What legal form is preferable for freelancers: a limited liability company (GmbH) or a sole proprietorship? What are the arguments for and against the respective legal forms?
Let me tell you in advance: Unfortunately, there is no one-size-fits-all answer for everybody.
It actually depends on your personal requirements: Do you want to minimize your administrative burden, or is limiting your personal liability your first priority?
Depending on how you answer these and other questions, the legal form best suited to your needs may differ.
In this post, I am offering a comparison of the two legal forms “sole proprietorship” and “GmbH”. You will learn:
- What constitutes a freelancer
- Advantages and disadvantages of sole proprietorship
- Advantages and disadvantages of GmbHs
- Why an entrepreneurial company (Unternehmergesellschaft, UG) is not an option
This post was updated on 18 August 2021.
What constitutes a freelancer?
According to the law (Section 18 German Income Tax Act (EStG)), the freelance professions comprise self-employed activities in the following areas:
- Science
- Arts
- Writing
- Education
- Teaching
In detail, this applies to: medical doctors, dentists, veterinarians, lawyers, notaries, patent attorneys, architects, tax consultants, non-medical practitioners, journalists, translators and similar professions. These are freelancers (Freiberufler) under German tax law.
Legal form for freelancers #1: Sole proprietorship
What are the advantages of a sole proprietorship?
- No legal accounting requirements:Sole proprietors are not required to record business profits using double-entry accounting principles.
- VAT not due until payment is received:As a sole proprietor, you must pay VAT once you receive payment, rather than when issuing your invoice. This is independent from how much revenue you generate.
- No disclosure obligation:Sole proprietorships do not need to publish asset or income figures in the form of annual financial statements electronically with the German Federal Gazette.
- Private withdrawals are possible:As a sole proprietor, you can withdraw money from your business on an ongoing basis without having to pay tax on these withdrawals.
- No minimum capital required:Theoretically, you can set up a sole proprietorship with as little as one euro.
When does the sole proprietorship not make sense?
- Risk of claims exceeding business liability insurance:If the risk of claims is too high and your insurance company will not pay, you should decide in favor of another legal form. Otherwise, you might be liable for damages with your private assets.
Legal form for freelancers #2: Limited liability company (GmbH)
Under what circumstances may the GmbH be a sensible option for freelancers?
- Business liability insurance insufficient:This could be the case if your business liability insurance does not cover enough damages in which case you as a freelancer would have to be liable with your private assets. This concern affects mainly: engineers, architects, lawyers, and tax consultants.
- Better options for pension provisions:You would like to improve your pension provisions? Then a GmbH would be the best option for you as a freelancer. It allows for the 5 different types of company pensions.
- Better image and higher creditworthiness:Due to the minimum capital of € 25,000 and the general prestige of the GmbH, your reputation with banks and business partners is enhanced.
Under what circumstances does the GmbH not makes sense?
- No desire for double-entry accounting:If you are reluctant to comply with bookkeeping or accounting requirements, a one-person limited liability company does not make sense for you.
- No desire for even more administration:A GmbH entails a higher administrative workload (annual reports, accounting, shareholder meetings, etc.). If you do not want this, a one-person GmbH is not recommended.
- No desire to disclose all information:If you do not wish to publish your business assets or business income, it is not advisable to set up a GmbH.
- If you want to make personal withdrawals:In the case of a GmbH, you cannot simply withdraw money or change your salary all the time.
- If you cannot afford the minimum capital:If you want to form a GmbH, you need minimum capital of € 25,000.
The UG is not a recommended legal form for freelancers
You might ask yourself, why I have not included the German entrepreneurial company (Unternehmergesellschaft, UG) in my comparison?
As a matter of fact, I have deliberately left out this legal form as it has a bad reputation and is therefore not a good alternative for freelancers.
While the establishment of a limited liability company with only € 1 of capital may very well sound tempting, in fact the UG has many drawbacks:
- Higher administrative workload: Comparable to the GmbH, the administrative workload for an UG is also very high. You have to expect increased formalism (=double-entry accounting), higher expenses for tax consultancy, own payroll (=additional costs for payroll accountant), etc.
- Higher tax rate: The tax rate for a full distribution is 48%(corporation, trade, and income tax). For a sole proprietorship, the tax rate is 45% at the most. This means: even if your profits are low, in the case of an UG you have to pay the highest possible tax rate!
- Low creditworthiness and bad reputation: The low level of capitalcan affect your company’s creditworthiness. It might affect your reputation and cause mistrust with banks and contractual partners.
- No absolute limited liability: Limited liability can be disregarded by tax offices or bank guarantees.
- 25% of profits must be retained:Other than with a GmbH, you cannot pay out the entire profit, but must leave at least 25% in the company to increase the capital base.
As you can see: In addition to the disadvantages of the GmbH already mentioned above, the UG has even more downsides. Due to the low level of capital the reputation of your company is usually not as strong and, in addition, you are forced to retain a certain portion of your earnings.
Conclusion: GmbH and sole proprietorship are both viable options for freelancers, UG – never a good idea
Whether a GmbH or a sole proprietorship are the better option for you depends primarily on your individual situation:
- If you want to keep the administrative workload as low as possible and accept the lack of limited liability, a sole proprietorship can make sense as a freelancer.
- If, however, you do not want to be liable with your private assets, while benefitting from better pension schemes, the formation of a GmbH is recommended.
I would advise against the formation of an UG, as it does not provide fully limited liability and has an inferior image compared with the GmbH.
I hope that this post has given you a brief overview of the legal forms suitable for freelancers and has provided you with a good basis for your decision.
Please feel free to contact me for more information about these legal forms or further advice. You can reach me by phone (+49 40 44 33 11), e-mail (anfrage@steuerberatung-breit.de) or via my contact form.
Kind regards,
Thomas Breit
Photo: © Elnur – fotolia.com
