Learn all about the taxation of sole proprietorships and find out everything you need to know about Umsatzsteuer (VAT), Einkommensteuer (income tax) and Gewerbesteuer (trade tax).
- What do I need to know about sole proprietorships & taxation?
- Sole proprietorships vs. partnerships & corporations
- EÜR: How to calculate sole proprietorship taxes
- What are the taxes of a sole proprietorship?
Knowing the answers to the following questions will keep you informed:
- What differentiates a sole proprietorship from partnerships and corporations in terms of taxes?
- Which types of taxes do sole proprietorships owe?
- What regulations are in place for sole proprietorships when it comes to VAT as well as income and trade tax?
- How are taxes for sole proprietorships calculated?
- What is trade tax?
Before we look at what taxes a sole proprietorship owes, let’s first unpack what a sole proprietorship is. There are different legal forms of business in Germany, and they are governed by different laws. We can distinguish between the following:
- Partnerships such as a GbR (civil-law partnership)
- Corporations (LLCs) such as a GmbH or an AG
- Einzelunternehmen (sole proprietorships)
As a sole proprietorship or sole proprietor, every type of self-employed work activity (performed by a person who carries on a trade or who carries out freelance work independently is specified. Traders must additionally request a Gewerbeschein (trade licence) at their local Gewerbeamt (trade office).
Sole proprietors are personally liable for any damages they may cause while carrying out self-employed work, therefore putting their private assets at risk. Unlike the GmbH, sole proprietorships have no limitation of liability. In addition to small-trade (Kleingewerber) status, another legal form for sole proprietorships is that of the eingetragener Kaufmann (registered merchant). Merchants usually register their commercial enterprise in the commercial register after reaching €600,000 in revenue.
Because sole proprietors derive their income from the profits they accumulate, they are subject to income tax. For corporations, this Lohnsteuer (wage tax) takes the form of a corporate tax (Körperschaftssteuer) placed on the corporation’s profit. The taxation of sole proprietorships, like that of partnerships and corporations, is defined in the German Commercial Code (Handelsgesetzbuch, or HGB) and Tax Code (Abgabenordnung, or AO). Sole proprietorships owe the following taxes, regardless of the amount of revenue or profit they generate:
- Income tax plus a solidarity surcharge (Solidaritätszuschlag) and a possible church tax
- VAT (Umsatzsteuer)
- Trade tax (Gewerbesteuer)
The accounts you keep of all revenue and expenditures of your commercial or freelance activities form the basis for taxation. This bookkeeping determines your profit, which forms the assessment basis for each individual tax. For this reason, we’ll take a quick look at the accounting process and the so-called Einnahmenüberschussrechnung (EÜR), a simplified revenue and expenditure statement.
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To fulfil your tax obligations, you have to document all business transactions, archive them and store them for ten years. The classic shoebox won’t cut it here – a more helpful solution would be tax software such as Lexoffice, Sage or WISO. In addition to using software to record your transactions, you should also sort your documents chronologically and according to revenues and expenditures, as you must present them in that fashion to the tax office in case of an audit. Digital invoices also have to be archived with the corresponding emails. All invoices and payment receipts must be filed away with your bank statements. The same applies to your expenditures, which also have to be filed with the original receipts. Subtracting expenditures from earnings will determine the amount of profit on which taxes for sole proprietorships are based.
Income tax and the solidarity surcharge
The framework for income taxation is laid out in the German Income Tax Act (Einkommensteuergesetz, or EStG) and the German Income Tax Implementation Regulation (Einkommenssteuer Durchführungsverordnung, or EStDV). All sole proprietorships must pay income tax on their profits, which are referred to as private withdrawals. Income becomes taxable once it exceeds the so-called Existenzminimum or the minimum subsistence level.
The current minimum subsistence level is € 8,820 per year for unmarried individuals as of 2017 – it will increase to € 9,000 in 2018. For married couples assessed jointly and registered partners, the taxable minimum subsistence level for 2017 is € 17,640. There are also allowances for children, which amounted to € 3,678 per child and parent in 2017.
The government also grants allowances for exceptional costs and provident expenses, such as for private pension plans. Such expenses can be declared in your income tax statement and will be deducted from your taxable income. All remaining profits will be subject to income tax and the solidarity surcharge.
