Partnerships should be able to decide whether they are taxed like companies or whether their partners pay taxes on profits, as in the past.
On March 24, 2021, the federal government passed a draft law to modernize corporate tax law. The legislative process should already be completed in the current legislative period. It is somewhat surprising that the draft of the German law on the modernization of corporate income tax law contains, among other things, a right for trade partnerships to opt for corporate income tax. This should come into effect from the assessment period 2022, but the application must be submitted to the tax authorities before the start of the financial year. Since applications are only possible after the law has come into force, it is likely that measures will have to be taken within a short period of time if the option is to be exercised for a financial year beginning January 1, 2022. Therefore, partnerships and their partners should check in good time whether they wish to exercise the option, regardless of the ongoing legislative process. There are a few points to consider in this context.
So far, partnerships were subject to trade tax on their profits, but not to corporation tax. Instead, depending on the legal form, the partners were subject to income tax or corporation tax on their share of the profits (so-called “transparent taxation”). This applies regardless of whether their share of the profits was paid out or withheld in order to strengthen the equity of the partnership. Corporations (e.g. German limited liability companies and stock corporations), on the other hand, are subject to trade tax and corporation tax on their profits, but their shareholders are only taxed after the dividends have been paid out. Although the corporate tax rate of 15% is significantly lower than the income tax rate (up to 45%), the overall tax rate on profits paid out is similar for partnerships and corporations. This is achieved by offsetting the trade tax on the one hand against the income tax for partners in partnerships and on the other hand against the reduced tax rate for dividends (final withholding tax). With retained earnings, however, things are different: as long as a company retains earnings, the overall tax rate is lower than that of a partnership, as shareholders are only taxed after dividends have been paid out. Companies therefore enjoy a cash flow advantage as long as profits are retained.
In order to eliminate this disadvantage of partnerships, the so-called Brühl recommendations already contained an option model 20 years ago. Instead, the legislature only included an optional tax rate for profits that are withheld in the partnership (Article 34a EStG), which is comparatively complex and sometimes has disadvantages. Even if the timing is surprising, the federal government now obviously intends to also implement the option of comprehensively equal taxation for partnerships and companies in the law.
For which partnerships is an option interesting?
The option model is interesting for all partnerships whose investment and cash flow planning is based on internal financing through retained earnings. In the case of joint partnerships that regularly pay out their winnings to partners, it usually makes more sense to maintain transparent taxation. If profits are to be partially retained and partially distributed, it is worthwhile to carry out a model calculation that is as accurate as possible.
In addition, partnerships wishing to withhold profits should study in detail the pros and cons of exercising the option and make all necessary preparations. The following points can be decisive:
- Does the structure of the partner accounts fit? Profits that are credited to shareholder accounts and can be withdrawn at any time are deemed to have been distributed under the draft law. If necessary, the partnership agreement must be changed.
- Does exercising the option result in taxation of unrealized capital gains? Exercising the option is to be viewed as a change in legal form within the meaning of the German Value Added Tax Act. Such a change in legal form can generally be made without profit or loss. However, this is not always the case. It is possible that the partners’ corporate assets associated with the partnership may need to be restructured first.
- Are there any investments in foreign companies? It is possible that withholding taxes on dividends from foreign corporations can no longer be offset against German tax after exercising the option.
- Are trade tax losses carried forward? Your fate when exercising the option is so far unclear.
Important: Exercising the option should not have any impact on the classification of inheritance and gift taxes of the partnership. This is important because inheritance and gift tax benefits for corporate assets come with stricter requirements for businesses than for partnerships. In addition, after exercising an option, it is possible to use transparent taxation with effect for the future, whereby this is viewed as a further change in the legal form for tax purposes.