Favorable treatment of retained earnings

Definition and legal basis:

The retention allowance is a tax regulation that enables partnerships and sole proprietorships to pay tax on profits that are not withdrawn at a reduced tax rate. It was introduced in 2008 with the corporate tax reform and is regulated in Section 34a of the German Income Tax Act (EStG). The aim of this regulation is to promote the formation of equity capital in partnerships and to achieve an approximation to the taxation of corporations. The preferential treatment of retained earnings is an option that taxpayers can choose anew for each assessment period. It only applies to profits from agriculture and forestry, commercial operations and self-employment that are determined by comparing business assets.

Functionality and taxation:

The preferential taxation of retained earnings works in two stages: 1. preferential taxation of retained earnings:
– The earnings not withdrawn are taxed at a reduced rate of 28.25% (plus solidarity surcharge and, if applicable, church tax).
– This leads to an effective tax burden of approx. 30%, similar to the burden for corporations. 2. subsequent taxation in the event of subsequent withdrawal:
– In the event of subsequent withdrawal of the preferentially taxed profits, subsequent taxation is levied at 25% (plus solidarity surcharge and church tax, if applicable).
– The total tax burden is therefore higher than the regular income tax at the top tax rate.

Requirements and scope of application:

The following requirements must be met for the application of the retention tax concession: 1. Profit determination by means of a comparison of business assets
2. Minimum amount of profit to be taxed preferentially: EUR 10,000 or 10% of the profit (maximum EUR 500,000)
3. Application by the taxpayer for each assessment period The regulation is particularly relevant for:
– Partnerships (OHG, KG, GbR)
– Sole proprietorships
– Freelancers with corresponding profit calculation

Advantages and disadvantages:

Advantages:
1. liquidity advantage due to lower immediate taxation 2. promotion of equity formation and investment capacity 3. alignment with the taxation of corporations Disadvantages:
1. complexity of the regulation and increased administrative burden
2. Possible higher overall tax burden in the event of later withdrawal
3. Restriction of flexibility in the appropriation of profits

Practical application and design options:

Careful planning is required for the application of the retention allowance: 1. optimization of the withdrawal strategy:
– weighing up between preferential retention and necessary withdrawals
– consideration of special withdrawals (e.g. for tax payments) 2. Combination with other tax instruments:
– Use of the investment deduction
– Coordination with the savings allowance 3. Long-term planning:
– Consideration of future investment projects
– Planning for company succession and sale 4. Company law arrangements:
– Adaptation of articles of association to make optimum use of the preferential treatment

Challenges and points of criticism:

The retention exemption is also criticized: 1. Complexity: The regulation is complex and difficult to understand for many entrepreneurs.
2. Subsequent taxation: The potentially higher total tax burden in the event of subsequent withdrawal is considered problematic.
3. Limited scope of application: Smaller companies with revenue-surplus accounting cannot use the regulation.
4. Liquidity tie-up: The preferential treatment can lead to excessive tying up of liquidity in the company.

Current developments and discussions:

The preferential treatment of retained earnings is the subject of ongoing tax policy discussions: 1. reform proposals: There are considerations for simplifying and extending the regulation.
2. Alignment of corporate taxation: Discussions on a fundamental reform of the taxation of partnerships and corporations.
3. Effects of the corona pandemic: Considerations on adapting the regulation to strengthen the corporate substance in times of crisis.
4. International competitiveness: Evaluation of the regulation in the context of international tax systems.

Summary and outlook:

The preferential treatment of retained earnings is an important instrument for promoting equity formation in partnerships. It offers opportunities for tax optimization, but requires careful planning and consideration of the long-term consequences. The complexity of the regulation and the potential disadvantages in the event of subsequent withdrawal mean that it is not used as frequently in practice as originally expected. In the future, it is to be expected that the retention exemption will continue to be the subject of reform considerations. Possible adjustments could be aimed at simplifying and expanding the scope of application in order to make it more attractive to a broader group of companies. At the same time, the regulation remains an important building block in the discussion about competitive and fair corporate taxation in Germany.