I often see figures in business plans that are completely up in the air and which thus present business owners with a tax problem: The payments that the company will actually have to make in the future will bring the owner crashing back down to earth in future years. In the worst case, such “pie-in-the-sky” calculations mean that insolvency proceedings have to be instigated.
There are usually two reasons for establishing a limited liability company: A successful sole proprietor wants to combine the advantage of limited liability in his legal form or a brand new company is about to be founded.
The former often hears about the much lower corporation tax in contrast to the income tax he has always had to pay. The latter, the founder, often scours the Internet by himself looking for information and then pieces together a business plan with risky and incomplete knowledge.
In this post, I would like to explain to you, on the basis of real-life examples, what taxes your limited liability company will have to pay if your business model is successful. I will also not shy away from telling you how much tax you will have had to pay as shareholder and/or managing director before the money actually hits your personal account.
What taxes actually exist for limited liability companies?
Corporation tax: In Germany, this amounts to 15 percent of profits generated. If your profit is 100,000 euros, you will pay 15,000 euros in corporation tax for the financial year.
Trade tax: The trade tax varies throughout Germany. The exact rate depends on the municipality where your business is registered. As a rule of thumb, however, you can also take 15 percent.
Land transfer tax (payable once when a property is purchased): A limited liability company only pays land transfer tax when it purchases a property (e.g. when buying, not renting, office space). In addition to the purchase price, you must also pay 6.5 percent of this amount as a land transfer tax.
Corporation tax and trade tax are, generally speaking, the two types of tax that are payable on the profits of the limited liability company. If a limited liability company makes a profit of 100,000 euros, it must pay approximately 30,000 euros in corporation tax (15 percent) and trade tax (approx. 15 percent) to the tax office.
Please note: Paying the taxes for the limited liability company does not mean that the rest of the money ends up on your personal account!
A mistake that many new entrepreneurs in particular make in their euphoria that they do not make any further calculations after these taxes have been deducted. Successful sole proprietors who want to convert their company are usually already prepared for the fact that there have to be other things to pay. What is then often missing, however, are the key details. I would also like to address this point in this post.
Once you have turned a profit with your limited liability company, the money then reaches your account in two ways:
- By way of your salary as an employee of the limited liability company: The owners are often the managing directors of their own limited liability company, which means that you are also normally employed by it. You also have the same rights and obligations as any other employee. You will therefore receive a “regular” salary, which means having to pay all ancillary wage costs and all taxes of an employee. This means you pay income tax on your salary as normal.
- By way of profit distributions to the shareholders: Profits may also be shared with the shareholders in the form of profit distributions. This happens after the respective shares have been distributed. If you own 75 percent of your limited liability company and your business partner owns 25 percent, you will receive – if 100,000 euros are distributed – 75,000 euros and your business partner 25,000 euros.
These amounts can then be taxed in two ways: 60 percent of the amount distributed is taxed at your normal income tax rate and 40 percent is tax-free. Or you can opt to pay a flat tax rate of 25 percent on the entire amount distributed.
The tax differences between salary and distribution for the limited liability company
It is important to mention here that a salary always has a profit-reducing effect. That means: The expenses for your salary, should you be employed as a managing director in your limited liability company, will be deducted from your profit before the taxes are calculated. This is different in the case of sole proprietors.
If your limited liability company has a turnover of 200,000 euros and 50,000 euros in other expenses (e.g. rent, purchasing of goods, other wages, etc.), your managing director’s salary also needs to be deducted before calculating the profit. If your salary now amounts to 50,000 euros, then the limited liability company’s profit is just 100,000 euros. And only these 100,000 euros are taxed as profits of the limited liability company.
It is a different story in the case of a distribution: In the above example, if you distribute another 40,000 euros of these profits to the shareholders, the taxable profit will still be 100,000 euros.
What does that mean for your personal and business accounts?
Let’s stay with the fictitious example above:
- Income: 200,000 euros
- Expenses: 50,000 euros
- Expenses for your managing director’s salary: 50,000 euros
- Profit of the limited liability company: 100,000 euros
- Distribution: 40,000 euros (75 percent of the shares belong to you)
The limited liability company’s tax burden is as follows:
- The limited liability company pays 15 percent corporation tax on profits = 15,000 euros
- The limited liability company pays around 15 percent trade tax on profits = 15,000 euros
- After taxes (a total of 30,000 euros) and distribution (40,000 euros), 30,000 euros of the 100,000 euros in profit remain on the limited liability company’s account.
The tax burden for you as a private person is as follows:
- You receive a salary which, including ancillary wage costs for the limited liability company, amounts to 50,000 euros. This salary is subject to income tax as normal.
- You receive a distribution of 30,000 euros (75 percent of 40,000 euros) at the end of the financial year. Now you can decide: Either you pay a flat 25 percent tax rate on the entire amount (= 7,500 euros) or you add the 30,000 euros to your normal annual salary and must tax 18,000 euros of it (= 60 percent) at your normal income tax rate. 12,000 euros of the distribution (=40 percent) would be tax-free in this case. You must therefore calculate exactly what is better for you.
Important note for managing directors: Please do not come up with the idea of paying out profits by giving yourself a higher salary, as this would reduce the amount of tax payable by the limited liability company. This is then known as hidden profit distribution and it is a criminal offence.
Does it make sense for tax purposes to leave profits in the limited liability company?
The above example uses figures that are generally much lower than many limited liability companies in Germany have today. It therefore makes sense for many business owners – if they do not need the money for personal use – to leave profits in the limited liability company.
There they are taxed only once (profit is only generated once) at 30 percent. Only when these funds generate further income is 30 percent payable on the newly generated income. This means that your money is safe on the business account.
You can now use it for investments or simply increase the capital and thus the enterprise value of your company. This helps you in your dealings with the banks and gives you a higher credit rating if you ever need financing for a very large investment.
You might even look to transform the legal form of the company to something other than a limited liability company. Combining the limited liability company with a silent partner (e.g GmbH & Co. KG) opens the door to other ways of reducing the tax burden below 30 percent (to 28.75 percent).
Conclusion: Truth in numbers at the beginning prevents a nasty surprise when paying out money to a personal account
As you can see, it is not as simple as is presented in many business plans. It is a tempting prospect to always pay only 30 percent tax. However, many forget that this is only half the story.
Additional taxes need to be paid before the money hits your personal account, meaning that the tax benefit which you envisaged for yourself is, in actual fact, a tax burden.
To prevent this from happening, I definitely recommend that you draw up your business plan and your planned company transformation together with an experienced tax advisor. This ensures that your figures (be they taxes, revenue forecasts or budgeted balance sheets) are not simply pie in the sky.
Photo: © olly – Fotolia.com