Navigating the complex world of German taxation can be challenging for freelancers and entrepreneurs. Understanding the various taxes, filing deadlines, and best practices is essential for maintaining compliance and avoiding potential penalties. This blog post will demystify the German tax system and provide practical tips for entrepreneurs to manage their tax obligations effectively.
Key taxes for self-employed in Germany
I. Income tax (Einkommensteuer)
Income tax (ESt) is levied on an individual's total income, including earnings from freelancing. If your annual earnings from self-employment in Germany are more than the tax-free allowance, you'll need to pay income tax — no matter whether you're a freelancer or run a company.
The purpose of the personal allowance, or income tax allowance, is to ensure that income required for minimum subsistence is not taxed. Workers are automatically entitled to this base living wage, regardless of whether they are self-employed or in a permanent employment relationship. The personal allowance is €9,984 for single individuals and €19,968 for married couples who submit their tax returns together. The federal government recalculates this every two years.
Income tax is calculated for every calendar year. On top of income tax, there's also a solidarity surcharge of 5.5 % on your profits. A church tax for your denomination will also be added if you are a church member. Your total income determines how high your tax rate is, as the income tax is calculated according to a progressive percentage scale – from 0% to 45%.
Income tax should be paid in advance every quarter. The tax office will determine the amount to be paid based on the tax payments made in the previous year. These advance payments are due on 10 March, 10 June, 10 September, and 10 December. If you register your self-employment with the tax office, be careful not to overestimate your expected profits, as the tax office uses your estimates to calculate the amount of income tax to be paid in advance. Your income tax return for the entire financial year must be turned in to the tax office along with the payment of any deficit by 31 May of the following year.
Subtracting expenditures from earnings will determine the amount of profit on which taxes for sole proprietorships are based. As a self-employed individual, you naturally have many expenses you can and should claim for tax purposes. Operating expenses cover a wide range of costs that you incur in the course of your freelance work. These may include leased office space, work materials, and travel expenses. If you work from home, you can also deduct costs for either part or all of your home office. You can deduct 100% of the fees for tax software or a tax consultant as an operating expense.
Costs that don't fall under "normal" operating expenses can sometimes be included on your tax return as special expenses. These include health and nursing care insurance, donations, childcare, maintenance, and vocational training.
Expenses of up to €410 can be credited in full in the same tax period. Costs over €410 may need to be written off over several years. For example, laptops can be fully amortized over 2-3 years.
All remaining profits will be subject to income tax and solidarity surcharge.
To manage income tax effectively, freelancers and small businesses should:
Keep accurate financial records of all income and expenses
Prepare and file annual income tax returns by 31 May (or 31 July if using a tax advisor)
Make quarterly advance payments on income tax
II. Value Added Tax (VAT, Umsatzsteuer) and input tax (Vorsteuer)
VAT (USt) is charged on most goods and services provided by businesses in Germany. The standard VAT rate is 19%, while a reduced rate of 7% or even 0% applies to certain goods and services. VAT compliance is crucial for freelancers and small businesses. Our previous article, "Mastering VAT in Germany: A Complete Guide for Entrepreneurs" discusses this topic extensively.
Among companies, this end-customer tax is known as 'value-added tax', and it must be added to all invoice amounts when charging customers or other companies for services provided. Businesses can deduct the initially paid VAT for services needed to maintain their business operations – this is known as input tax (Vorsteuer). Remember that your company expenses — like internet, office supplies, and even the rent for your office space — generally include sales tax. You can deduct these expenses on your sales tax return to save tax, which is helpful if you're self-employed! If the amount of input tax you pay exceeds the amount of VAT tax you take in, you can have the tax office compensate you with an advance VAT return.
Best practices for managing VAT include:
Registering for VAT and obtaining a VAT number from the tax office
Charging the correct VAT rates on goods and services
Keeping accurate records of VAT collected and paid on business expenses
Filing regular VAT returns and making regular VAT payments to the tax office
III. Trade tax (Gewerbesteuer)
Trade tax is a municipal tax levied on the profits of businesses operating in Germany. Freelancers generally do not pay trade tax, as their activities are considered freelance work rather than a trade. However, some self-employed and small businesses may be subject to trade tax depending on their legal structure and location—for example, e-commerce.
