Broke due to tax payments? Not an unlikely scenario. There are a number of companies that have to close their doors after just a few years, and it’s not due to their business model, nor to a lack of customers or orders.
Rather, the German tax system combined with typical human behavior, can result in a tax trap for many founders and self-employed that often means the end of an otherwise successful enterprise.
I have been self-employed for about four years and worked in tax consultancy before. Despite being a self-employed tax expert who knew about this trap and how to avoid it, I have to admit, I too have nearly fallen into it at times.This article is my heartfelt attempt to help as many self-employed people as possible avoid making the same mistakes that have ended thousands of otherwise successful freelance businesses.
When do I have to pay taxes and for what period?
Let’s start simple. Taxes are a fact of life, and must be paid.
As a freelancer, there are a number of taxes you may have to pay, including:
- Value Added Tax (VAT)
- Income tax (or corporation tax with a GmbH or UG)
- Commercial tax (of which freelancers are exempt)
For each of these tax types, you must submit a tax return to the tax authorities (Finanzamt) that specifies your revenue (the total amount of money coming into your business) and profit (your revenue minus expenses). Afterwards, you will receive a tax assessment (Steuerbescheid), in which the tax office will tell you how much money you owe in tax.
After your initial tax return, the government sets up a regular payment plan, based on their estimate of what you will owe in any given year, typically set by the previous tax return. Although these payments don’t begin until you earn a certain amount, they can be problematic, in particular if you are earning varies wildly from your last tax declaration. If you’re earning a lot more, you could be stuck with a big tax bill at the end of the year. If you’re earning a lot less, you could find yourself struggling to make tax payments that are much larger than what you actually owe.
The cadence of VAT payments is based on how much VAT you collect. If you collect less than 1,000 Euros a year of VAT, then you do not have to make any prepayments, instead everything will be settled at the end of the year with your tax declaration. If you have a value added tax liability between 1,000 and 7,5000 Euros, your VAT prepayments will be due on a standard quarterly basis in Jan, April, July and October. If your VAT liability exceeds 7,500 Euros per year, you will need to pay on a monthly basis.
Note: If your sales are less than 17,500 Euros per year, you may qualify as a “Kleinunternehmerregelung” which exempts you from collecting and paying VAT. If you freelance full time this may not be an option, but it’s something to look into if you’re just starting out and don’t expect to earn a lot in the first year.
Prepayment dates for VAT:
- Quarterly advance notification: Due 10 January, 10 April, 10 July and 10 October (one month later if you have a permanent extension “Dauerfristverlängerung” )
- Monthly advance notification: Due every 10th of the month for the previous month (one month later if you have a permanent extension “Dauerfristverlängerung”)
Income tax and corporate tax:
Advance payments on income tax must be paid if the taxable amount is at least 400 Euros per year. However, you have a tax exemption on income of roughly 1000 Euros/month (precise amounts are depend on your life circumstances and costs).
The corporate tax is the “income tax for corporations” and in principle the same regulations that govern income tax also apply for corporate tax. With one exception - there is no tax exemption threshold and taxes have to be paid on any profit.
Prepayment dates for income tax and corporation tax:
- 10 March, 10 June, 10 September and 10 December
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Local tax (freelancers are exempt):
Local tax calculation is straightforward. To simplify life for you, you only have to pay for this tax when your profits exceed 24.500 Euro (commercial tax threshold) if you are self-employed. If your profit exceeds this threshold, you will have to make prepayments on a quarterly basis.
There is no tax exemption for incorporated companies. Similar to corporate tax, local tax must be paid from the first euro of profit.
Prepayment dates for the commercial tax
- 15 February, 15 May, 15 August and 15 November
Final tax payments
In addition to your prepayments, you must also submit an annual tax return for each of the tax categories. Your annual return will report on your actual earning, rather than simply what was projected. You may be required to make an additional payment, or get money back after the annual tax declaration.
A word of caution:
As there are many different type of tax payments, and they are due at various times, it is important that you always have an overview of which taxes you’ve paid and when you paid them.
For example, it’s possible that on 10 September 2017 you will pay the VAT advance payment for August 2017, the third income tax advance payment for 2017, the trade tax year-end payment 2016, the additional payment on the income tax for 2015 or some combination of the above.
How are the tax prepayments calculated?
The tax prepayments are dependent on your last tax declaration.
In the case of income tax, corporation tax and local tax, the government takes your profit from last year, and assumes you’ll make the same this year. Then, it divides the profit by four and asks you to prepay that amount every three months. Many businesses run on a traditional calendar year, but yours may also run on an alternate calendar. In either case you still must provide four payments, but the timing may be offset.
For VAT, you need to send periodic reports to the tax office to calculate your actual tax liability (Umsatzsteuer-Zahllast). However, the interval in which these reports (Voranmeldezeitraum) must be submitted is dependent on your last sales tax declaration.
When are tax declarations made?
When you tax declaration is due depends a bit on your setup: if you make the declaration yourself, it must be submitted by May 31 of the following year (so May 31 2017 for the 2016 year), but if you work with a tax advisor, you get a bit more time and have until December 31st (so Dec 31st, 2017 for 2016).
Despite the official deadline,, I only know a few self-employed people, who actually adhere to it. If you’re not much of number person, it is likely that you are pushing your accounting and tax records down again and again in the to-do list.
This procrastination is rarely dramatic. The tax office is known to be overwhelmed with work, and is late in sending reminders and warnings tol defaulting taxpayers. It therefore can be that the tax declarations for 2014 are only being issued in April 2017. If the tax office then still need eight weeks to process the tax declaration, you have your tax assessment for 2014 in your hands in June 2017.
