German ‘check the box-election’ for partnerships, an interesting opportunity for family-owned businesses and family offices

The core idea of the corporation tax option is that partnerships are entitled to choose to be taxed as if they were corporations, the goal being to have the same taxation across legal forms. The corporation tax option will be available for the first time for the 2022 assessment period.

Meanwhile, the corporate law advantages specifical to partnerships will remain in place (broad structural flexibility, limited publicity, control even without a majority interest, etc.).

The corporation tax option’s most important advantage lies in the fact that partnerships can retain their earnings, the same way as corporations do, at a lower tax rate of around 30%. Under certain circumstances, profits from certain capital gains can even be retained with an effective tax rate of around 1.5%. This is especially interesting when the profits are to be used for investments. Up to now, partnerships with individuals as partners have been subject to a relatively high (top) income tax rate of 45% plus solidarity surcharge (introduced to cover the costs of German reunification) and (if applicable) church tax, even on retained profits. Trade tax is usually added to this, which, depending on the municipality’s trade tax rate, cannot be set off in full against the income tax. While it is true that the members of partnerships have been able to opt for preferential treatment of retained earnings (Thesaurierungsbegünstigung) under section 34a German Income Tax Code (Einkommensteuergesetz – EStG), this has apparently not been attractive in everyday practice (studies show fewer than 6,500 cases per year). One of the reasons for this is that there are several hurdles and practical difficulties to overcome in order to claim preferential treatment of retained earnings. For instance, payment of income tax on retained earnings is as a withdrawal itself subject to income tax. Furthermore, in the event of subsequent share transfers or restructuring measures, the retained profits could be subject to retroactive taxation. These restrictions are eliminated in the corporation tax option.

The corporation tax option can be exercised by commercial partnerships such as general partnerships (offene Handelsgesellschaft – OHG), limited liability partnerships (Kommanditgesellschaft – KG), potentially with the general partner being a limited liability company (GmbH & Co. KG), a stock corporation (AG & Co. KG), a European company (SE & Co. KG) or a foundation (Stiftung & Co. KG), as well as freelancing partnerships (Partnerschaftsgesellschaft). The option is not currently available to civil-law partnerships (Gesellschaft des bürgerlichen Rechts – GbR). Such partnerships would have to first be converted into the legal form of a commercial partnership.

Theoretically, the option is also available to foreign commercial partnerships and freelancing partnerships. However, this is only true if after exercising the option they are or remain fully subject to taxation in the country in which their management is placed (i.e., are treated as tax opaque). The intention behind this restriction is to prevent hybrid companies from arising due to the option, i.e. companies that are transparent for tax purposes in their management’s country but are treated opaque for tax purposes in Germany as the source state of the income. The result is that the option is in most cases only open to foreign partnerships or companies that had been taxed abroad like corporations even before exercising the option (e.g. a US partnership that is taxed like a corporation according to the “check the box election” for US tax purposes). This sharply limits the number of non-German companies that are entitled to exercise the corporation tax option.

Sole proprietorships and investment funds within the meaning of the German Investment Tax Act (Investmentsteuergesetz – InvStG) are likewise not entitled to opt for corporate taxation.

Partnerships are eligible to apply to be taxed like a corporation for the first time for the assessment/reporting period 2022. The option is only effective if the application has been filed at least one month before the beginning of the first financial year for which the taxation as a corporation shall apply. Consequently, for first-time applicability as of the assessment/relevant period 2022, the application will have to be filed by 30 November 2021.

The application is usually to be filed electronically via the officially designated interface at the tax office responsible for the partnership’s separate and uniform determination of the tax base, and it is irrevocable (although the option can be reversed, as explained below). If there is no separate and uniform determination of the tax base, the application is to be filed with the tax office of the district in which the partnership has its registered office (in Germany), and otherwise with the tax office responsible for the partners’ income or corporate tax. Applications for partnerships that only have earnings that are subject to withholding tax and whose members are only subject to limited taxation in Germany (in particular capital gains tax on investment income in Germany) are to be filed with the German Federal Central Tax Office (Bundeszentralamt für Steuern – BZSt).

