The difference between a trade and a Ltd.

Trade or limited company? This is perhaps the most common question traumatizing every budding entrepreneur. We have analysed this issue comprehensively and bring you a comparison between the business of a natural person – a sole trader and the business of a limited liability company (Ltd.), both from the tax, levy and legal point of view.

Taxes and levies

Comparison of the tax and levy burden of a sole trader and an entrepreneur doing business through s. r. o. can be illustrated by the following simplified examples:

Example no. 1: An entrepreneur has set up a company ABC, s. for his business. r. o. The company’s revenues amount to EUR 30,000 per year and no additional costs have been incurred for the business.

In 2020, one of the major changes in the tax burden on entrepreneurs was adopted, which is a reduced 15% income tax rate for entrepreneurs with sales of up to EUR 100,000 per year. A 21% income tax rate applies for entrepreneurs who exceed this annual sales threshold. Since the sales of ABC, s. r. o. do not exceed EUR 100,000 per year, a 15% tax rate applies. Profit ABC, p. r. o. after tax will therefore amount to EUR 25,500.

Net profit ABC, s. r. o. however, may be slightly lower. For smaller s. r. o. it is common practice for a managing director to be employed by a company or to be paid a director’s fee[1], these costs must therefore be deducted from the entrepreneur’s after-tax profit for the calculation of the entrepreneur’s net profit. For simplicity, however, in this example we will assume that the entrepreneur does not pay himself a salary or a director’s fee.

A 7% dividend tax must then be deducted from the amount of the after-tax profit if the entrepreneur earns the profit ABC, s. r. o. will be paid as a dividend and used for private purposes. After deducting the dividend tax, we arrive at EUR 23 715.

If the entrepreneur is not employed alongside the management of his/her company, he/she is obliged to pay a minimum amount of health contributions as a self-employed person, which for 2020 amounts to EUR 70.91. As regards social contributions, he is not obliged to pay them unless he is employed or pays himself a director’s remuneration.

Example no. Example 1: An entrepreneur is a sole trader with sales of EUR 30,000 per year and no other costs incurred in his business.

The legislation for sole traders is currently very generous. For tradesmen who have no costs, resp. It allows so-called flat-rate expenses of 60% of the total income from the business, up to a maximum of EUR 20,000. After deducting the lump-sum expenses, the amount of EUR 30 000 of sales is EUR 12 000, which will serve as the basis for calculating the amount of health, social security and income tax contributions.

When setting up a business, the entrepreneur – self-employed person always initially pays a minimum advance payment for health insurance. Their actual amount is determined by the entrepreneur’s health insurance company in the annual settlement, based on the entrepreneur’s tax return.

We calculate the amount of the entrepreneur’s health levy by dividing EUR 12,000 by 1.486 = approximately EUR 8,000 and applying a 14% health insurance rate. The resulting amount of the entrepreneur’s health insurance contributions will be approximately EUR 1 130.

As regards the calculation of income tax, for simplicity we can state that the entrepreneur has been running a business for 12 months, during which he has paid minimum advance payments for health insurance in the aggregate amount of approximately EUR 800. After deducting this amount from EUR 12,000, we arrive at EUR 11,200, from which the tax-free parts of the tax base can be further applied. From 2020, the most basic tax-free part of the tax base will increase from around EUR 3,800 to EUR 4,400[2]. After deducting the tax-free part of the tax base, we arrive at EUR 6,800, on which income tax will be calculated.

As with the income of an entrepreneur running an LLC, a reduced 15% income tax rate applies to sole traders from 2020. The income tax for a sole trader with sales of EUR 30,000 will therefore be approximately EUR 1,000.

After adding income tax and advance payments for health insurance, we arrive at the final amount of EUR 2,100 as the final tax-tax burden for a sole trader with an income of EUR 30,000. In this case, the effective tax-tax burden of the entrepreneur is well below 10%, which may seem very advantageous and attractive.

What about social contributions? Unlike health levies, social levies are subject to a levy holiday for those starting a business. In practice, a levy holiday means that the sole trader does not pay social contributions until his annual income exceeds a threshold of around EUR 6,000. As soon as the income of the sole trader for a calendar year exceeds this threshold, from 1. June or from 1. October of the following year[3], the sole trader starts to pay social contributions. The amount of social contributions is calculated by the Social Insurance Institution on the basis of the entrepreneur’s tax return, but unlike health insurance companies, the Social Insurance Institution does not carry out an annual reckoning.

In practice, we often encounter that in order to avoid paying social contributions, entrepreneurs start a business on the basis of a trade, which they subsequently close down at the end of the tax holiday and set up a limited liability company through which they continue their business.

