as a transfer of business, rather than a supply of goods under the Value Added Tax Act, the business identity must be maintained at each location. However, the law stipulates that a business transfer can be considered even if certain assets, rights, or obligations are excluded, as long as they are not directly related to the business and do not undermine its identity. Supreme Court precedent also holds that a transfer of business can be considered even with some exclusions, as long as the management entity is replaced and the substance of the business is maintained.

Meanwhile, if real estate is included in the assets subject to transfer, VAT is exempt, but capital gains tax is levied. Furthermore, if a sole proprietorship was subject to verification of good faith reporting, the corporation must also submit a verification of good faith reporting for three years after conversion to a corporation.

(3) Conversion to a tax-exempt corporation

Under Article 32 of the Special Tax Treatment and Limitation Act, a corporation can be converted to a corporation by a sole proprietor, with an investment exceeding the net asset value, in an industry other than consumer services. Capital gains tax can be carried forward if the sole proprietor comprehensively transfers all rights and obligations related to the business within three months of the corporation's establishment. Furthermore, a conversion to a corporation that meets the above requirements is tax-effective even if none of the transferred assets are subject to capital gains tax. The corporation can inherit tax reductions previously granted to the sole proprietor for the remaining period of the reduction, and the corporation can also inherit tax credits granted to the sole proprietor.

(4) Contribution in kind

When real estate accounts for a significant portion of the assets subject to transfer, or capital requirements make a comprehensive transfer difficult, an in-kind contribution is considered. This method involves establishing a corporation by contributing fixed business assets instead of cash. However, the investment requires an appraisal of the contributed assets and court approval, which is a time-consuming and costly process, and the process itself is complex.

2. Incorporation Procedure

(1) Estimation of net asset value

To estimate the net asset value, the net asset value to be transferred is estimated by conducting the individual business settlement at a time close to the date of conversion to a corporation.

(2) Establishment of a corporation

This process involves establishing a corporation by setting capital above its net asset value. Since individual business accounts are finalized after the corporation's incorporation, it's common to set capital with a margin of error greater than the estimated amount. The incorporation registration process takes approximately one to two weeks after all required documents are prepared.

(3) Preparation of a comprehensive transfer contract

Since all transactions after the acquisition record date must be conducted in the corporation's name, the time required for title transfer must be considered when setting the record date. In the case of a business acquisition by a sole proprietor, it is a transaction involving the corporation's directors and, therefore, generally requires board approval. However, for small corporations with fewer than three directors, this approval is typically granted through a general shareholders' meeting resolution.

(4) Corporate business registration

After establishing a corporation, business registration is required, which requires a lease agreement in the corporation's name. To inherit the startup tax deductions of individual business owners, the corporation must maintain the same business type.

(5) Value-added tax reporting and settlement for closure of individual business

Finally, the individual business must report the closure of the business and report the value-added tax on the closure as of the transfer date. Furthermore, after the individual business's financial statements are finalized based on the transfer date, the assets and liabilities subject to the transfer must be reflected in the corporation's opening financial statements. If there are employees who will not be transferred from the individual business, payment statements must be submitted.

Incorporation is not simply a process of establishing a corporation. Depending on the method chosen, tax burdens and future management structure can vary. Therefore, prior to incorporation, thorough tax review and careful consideration are essential.

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