The application is to be filed by the managing partner with power of representation. Furthermore, an unanimous resolution by the members is generally required. However, the partnership agreement can also provide for a majority decision of the partners. In such a case, the majority must constitute at least three quarters (75%) of the votes cast (section 1a(1) sentence 1, second clause German Corporate Tax Act (Körperschaftssteuergesetz – KStG), section 217(1) German Reorganisation Act (Umwandlungsgesetz – UmwG)). Existing partnership agreements of family-owned companies often stipulate that reorganisation measures can be resolved with the corresponding majority. However, due to the fact that an application to be taxed as a corporation has wide-ranging legal and economic implications, and – in contrast to a genuine change in legal form – the majority is not required to offer any opposing minority a settlement under section 207 German Reorganisation Act, exercising the option is not to be considered equal as a whole to a reorganisation measure. Instead, the permissibility of the majority decision is to be determined in light of the actual partnership circumstances, including what can reasonably be expected from the minority. This applies all the more if the partnership agreement only allows majority decisions in a broadly generalised manner. Thus, in anticipation of the revision of partnership agreements that is already impending for many partnerships due to the German partnership law reform, it is advisable to include a specific provision stating that a resolution on the option application is permissible with a majority of three quarters of the votes cast.

The Circular of the German Federal Ministry of Finance (Bundesfinanzministerium – BMF) on the application of the corporation tax option that has been published on 10 November 2021 stipulates in this context that “documentation that the necessary number of partners have consented to exercising the option is to be included with the application for the corporation tax option”. In our opinion, the reference here can at most be to a high level examination. Otherwise, the responsible tax authorities would be obliged to conduct a deeper examination of the partnerships’ circumstances, which can hardly be deemed a reasonable expectation.

Whether exercising the option in itself leads to a (one-off) tax burden on the partnership or the partners depends in particular on the following aspects:

• The option to corporate taxation is treated like a change in legal form to a corporation from a tax viewpoint, and it is thus basically possible for it to be tax-neutral (i.e. without realization of hidden reserves) if certain prerequisites are met. In particular, all essential business assets that are (still) available at the partnership are required to be transferred into the new tax regime. This can be a challenge in the case of special business assets, i.e. assets owned by one of the partners under civil law but that are counted as business assets of the partnership for German taxation purposes. This usually applies to real property used by the company for its operations, which is considered an essential business asset. In order to avoid taxation of hidden reserves (without a corresponding in-flow of liquidity), such assets must for example be transferred under civil law to the opting partnership at the same time as the option enters into effect or, alternatively, be transferred into another business with a sufficiently large time interval to the effective date of the option.

• It must also be kept in mind that the interests in the partnership held by the partners after the corporation tax option has become effective are subject to a lockup period of seven years. This means in particular that the sale of these interests, any processes equivalent to such a sale or certain transfers without valuable consideration within this seven-year period are a breach of the lockup period, which in turn means that the hidden reserves in the contributed assets are capitalised tax-wise retroactively to the effective date of the exercise of the option. However, this retroactive taxation decreases over time, i.e. for every year that elapses after the option becomes effective the retroactive taxation is reduced by 1/7. Hence, even partners who are considering selling their interests in the near or medium-term future can use the corporation tax option to a certain extent.

• Because the option is treated like a change in legal form, it can also trigger subsequent taxation of retained earnings amounts (Thesaurierungsbeträge) under certain circumstances. This can affect partnerships that have been making use of the preferential treatment of retained earnings (section 34a German Income Tax Code).

In addition, at the level of the opting partnership, any existing trade tax losses carried forward are forfeited. Conversely, any existing income tax losses carried forward at the level of the partners generally remain intact, but cannot be set off against positive income from the opting partnership.