The legal context of the transformation of a business from a trade to a s. r. o.

According to the above examples, a sole proprietorship appears to be the most advantageous choice for an entrepreneur with regard to his tax and levy burden. An even more attractive solution, which a number of entrepreneurs use, is to dissolve the trade and set up a s. r. o. in order to avoid having to pay social security contributions.

However, the change of legal form from a trade to a limited liability company is not explicitly regulated in the Commercial Code. The most elegant solution for transferring a business from a trade to a limited liability company seems to be the use of the institute of sale of the company. When the business is sold, the entire live part of the sole trader’s business is “wrapped up” and, together with all contractual obligations of the sole trader, is transferred to the s.r.o. At the moment of the effectiveness of the contract on the sale of the business, the sole trader ceases to carry on business within his trade and starts doing business through the s.r.o. The advantage of this variant is that the s.r.o. to which the business has been transferred does not have to conclude new contracts, since all contracts concluded by the sole trader until then remain valid.

Despite its apparent simplicity, however, this variant of the solution is hardly ever used in practice. The big disadvantage of this form of transformation from a trade to a s. r. o. is the fact that the sole trader is liable to pay taxes on such a sale of the business. Moreover, as the sale is a purchase and sale between related parties, the price for the sale of the business must be market price and cannot be reduced in order to pay less tax.

In practice, this situation is solved by entrepreneurs who simply cancel their trade and start invoicing from s. r. o. If we look at such a solution from a purely “spreadsheet” perspective, such a transformation from trade to s. r. o. makes absolute sense for entrepreneurs and many of them use such a solution. However, if we put a similar situation in a different context in the optics of larger, multinational companies, we can see that such a solution is not the right one from a legal point of view.

As an example in this context, we can mention the case of our client, a multinational company, which had a subsidiary established in the Slovak Republic. r. o. This p. r. o. performed certain activities in the Slovak Republic for other companies within the group, from which it also generated income. However, from one day to the next, the parent company of the Slovak s. r. o. decided that the following activities of the Slovak s. r. o. will no longer be exercised and its competences will be transferred to a second foreign-based subsidiary within the Group. From one day to the next, the Slovak s. r. o. ceased to generate income that could be taxed in Slovakia (in the same way as a sole trader would close down his trade from one day to the next and stop generating income from it). In order for the entire restructuring to be carried out in accordance with the transfer pricing rules, the Slovak s.r.o. had to be compensated by the foreign company to which the functions and risks were transferred. By analogy, this case can be applied to the termination of “invoicing” in a sole proprietorship and the commencement of invoicing through an LLC.

Liability in the context of a trade vs. with. r. o.

One of the most common planes on which the trade and s. r. o. compare, is the plane of liability. It is perhaps already common knowledge that a sole trader is liable with all his assets and a partner with. r. o. only up to the amount of its outstanding contribution to the company’s share capital – so practically not at all. In practice, however, situations may arise where the extent of liability in s. r. o. will change.

For example, this may be the situation if s. r. o. owes so large an amount to its creditor that the entrepreneur decides that it does not want to continue in business at the level of that s. r. o. go ahead and decide this with. r. o. “drown”. In such a case, the creditor of the company can claim its rights in various ways, either directly from the managing director with. r. o.[4], or even directly from its shareholder[5]. The creditor can assert his rights through a number of institutes, which are enshrined in the Commercial Code, the Bankruptcy and Restructuring Act and the Criminal Code[6].

[1] The remuneration of the managing director, or his/her income from employment, is usually very low, especially in small companies, often at the minimum wage level.
[2] When applying the non-taxable part of the tax base, various modifications may occur for a particular entrepreneur (e.g. a higher tax base, the entrepreneur is a recipient of an old-age pension, the entrepreneur has a wife who takes care of a child, etc.). For the sake of simplicity, we assume only the basic non-taxable part of the tax base without modifications.
[3] Depending on when the sole trader filed the tax return.
[4] An example is the institute of the liability of the managing director. The managing director of a company is obliged to behave economically towards the company. If the managing director decides from one day to the next to cancel revenue generating contracts or to sell the company’s assets for an unreasonably low amount, such conduct will not be considered to be economical, as a result of which the managing director could be sued by the company’s creditors.
[5] For example, if the shareholder’s actions have caused the company’s bankruptcy to a large extent, including by the fact that the company has ceased to carry out business activities.
[6] For example, the offence of defamation of a creditor under section 239 of the Criminal Code.

Full lecture in video format. The topic is divided into two parts: