Capital reserve explained: Legal purpose and use in German LLCs

What are reserves?

Put simply, reserves 💬Rücklagen are a company’s savings. For some German legal forms there are separate regulations for to build up statutory reserves. These additional obligations do not apply to the GmbH.

There are two different types of reserves on the balance sheet: open reserves 💬offene Rücklagen and hidden reserves 💬stille Rücklagen. Let’s unpack these terms.

Open reserves

In accounting, open reserves are recorded in a separate reserve account. Reserves serve as additional debt capital and thus increase the creditworthiness of the company.

They are considered variable equity 💬Eigenkapital in terms of the appropriation of profits and the purpose for which they are used.
All reserves appear separately from subscribed capital on the liabilities side of the balance sheet.

Hidden reserves

Hidden reserves are values that exist in a company but do not appear on the balance sheet. They arise when assets are recorded at a lower value than they are actually worth, or when liabilities are recorded at a higher value than they truly are. As a result, the company’s reported equity or profit looks smaller than it really is on the balance sheet date 💬Bilanzstichtag.

Example:
If a machine is listed at €5,000 in the books but could realistically be sold for €12,000, the €7,000 difference is a hidden reserve. The value is there—it just isn’t shown in the accounts.

Companies can end up with hidden reserves because of conservative accounting rules, depreciation methods or intentional risk-buffering.

Reserves vs. provisions: What’s the difference?

Reserves and provisions 💬Rückstellungen are often confused, but they serve different purposes. Reserves are part of equity, while provisions are open liabilities and count as debt capital 💬Fremdkapital.

Example:
A company expects a tax audit and believes it may need to pay approximately €5,000 in back taxes. Since the exact amount and timing are uncertain, it records a provision.
By contrast, if the company allocates €5,000 of its profit to strengthen its financial position, that amount becomes a reserve.

How to create reserves in limited liability companies

All companies should create capital reserves. But what are the rules for German LLCs? Reserves are usually formed from the annual net profit. Instead of distributing the profit, the shareholders meeting decides to retain all or part of the annual surplus to increase the company’s equity capital. Other typical events that lead to the creation of reserves:

• Additional contributions from shareholders
• Capital reductions of share capital
• Payments above par value

Capital reserve

As per the German commercial code (§ 272 (2) HGB), capital reserves include the following:

• Share issuance amounts, including subscription shares that exceed the nominal value or, when there is no nominal value, exceed the accounting par value.
• Amounts received from issuing bonds for conversion rights and option rights to acquire shares.
• Any additional payments made by shareholders in exchange for preferred stock.
• Other additional payments made by shareholders into equity.

While the GmbH and the UG have the freedom to utilise their capital reserves, stock corporations can only withdraw them under certain conditions precisely defined in § 150 (3) and (4) of the stock corporation act. For more information, see below.

Retained earnings

Retained earnings 💬Gewinnrücklagen are the profits a company retains after paying taxes and expenses. These earnings come from the surplus of income over expenses in the current or previous financial years. Before allocating or using these funds, the company must first pay corporation tax.

Retained earnings are a result of the company’s self-financing activities. German law recognises three types of revenue reserves: legal, statutory and voluntary reserves.

UG and legal reserves

When it comes to setting aside reserves for a UG (haftungsbeschränkt), specific rules apply. Every UG must allocate at least 25% of its annual net profit (after subtracting any losses carried forward from the previous year) as capital reserves. Additionally, this means that a maximum of 75% of the UG’s profits can be distributed amongst shareholders.

In simple terms, retention means saving a portion of the profits to create reserves.

How long does the retention obligation last?

As soon as the reserves have exceeded 25,000 euros it expires—the minimum share capital of GmbH. There is no specific time limit to achieve the target amount. On the flipside, if the €25,000 goal is not reached, the obligation to retain reserves continues indefinitely.

A simple example

Let’s say a UG records a profit of €15,000 after taxes. According to the legal requirement, 25% of this profit, which is €3,750, must be set aside as a legal reserve. This reserve serves as a financial buffer for the company. The remaining amount of €11,250 can be distributed among the partners as profits, which they can then use as they please.

Building reserves in difficult financial years

For the UG, the amount available to distribute to its shareholders is the difference between profit and the required amount retained. If a UG is in financial difficulty, it has the flexibility to reduce the amount of retained earnings.

But what if there’s no surplus for the year, or if the losses carried forward completely offset the surplus? In such situations, there’s no obligation to retain profits, which means that the legal requirement to build up reserves doesn’t apply for that financial year. In this case, there can be no profit distribution either!

Legal reserves

In Germany, stock companies and partnerships limited by shares must set aside part of their profits as legal reserves to protect their creditors in the long term, as per the German Stock Corporation Act (§ 150 para. 2 AktG). But what exactly is involved in creating these reserves?