Taxation at the partnership and partner level after exercising the option is fundamentally different from the previous (transparent) taxation of a partnership:

• The income of the opting partnership is subject to corporate tax and trade tax. In a nutshell, this means that the company’s income is subject to an additional burden of 15.825% (corporate tax, including solidarity surcharge). Furthermore, the trade tax payable at partnership level where the partners are natural persons can no longer be set off against income tax. Because the opting company is taxed like a corporation, profits from sales of shares in corporations and (if the holding is at least 15%) dividends can be received 95% exempt from corporate and trade tax.

• Contractual relationships between an opting partnership and its partners are recognised, with some exceptions (hidden profit distribution/hidden contributions). This applies to situations such as leasing real property to the company, granting shareholder loans or providing other services to the company (e.g. advisory or management services). In contrast to the situation prior to effectiveness of the corporation tax option, the income generated by such activities is not treated as so-called special remuneration (Sondervergütungen) or special operating income (Sonderbetriebseinnahmen) but rather as rental income, income from capital investments or employment income. Consequently, those expenses can be recognised at company level as operating expenses and, thereby, , also reduce the company’s trade earnings that are subject to trade tax. It is also to be kept in mind that expenses incurred by partners in connection with their status as partners (e.g. interest expense from the financing of the acquisition of the participation) can no longer be deducted as special business expenses (Sonderbetriebsausgaben) but only as expenses in relation to capital income.  

• With regard to their income arising from their interests in the partnership, members of the opting partnership are treated as if they were the shareholders of a corporation. The company’s profits and losses are not automatically attributed to the partners. Instead, the company’s profits are subject to taxation at partner level only if and to the extent that they are deemed distributed. This, in turn, is the case if a partner’s share in the profit is withdrawn from that partner’s account or such partner is entitled to request withdrawal or payment of the partner share. Because partnership agreements are usually tailored to transparent taxation and stipulate that at least parts of the net income for the respective fiscal year is attributed to individual partners’ accounts and can be withdrawn by the partners, these profit shares are treated as having been distributed following a corporation tax option has become effective and, hence, are subject to taxation. Thus, it is strongly recommended that the existing provisions of the partnership agreement that govern the partner accounts and profit distribution be examined and amended so that the individual profit shares are not subject to taxation until they are “actually distributed” and the preferential treatment of retained earnings of the opting partnership can be effectively used. For example, the appropriation of net profit can be made subject to a resolution (as is the case for corporations) in order to avoid unforeseen taxation of profit distributions. When the company exercises the option, losses are “frozen” and cannot be set off against the partners’ positive income.

• The flat-rate withholding tax (Abgeltungssteuer) of 26.375% (including solidarity surcharge) is generally applicable to profit distributions to individuals that are members of opting partnerships. Income-related expenses such as debt-financing expenses are not deductible. Only the standard deduction for income-related expenses of €801 (or €1,602 for joint taxation of couples) can be made. In the case of a partnership interest being held as part of business assets and (depending on the percentage participation in the partnership) upon application in the case of the partnership interest being held as private asset, the “partial income” method (Teileinkünfteverfahren) (i.e. standard income tax rate, but 40% tax exemption on the income) is applicable. Where corporations are partners, profit distributions are generally likewise subject to corporate and trade tax. However, for participations of at least 10% or 15%, an exemption from corporate or trade tax effectively applies to 95% of the amount distributed (i.e. the effective tax burden that remains is around 1.5%).

It is to be kept in mind that the option has no direct effect on VAT, inheritance and gift

Withdrawals from the private accounts relating to profits generated and taxed before the exercised option becomes effective are tax-neutral. The profits generated after the option enters into effect are first subjected to corporate tax plus solidarity surcharge and where applicable trade tax. When after-tax profits are withdrawn or allocated to a private account, these profit shares are also taxed as being distributed (see question 6). In the latter case, the withdrawal from the private account itself is then tax-neutral (i.e. no double taxation).

