There are many reasons why founders or owners in the Philippines might decide to transition their business from a Sole Proprietorship to a Corporation.
Sometimes, it can be as simple as the business is starting to scale and the owner now wishes to operate through a Corporation – the market standard corporate vehicle for larger and growing businesses.
Whatever the reason, there are a number of key finance matter that owners need to be mindful of to ensure that the transition is successful.
We have outlined 7 of these important finance matters below!
- 1 Why Transition from Sole Proprietorship to Corporation?
- 2 1. New Entity Means New Tax Compliance Obligations!
- 3 2. Customer Invoices
- 4 3. Customer Contracts
- 5 4. Employment Contracts & Benefits
- 6 5. Business Assets
- 7 6. Lease Contracts
- 8 7. Don’t Forget About The Sole Proprietorship!
- 9 CloudCfo – End-To-End Accounting Services For Sole Proprietorships and Corporations in the Philippines
Why Transition from Sole Proprietorship to Corporation?
Every founder or owner may have different reasons for wanting to transition their business from a Sole Proprietorship to a Corporation.
Sometimes, the owner might have just registered as a Sole Proprietorship at the start because it can be a little quicker, more efficient and (slightly!) less paperwork to get their business up and running.
As the business grows and the owner finds that their product or service has market fit, they might then start to consider the long-term future of the business and decide that registration as a Corporation is the first step on this growth journey!
Below are just a few of the more commons reasons why owners in the Philippines might make the transition from Sole Proprietorship to Corporation:
- Limited Liability: In short, owners of a Sole Proprietorship are, effectively, the business. The owner is personally responsible for everything the business does (or does not do). The owner and the business are one and the same. The owner will be personally liable for any debts of the business. The owner is also liable to be sued for business-related activity. A Corporation, however, is separate from its owners. Any legal action against the business would generally be taken against the Corporation. In summary, the Corporation provides more protection for the owners or shareholders.
- Investment: A Sole Proprietorship will have just one owner. If the owner wishes to bring on investors or start issuing shares to partners, they cannot do so under a Sole Proprietorship. A Corporation does, however, enable multiple shareholders (i.e. multiple owners) with different levels of shareholding/ownership.
- Financing: A Corporation is generally a more attractive vehicle for investors, financiers and other parties that might be interested in providing finance to a business. In general, banks and corporate lenders are more likely to want to lend or enter into a commercial relationship with a Corporation than a Sole Proprietorship.
- Legitimacy: There is a perception, whether right or wrong, that running a business through a Sole Proprietorship is for smaller and less aspirational businesses. Setting up and running a business through a Corporation can provide a level of legitimacy and professionalism from the perspective of the general market and various stakeholders (customers, suppliers, media, partners, etc).
- Exit: As the business grows, an owner may start considering their exit strategy from the business. With a Sole Proprietorship, if the owner leaves, the business will generally cease to operate and the owner will no longer be able to generate any benefit from the business going forward. However, in the case of a Corporation, there will usually be other shareholders or part-owners, who can keep the business running in the absence of the original owner (and potentially keep generating returns for that owner if he/she wishes to remain on as a silent or non-participating shareholder). In short, the Corporation can continue operating into the future.
1. New Entity Means New Tax Compliance Obligations!
Expert Tip No. 1: Make sure you are fully aware of the new tax and compliance obligations that arise upon registration of the new Corporation. They might not be the same as the Sole Proprietorship!
This means that for every new legal entity a person or group registers, there will be new set of tax and compliance obligations applicable to that entity!
What does this mean for owners moving from Sole Proprietorship to Corporation? Once a Corporation is registered in the Philippines, the tax obligations with the BIR will be triggered immediately from the first month after registration.
Depending on the type of set-up and registration of the new Corporation, it could have some additional and/or new tax and compliance obligations that might not have applied to the Sole Proprietorship!
Further, there is likely to be a period of time where the owner will have to take care of and pay for ongoing tax and compliance obligations for both entities at the same time!
Here’s a more detailed analysis of the type of taxes that apply to corporations in the Philippines.
2. Customer Invoices
Expert Tip No. 2: Make sure your invoices reflect the details of the new Corporation! Inform your customers that invoices will now be issued by a different entity.
Due the nature of the local tax and compliance framework, the matter of business invoicing and issuing of official receipts is an important requirement for all types of businesses in the Philippines.
At a minimum, the new Corporation should be issuing invoices that reflect the corporate details of that Corporation. Owners should not just continue issuing the same invoices that they were issuing from the Sole Proprietorship!
Why does the transition to a new Corporation have such an impact on invoicing?
- It is important for customers to understand the actual legal entity with which they have a commercial and legal relationship.
- BIR requires that Corporations selling goods issue a BIR-approved Sales Invoice for every sales transaction. The new Corporation will have to apply for new invoices from the BIR upon registration. The BIR approved invoices must therefore reflect the correct legal entity engaging in the sales transaction.
- From an accounting and bookkeeping perspective, both the seller and the buyer will need to ensure that they have the correct supporting documentation to evidence all sales and purchases. This will be important in the case of a BIR audit and indeed, for the statutory annual financial audit that Corporations in the Philippines must conduct each year. If the details of the invoice do not match the details of the parties entering into a sales transaction, the supporting documentation will not match the transaction in the company books!