As with the UG, every stock corporation is also required to set up a legal reserve from retained earnings. The legal reserve should be set at 5% of the annual surplus after deducting any losses carried forward from previous years. This requirement remains in force until the total of the legal reserve and capital reserve reach 10% of the company’s share capital. Once this threshold is reached, the obligation to retain legal reserve no longer applies.
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Statutory reserves

In a company’s articles of association, shareholders can decide to set aside a certain percentage of annual profits as a revenue reserve. This practice helps to build up the company’s equity gradually over time.

Reserves for ownership interests

Companies are required to set up a reserve for “shares in a controlling or majority-owned company” (according to § 272 (4) HGB). This type of reserve is particularly relevant in a holding structure. The amount of the reserve should be equal to the value of the shares in the company shown as fixed assets on the balance sheet. This reserve can only be dissolved if the shares are sold or withdrawn. In addition to the statutory reserve requirement, limited liability companies also must have a reserve for company shares.

Voluntary reserves

Some firms may prefer to set up a voluntary rather than a compulsory revenue reserve, which gives them greater flexibility in setting the annual amount. This is particularly advantageous for companies whose profits fluctuate.

Similarly, stock companies have the option of allocating reserves voluntarily. When approving the annual financial statement, the board of directors and the supervisory board may allocate up to 50% of the annual surplus to other revenue reserves.

How are reserves dissolved?

Once a reserve has been created, it is usually not easy to dissolve. The law clearly outlines the circumstances under which this may be done:

How can the UG use its reserves?

The rules in the GmbH Law explain when and how a UG’s reserves can be used:

• Increase of share capital from company funds (§ 57c GmbHG).
• Offset a net loss for the year that is not covered by profits carried forward from the previous year.
• Offset a loss carried forward from the previous year if the net profit does not cover it for the year.

How can the stock companies use its reserves?

Stock corporations are subject to stricter and more comprehensive rules (§ 150 (3),(4) AktG). If the legal reserve and the capital reserve amount to less than 10% of the share capital, the revenue reserves may only be used for the following purposes:

1. Offset a net loss for the year that is not covered by profits carried forward from the previous year and which cannot be offset by releasing other retained earnings.
2. Offset a loss carried forward from the previous year that is not covered by the current year’s profits and which cannot be offset by releasing other retained earnings.

If the total reserves exceed 10% of the share capital, the rules for releasing reserves are somewhat less strict. The company may use the reserves in the following ways:

1. Offset a net loss for the year that is not covered by profits carried forward from the previous year, provided there is no distribution of profits.
2. Offset a loss carried forward from the previous year that is not covered by the profits of the current year, provided there is no distribution of profit.
3. Capital increase from company assets according to §§ 207-220 AktG.

FAQ

How are reserves formed in a holding company when the parent company is a UG?

The creation of reserves in a holding company follows the same principles as in a regular UG. If the parent company isn’t an operational business, the reserves are generated from the profit distributions of its subsidiaries. The parent company must also set aside 25% of its profits as retained earnings if it is a UG.

Can different types of reserves be set off against each other?

Yes, it is possible to offset capital reserves against legal reserves, which reduces the company’s equity.

How are reserves determined?

The amount of reserves is decided by the shareholder meeting of the UG or GmbH before the balance sheet date. In the case of a public limited company, the general meeting decides on the appropriation of profits.

Why is there a legal reserve obligation for the UG?

The main reason for creating reserves is to boost equity and safeguard creditors. The UG legal form was introduced to enable the establishment of a limited liability company with a lower initial capital requirement. Previously, entrepreneurs had to form a GmbH with a minimum share capital of €25,000, which was often challenging without enough external funding. The obligation to retain profits ensures that the UG’s liability capital grows over time.

What are the advantages of building reserves for a UG?

• Reducing the risk of insolvency and improving creditworthiness: Building up reserves helps to reduce the UG’s risk of insolvency. Low share capital can lead to financial difficulties, making the company vulnerable in the event of losses or liabilities. By allocating the retention amount, the UG can gradually reduce this risk.
• Enhancing the balance sheet structure: Reserves contribute to a stronger balance sheet and are seen in many industries as a sign of prudent financial management. Lenders and stakeholders perceive companies with substantial reserves as having better creditworthiness and financial stability.
• Absorbing unexpected losses: Reserves play a vital role during economic crises or unforeseen financial challenges. They provide a cushion to absorb losses and reduce reliance on external borrowing, which may be difficult to obtain in such circumstances.

What happens if the obligation to have reserves is breached?

If a breach of the reserve requirement is discovered during insolvency proceedings, the shareholders are usually personally liable.
Claims become statute-barred after ten years. Non-compliance with this obligation represents a significant liability risk for UG founders.

Hidden profit distributions, such as excessive salaries paid to managing directors, are also penalised.
These salary payments reduce the net profit for the year and distort the balance sheet. If the salaries are found to be unreasonable, the annual financial statements lose their validity, and the company can demand repayment from the director.