I. Taxation of capital gains

Income from self-employment that is subject to income tax also includes the profit that accrues on the sale of assets that were used to carry out a freelance activity. Since the sale of freelance practices often leads to the disclosure of considerable hidden reserves, the tax privilege of such capital gains is of particular practical relevance.
The German Income Tax Act (EStG) provides two main options for a tax-privileged treatment of capital gains.

1. Tax allowance on capital gains

If a selling freelancer has reached the age of 55 or is permanently unable to work in the sense of social insurance law, any capital gain resulting from the sale of the practice is only subject to income tax if it exceeds EUR 45,000 (section 18 para. 3 sentence 2 EStG in conjunction with section 16 para. 4 EStG). However, this tax-free amount – which is available on a one-off basis – is reduced by the amount by which the capital gain exceeds EUR 136,000. As a result, it is no longer possible to claim a tax allowance if the capital gain exceeds EUR 181,000. Given that this limit is often exceeded, the practical significance of tax privileges for capital gains via a tax allowance is rather limited.

2. Preferential rates

All the more relevant is the privileged treatment of capital gains over the applicable tax rate under section 34 EStG.

2.1 One Fifth-Rule (Fünftelregelung)

According to the so-called one fifth-rule (Fünftelregelung) of section 34 para. 1 EStG, profits from the sale of independent professional practices are to be taxed as extraordinary income only at the tax rate that would result from a notional distribution of the capital gain over a five-year period for the respective assessment period. The one fifth-rule thus leads to a smoothing of the tax progression through a notional distribution of the capital gain over several years (L. Seeling in: BeckOK EStG, section 34 marginal no. 279).

2.2 Reduced tax rate

As an alternative to the application of the so-called one fifth-rule, section 34 para. 3 EStG provides for taxation of the capital gain at a reduced tax rate of 56 % of the taxpayer’s average tax rate, but at least at a tax rate of 14 %. Such preferential rates pursuant to section 34 para. 3 EStG are granted once upon application by the seller if the seller has reached the age of 55 or is permanently incapacitated for work within the meaning of social insurance law, and are limited to the amount by which the capital gain does not exceed EUR 5,000,000.

2.3 Prerequisite: Definitive transfer of the asset base

Both the one fifth-rule in section 34 para. 1 EStG and the rate reduction under section 34 para. 3 EStG presuppose, according to the BFH’s established case law, that the taxpayer transfers, against payment and definitively, to another person the assets which are essential for the exercise of his or her freelance activity (this includes in particular the practice/client base in the case of freelancers). This requires, inter alia, that the seller ceases his freelance activity in the previous local sphere of activity at least for a “certain time” (see BFH, judgment of 23 January 1997 – Ref. IV R 36/95). This is based on the idea that in the event of an unrestricted resumption of activities within the previous local area of activity, it is particularly likely that the client/practice base will be taken along. In such a case, a definitive transfer of the main business fundamentals to the acquirer cannot be said to have taken place. The length of the waiting period (“certain time”) required by case law is assessed on a case-by-case basis. According to the BFH, a period of two to three years may be sufficient, depending on the specific circumstances.
However, it is not an obstacle to the application of preferential rates according to section 34 EStG if a seller acts on behalf of and for the account of the purchaser following the sale, which may often be desired by the purchaser in order to maintain the client base. It is also harmless if a seller resumes his or her freelance activities within the previous local sphere of activity to such a small extent that the resulting turnover is less than 10 % of the average annual income in the three years preceding the sale (so-called marginal-threshold). These two exceptions to the requirement to give up the activity within the previous local area of activity are now recognized in principle in case law and by the tax authorities. In detail, however, there is still a need for clarification regarding the application of these exceptions between tax authorities and the courts. This is shown by a recent decision of the BFH, in which it has commented on the limits within which the continuation of an activity in the previous local sphere of activity is permitted without at the same time losing the possibility of a privilege under section 34 EStG (ruling of 11 February 2020 – Ref. VIII B 131/19).

II. Facts and BFH judgment

The facts on which the above-mentioned decision was based concerned the sale of the single office of a tax adviser. He had sold his law firm to two buyers. Subsequently, the seller worked for a newly founded partnership company, into which the single office had been contributed by the two purchasers, on behalf and for the account of the partnership company, first in the context of a so-called transitional cooperation and then as a freelancer. Two and a half years after the sale of the practice, the seller resumed independent tax consultancy activities within his previous local sphere of activity. However, as a result of this new independent activity, the seller only achieved turnover which was below the marginal-threshold. Nevertheless, the relevant local tax authority ultimately denied the seller the preferential rate treatment of section 34 para. 3 EStG on the grounds that the seller had taken on new clients in an inadmissible manner within the “certain period”.
The opinion of the local tax authority corresponded to the legal opinion of the highest tax authorities of the Federal States expressed in a letter from the BMF in 2003, according to which “the acquisition of new mandates/patients within the “certain” period after the business ceased to operate – even without exceeding the 10 % limit – was in any case harmful, since a ceasing of business had not actually taken place.” (BMF letter of 28 July 2003, DStR 2003, 2166).
With its decision of 11 February 2020, the BFH has now contradicted this: The BFH states that the fact that the selling tax adviser, following his sale, carried out activities which were below the marginal-threshold and in this connection also looked after new mandates, does not exclude the existence of a sale of a practice benefiting from a preferential rate under section 34 EStG. In the opinion of the BFH, it does not make any difference whether the seller continues to look after individual old clients on his own account or whether he uses the relationship with old clients to win new clients. The only decisive factor in both cases is whether the seller remains below the marginal-threshold of 10 % of the average turnover of the three assessment periods preceding the sale. In the constellation to be decided by the BFH, it was therefore irrelevant whether the seller had observed the “certain period” required for a definitive transfer of the essential business assets.

III. Classification and assessment

In its decision of 11 February 2020, the BFH makes a logical specification of the marginal-threshold to be observed in the case of tax privileges for capital gains. The previous view of the tax authorities, according to which newly acquired clients in any case exclude the application of preferential rates according to section 34 EStG, cannot be justified against the background of the purpose pursued by the precondition of discontinuing activities in the previous local sphere of activity. This prerequisite is intended to protect the acquirer against the loss of the acquired asset “practice/client base”, since it is by its very nature a “volatile asset” (Diemer, DStR 2020, 486 (491)). This protective purpose is at most indirectly affected in the case of new clients of the seller, and only to the extent that existing client relationships are used to acquire new mandates. However, if – as is also recognized by the tax authorities – action for old mandates within the marginal-threshold does not prevent a preferential rate, this must apply a fortiori to action for new clients, which may be indirectly linked to the client base existing at the time of the sale.