Income tax is calculated for every calendar year. On top of income tax, there’s also a solidarity surcharge of 5.5 % on your profits. If you are a member of a church, a church tax for your denomination will be added to that as well. Your total income determines how high your tax rate is, as the income tax is calculated according to an increasing percentage scale. The first euro earned above the minimum subsistence level will be taxed at 14 % (as of 2016). After that, the percentage increases significantly as part of a progression. For every euro above € 10,000 and up to € 14,000, you’ll pay 17.2%. 24.7 % will be charged after that, and 27 % will go to the government for a total income between €20,000 and €26,000.
The tax rate continues to climb up to a taxable income of € 53,666, after which the maximum tax rate of 42 % applies. If you earn over € 254,477, you’ll even pay 45 % of every additional euro to your tax office.
Advance income tax payments must be made every quarter. The tax office will determine the amount to be paid based on the tax payments made in the previous year. These advance payments are due on 10 March, 10 June, 10 September and 10 December. Your income tax return for the entire financial year must be turned in to the tax office along with the payment of any deficit by 31 May of the following year.
VAT and entitlements
VAT, or Umsatzsteuer, is a tax paid by the end customer that companies add to all goods and services before transferring it to the government. To the end customer, this 19 % tax is known as ‘sales tax’ (Mehrwertsteuer). In addition to this tax rate, there is also a reduced rate of only 7 % – this applies to basic food products and goods considered to fulfil daily consumer needs.
Among companies, this end-customer tax is known as ‘value-added tax’, and it must be added to all invoice amounts when charging customers or other companies for services provided. Businesses can deduct the initially paid VAT for services needed to maintain their business operations – this is known as input tax (Vorsteuer). If the amount of input tax you pay exceeds the amount of VAT tax you take in, you can have the tax office compensate you with an advance VAT return.
Companies are required to pay trade tax (Gewerbesteuer or Gewerbeertragssteuer) on their trade earnings. Sole proprietorships must also pay trade tax if they carry out a trade and pass a certain profit threshold.
Freelancers, as well as agricultural and forestry businesses, have it a bit better in that respect: As long as they aren’t registered in the commercial register, they are exempt from trade tax.
Trade tax is considered a municipal tax and is meant to refinance the costs for municipalities that arise from the use of their infrastructure (roads, educational and cultural opportunities, etc.). This tax is regulated by the German Trade Tax Implementation Regulation and the Trade Tax Directive (the Gewerbesteuer-Durchführungsverordnung and the Gewerbesteuer-Richtlinie).
All businesses have to pay a trade tax when they reach a certain level of profitability. Sole proprietorships and partnerships such as the GbR, oHG and KG are exempt if they earn less than € 24,500 in profits.
Municipal assessment rates
Trade tax for sole proprietorships is usually calculated based on the EÜR. However, some certain additions and reductions can alter that base amount of profit. Additions can take the form of financing costs or profit shares. You can also use other taxes, such as property taxes on business properties, to reduce your profits. The gross profit is then multiplied by the Germany-wide federal tax rate of 3.5%, resulting in the base amount that will be subject to trade tax. Here is where the municipal assessment rate (kommunaler Hebesatz) comes into play.
Every municipality and city can set their own assessment rate. One basic rule of thumb applies: The more attractive a municipality or city is, the higher the assessment rate will be. That’s how Munich, with an assessment rate of 490 points, remains one of the most expensive cities for businesses in Germany. Read more about trade tax here.
It certainly goes without saying that sole proprietorships must pay taxes. However, the relatively complicated calculation processes and bases, especially for trade taxes paid by sole proprietorships, are not exactly basic knowledge. If you come across uncertainties regarding taxes as a sole proprietor, you should seek out a tax consultant to assist you with each type of tax you owe.
By the way: You can deduct 100% of the costs paid for tax software or a tax consultant as an operating expense. And if you’re just starting to establish your sole proprietorship, do consider what legal company form you choose while you’re creating your business plan. In the case of major liability risks like the ones that often confront trading companies or company successions, it may be wise to form a GmbH or another limited liability company right from the start.
You can find an overview of the basic principles, requirements and applications for establishing a sole proprietorship in our guide.