In this context, the so-called deemed distribution order (Verwendungsfiktion) generally applicable to corporations is to be taken into account. The deemed distribution order means that, from a tax standpoint, any retained earnings (“distributable profit”) are deemed to be distributed first and only thereafter the contributed capital and the profits generated and taxed prior to effectiveness of the corporation tax option are distributed. The two latter amounts are posted as contribution items in the “tax contribution account” (steuerliches Einlagekonto) when the corporation tax option becomes effective. In this context, it is important to note that a joint tax contribution account for all partners is to be maintained for the opting partnership. Any supplementary balance sheets that are kept for tax purposes (Ergänzungsbilanzen) for the individual partners increase or decrease the opting partnership’s capital and thus the tax contribution account. In order to ensure that each partner’s share of the tax contribution account also corresponds to that partner’s capital share, the contributions of the various partners should be equalised (e.g. by withdrawals from or contributions to the capital accounts) before the option is exercised. Otherwise, there is particularly the risk that individual partners receive capital repayments from the tax contribution account that exceed their acquisition costs on the interest in the opting partnership. This would constitute a disposal event for those partners that, if this occurred during the seven-year holding period after an option was effectively exercised, would result in a retroactive taxation of the corporation tax option.

The corporation tax option for partnerships does not directly cause any changes in inheritance or gift taxation. In particular, the interests in opting partnerships continue to be privileged (and potentially tax-exempt) business assets and not administrative assets regardless of the participation quota For shares in corporations, this only applies if the donor or decedent directly held a participation greater than 25%. Particularly in case of family-owned businesses, partners often enter into “pooling agreements” under which these partners agree to only transfer their shares together or amongst themselves and to exercise their voting rights uniformly in relation to other members. In such cases, the individual interests are added together to achieve the required 25% interest. 

In this context, it is important to note that in cases where interests in a partnership are transferred as part of anticipated corporate succession and such transfers benefit from gift tax exemptions for business assets, exercising the option for this partnership thereafter does not constitute a breach of the five- or even seven-year holding period under gift tax law.

Exercising the option is disadvantageous if a partner plans to relocate their residence to outside Germany. This is because the shares in the opting partnership are treated like shares in a corporation. While members of partnerships can generally relocate abroad without incurring additional taxes (exemptions may apply), for corporations as well as any future opting partnerships the exit taxation  (Wegzugsbesteuerung) applies (if the interest of the partner who relocates has amounted to at least 1% at any time during the previous five years). This means that the (assumed) shares in the corporation are deemed sold, and corresponding proceeds of the sale are taxed. If an option is exercised less than seven years previously, the option itself is retroactively taxed (with a 1/7 decrease per elapsed year). In this regard, it needs to be considered that the exit taxation is becoming more restrictive as of the year 2022, since any exit taxes triggered by a relocation to an EU member state can no longer be deferred until the actual disposal of the shares; instead, irrespective of whether an individual relocates to an EU or non-EU member state (such as the USA), the exit tax is generally due immediately and payment may only be made in instalments of seven years.

Each year, it will be possible to file an application to reverse the option as of the beginning of the subsequent financial year. However, two things must be kept in mind: firstly, that exercising a reversal option within seven years after exercising the option results in retroactive taxation as of the date of the first exercise of the corporation tax option. This retroactive taxation is reduced pro rata temporis for each elapsed year as of the date of effectiveness of the option.

Secondly, it is important to note that from a tax perspective the reversal option is likewise treated in the same way as a change in legal form. This means that the retained earnings in the opting partnership are treated as if they had been distributed – thus ending the preferential treatment of retained earnings in regard to the corresponding profits. In addition, any tax loss carry-forwards accumulated by the company are lost without compensation. A careful analysis of the opportunities and risks for a specific company and partner before exercising the option will help to prevent unpleasant surprises.