3. Customer Contracts
Expert Tip No. 3: Inform your customers that the engagement will now be with the Corporation and request for them to enter into new customer contracts.
This is a very similar point to the customer invoices point above.
When the business was operating through the Sole Proprietorship, the commercial and legal relationship will usually be through a customer contract with the Sole Proprietorship.
It will be important for the owner to have all customer contracts transferred to the new Corporation. As a customer contract is a legal document, generally, both parties will have to agree and sign up to any changes to that contract.
Customer contracts are a significant factor when considering the true value of a business, whether it is for a loan application or a due diligence by a potential investor. It is important, therefore, that the customer contracts reflect the relationship with the new Corporation.
This should not be a significant issue (assuming all of the contract terms remain the same) and the owner should reach out to their existing customers, inform them of the changes and request the signing of new contracts.
4. Employment Contracts & Benefits
Expert Tip No. 4: New employment contracts will need to be signed by all employees. Discuss this change clearly with your employees!
If you are moving your entire business from a Sole Proprietorship entity to a Corporation entity, you will definitely need to consider what this means for your employees!
If the business moves to the new Corporation, the employees will usually move also. In fact, they will have to move if there is no business activity in the Sole Proprietorship any longer! How would the employees be paid if there is no money coming in?
Remember, however, that employees are engaged by a company through their employment contracts. If the employees are changing employer (i.e. to the new Corporation), they will need to sign new employment contracts with the new Corporation to ensure their employment status is reflected accurately!
What else needs to be considered when moving employees to the new Corporation?
- Employment Contracts: As outlined above.
- HMO: HMO benefits are generally provided to employees pursuant to a relationship between the employer and the HMO provider. If the employees are moving to a new Corporation, a HMO provider will also have to be engaged by the Corporation to ensure the employees are still covered.
- DOLE/SSS/Pag-IBIG/PhilHealth: The new Corporation will need to ensure that the employees are fully registered under the new Corporation with each of the mandatory government agencies.
- Length of Service: Employees will gain benefits and rights based on their length of service with a company. Under any transition, employees are likely to want to retain any prior service that they had under the Sole Proprietorship.
5. Business Assets
Expert Tip No.5: Make sure that the transfer of any business assets to the Corporation are accurately reflected in the Books of Accounts of both the Sole Proprietorship and the Corporation!
When moving from a Sole Proprietorship to a Corporation, the owners will want to ensure that the full value of the business is transferred also. You don’t want to end up in a situation where the value of the business is split across two companies – one of which is no longer doing anything!
A business asset refers to all tangible and intangible resources owned by a business. Examples of a business asset would include cash, inventories, furniture, equipment, plant and machinery.
One option is for the new Corporation to “purchase” any business assets from the Sole Proprietorship.
However the transfer of assets is conducted, it is crucial that the transfer is reflected accurately in the Books of Accounts of both the Sole Proprietorship and the Corporation!
If not, the business could face issues later down the line when conducting an audit or going through a due diligence with a potential investor!
6. Lease Contracts
Expert Tip No. 6: Contact the landlord of your Sole Proprietorship early on and explain the situation.
Again, it’s important to remember that any key contracts the Sole Proprietorship has entered into must also be transferred to the Corporation.
A lease or rent agreement would be a core contract that most businesses will have signed up to with their landlord.
If the business is moving from Sole Proprietorship to a Corporation but retaining the same address, this can be quite straightforward. The owner will just have to speak to the landlord, explain the situation and seek to change the contract to reflect the Corporation as the new lessee.
If the business address will be changing, this can be a little more complex. Depending on the how long is left on the Sole Proprietorship’s lease, the owner may have to reach a commercial agreement on when the lease can end.
In the above case, it might even help to plan the business transition at the point at which the existing lease of the Sole Proprietorship ends!
7. Don’t Forget About The Sole Proprietorship!
Expert Tip No. 7: Owners should have a transition strategy that identifies what will happen to the Sole Proprietorship after the business transitions to the Corporation.
There is a key point here that can often be forgotten by owners once the business has started running its operations through the Corporation.
What happens to the Sole Proprietorship?
Remember – just because the business is now running through the Corporation, it does not mean that the Sole Proprietorship ceases to exist! From the BIR’s and SEC’s perspective, the Sole Proprietorship is still a legal entity existing in the Philippines and must therefore continue to adhere to its tax and compliance obligations!
Owners may decide to close the Sole Proprietorship entirely through an application process with the BIR and SEC. They may chose to keep the Sole Proprietorship dormant for a period of time as they may use it again in the future for other business activities.
Whatever the strategy is for the Sole Proprietorship, don’t forget that the tax and compliance obligations still have to be managed every month, quarter and year for as long as the Sole Proprietorship is still in existence!
Otherwise, financial and administrative penalties will start to add up very quickly!
CloudCfo – End-To-End Accounting Services For Sole Proprietorships and Corporations in the Philippines
The CloudCfo Team has significant experience advising all types of companies, entities and group structures in the Philippines.
Our accounting, bookkeeping, compliance and financial reporting services are customized specifically for each of the business models and corporate structures with which we work!
Contact the CloudCfo Team Today and let’s discuss how we can help your business grow here in the Philippines!