As a tax expert, I can assure you that the whole thing does not go faster when a tax consultant is on your side. It may even take longer, because tax consultants sometimes employ additional tricks that allow them more time to complete and submit tax returns. .
Attention! How the tax payments add up
Putting off, forgetting or simply ignoring your tax payments can become become a real hazard.
It is unusual to find anyone who relishes dealing with taxes. As a result, some freelancers just use their gut to manage their finances. This is clearly dangerous as it’s hard to get a feeling, particularly in the first few years of your business how much money you actually need to save for taxes and VAT. Other freelancers work with a tax consultant in the hope that they will just take care of everything for them. This can turn out to be a big mistake. Although a tax consultant can help you organize your financial life, they are ultimately not responsible for making sure you have enough money saved to meet your tax burden.
Although there are many reasonable reasons your tax declaration might be delayed,, there are also some mechanisms are in place which can dramatically increase the chance your company goes out of business.
Here’s an example to illustrate what I mean.
Note to all tax experts out there: I simplify the facts here and ignore some subtleties. My concern is the basic problem where details distract us from the basic mechanisms (and are usually the reason why we lose the overview).
Arthur started his career as an IT consultant in 2013 and has now been independent for four years with a corporate company type. Although the first year was tough, since then, everything seems to be going very well, as his revenue and profits are rising sharply.
Arthur is struggling with his internal organisation, though. He is a numbers guy, but he does not have much patience for doing his taxes. Following a second reminder from the government, he figured out the tax returns for 2013 by himself.
Since he has already received second reminder for 2014, he decided to put all of his tax documents into a box and go to a tax consultant.
The tax consultant does his accounting and notes that Arthur has achieved the following revenue:
2013: 15.000 Euro gross revenue (10.000 Euro profit) 2014: 45.000 Euro (30.000 Euro) 2015: 70.000 Euro (50.000 Euro) 2016: 100.000 Euro (60.000 Euro)
Using the tax declaration from 2013, the tax authorities set the prepayments:
VAT: 0 Euro because of the the small business rule (Kleinunternehmerregelung) Income tax: Euro € because of the income tax threshold Commercial tax: Euro € because of the local tax threshold
As we can see, Arthur has not paid any prepayments taxes yet. Since the tax authorities did not know how the sales had developed, they did not ask him to pay either.
Now, in 2017, the tax declarations for 2014 and 2015 are urgently needed. For the given figures, the following payments are made:
VAT: 0 Euros because of the the small business rule (Kleinunternehmerregelung) Income tax: 3,900 Euros Local tax tax: 750 Euros
VAT: 8,000 Euro (the small business rule doesn’t apply any more with this revenues) Income tax: 9,400 Euros local tax: 3,600 Euros
Note: Tax rates and amounts are rounded to simplify the calculation.
Arthur has to catch up and pay the taxes owed for both 2014 and 2015, which comes to 24,650 euros. This really hurts with an annual income of 60,000 euro, but it doesn’t end here, see because Author still owes taxes for money earned in 2016 AND any prepayments owed in 2017.
But it gets much worse (this is not fictitious, every tax office will react like this)
As the tax office now has new numbers to go by, it will adjust what it expects in terms of prepayments.
VAT: Since the taxable revenues exceeds 7,500 Euro, monthly prepayments must now be submitted. Arthur will have a four-week deadline to submit all retrospective prepayments (welcome to Germany) for 2016 and all outstanding pre-registrations for 2017. If costs stay the same, this amounts to 11,400 Euro retrospective VAT advance payments for 2016.
Income tax: The prepayments for income tax are set at 2,350 Euros (one quarter of the last tax burden). For 2016, four subsequent advance payments are due, i.e. 9,400 Euros.
local tax: Here the same mechanism applies as for income tax. Tax prepayments of 3,600 Euros are due.
In total, Arthur will owe: 24,650 Euros in taxes for 2014 and 2015 24,400 Euros in pre-payments for 2016 In total, this means Arthur will have to pay 49,050 Euros for taxes. With an annual income of 60,000 Euros. With a deadline of four weeks.
To top it off, the tax consultant hands him a bill of 5,000 Euro to take home.
But the future seemed so bright…
The tax office is not squeamish. If not paid, they will send out 1-2 more reminders and then seize your bank account. Even if Arthur manages to pay his tax debts, which amount to over 80% of his annual income, the next advance payment for 2017 and the next final payment for 2016 will soon be waiting for him.
While this example is fictional,it is similar to the situation in which thousands of self-employed people find themselves, particularly, those whose sales and profits increased considerably year over year. Speaking from my own experience, I can tell you that you have to deal with fundamental questions at this point.
I have seen some entrepreneurs give up.
Most self-employed people are ashamed by situations like this and do not talk about it. After all, conventional wisdom says you (should) know that you have to save money each month for taxes. On top of that, entrepreneurs are subject to tough criticism in Germany when their business fails.
I firmly believe that it is very important to talk about such dangers and to draw attention to them.
The basic problem is procrastination. Simply handing in your tax declaration on the deadline isn’t enough - you need to get ahead of taxes and figure out how much you need to set aside for prepayments before they’re due. Otherwise, you can find yourself in for a nasty and expensive surprise.
Financial management following gut feeling is doomed to failure!
It would be ideal if you could know as soon as your money hits your bank account, how much money you can keep and how much you have to put aside for the state, avoiding entirely the invisible build-up of tax debt.
This is the basic idea of Kontist and this article outlines the reasons why I am 100% behind this idea. Anyone who has lived through a similar situation can confirm this.
Finally, a small best practice tip: It is good to know how much you have to pay once. But it is safer if you pay immediately, so as not to be tempted to spend the money.
If your sales increase, you can always tell your tax office and ask to raise the prepayments. For this, you should create a rough calculation and write how much you would like to pay.