Any tradespeople or freelancers that do not fall under the catalog professions must pay trade tax (Gewerbesteuer) in addition to income tax. Trade tax is calculated based on profits made each financial year.
Trade tax is considered a municipal tax and is meant to refinance the costs for municipalities that arise from the use of their infrastructure (roads, educational and cultural opportunities, etc.). This tax is regulated by the German Trade Tax Implementation Regulation and the Trade Tax Directive (the Gewerbesteuer-Durchführungsverordnung and the Gewerbesteuer-Richtlinie).
Sole proprietorships are exempt from trade tax if they earn less than €24.500 in profits. Otherwise, you'll pay the tax office 3.5% of your profits. You'll need to complete a trade tax return and make an advance payment, which you usually do quarterly.
Here is where the municipal assessment rate (kommunaler Hebesatz) comes into play. Every municipality and city can set its own assessment rate. One basic rule of thumb applies: The more attractive a municipality or city is, the higher the assessment rate. That's how Munich, with an assessment rate of 490 points (4,9%), remains one of Germany's most expensive cities for businesses.
To ensure compliance with trade tax regulations, small businesses should:
Register their trade with the local trade office (Gewerbeamt)
Calculate trade tax liability based on taxable profits and the local trade tax rate
File an annual trade tax return and make any necessary payments
IV. Wage tax on employees' salaries
If you've got employees, you'll also pay wage tax on their monthly salaries when you run your payroll. Not only is wage tax deducted from employees' gross salaries, but employers also need to pay their contribution, roughly the same as what your employee pays.
Being employed and self-employed is not a problem
Want the freedom of going freelance and the security of a permanent job? You can! You can work full-time or part-time and also generate income from self-employment on the side. If you have a side job in which you're self-employed, you might need to pay taxes on that income. The amount you'll have to pay depends on your total income from all sources.
Best practices for managing taxes for sole proprietorship
I. Maintain accurate financial records
To fulfill your tax obligations, you have to document all business transactions, archive them and store them for ten years. The classic shoebox won't cut it here – a more helpful solution would be tax software. In addition to using software to record your transactions, you should also sort your documents chronologically and according to revenues and expenditures. You must present them to the tax office in case of an audit. Digital invoices also have to be archived with the corresponding emails. All invoices and payment receipts must be filed away with your bank statements. The same applies to your expenditures, which also have to be filed with the original receipts.
II. Stay informed about tax laws and regulations
Tax laws and regulations change frequently. Stay informed about updates and changes to the tax system by consulting professional tax advisors, attending workshops or seminars, or subscribing to tax newsletters.
III. Plan for tax payments and deadlines
Missing tax deadlines will result in fines and penalties. Create a calendar of important tax deadlines and set aside funds for upcoming tax payments to avoid any last-minute surprises.
IV. Take advantage of tax deductions and credits
Self-employed can benefit from various tax deductions and credits. Some of them were mentioned above but are far from the complete list. Research and identify relevant deductions and credits to reduce your tax liability.
V. Keep business and personal finances separate
Separating your personal and business finances is crucial for accurate financial record-keeping and tax compliance. Open a dedicated business bank account and use it for all business-related transactions. This will make it easier to track income and expenses and help avoid potential issues during tax audits.
VI. Regularly review and update financial records
Regularly reviewing and updating your financial records will help you stay on top of your tax obligations and identify potential issues before they become significant problems. Set aside time monthly to review your financial records, reconcile bank accounts, make VAT payments to Finanzamt, and check for errors or discrepancies.
VII. File taxes electronically
Filing taxes online can save time, reduce errors, and streamline the tax filing process. Many tax advisors and accounting software solutions offer electronic filing options. In addition to being more efficient, electronic filing often allows for faster processing of tax refunds.
Conclusion
Understanding and managing taxes is crucial for freelancers and small businesses operating in Germany. By familiarizing yourself with the key tax principles, keeping track of deadlines, and implementing best practices, you can effectively navigate the German tax system and minimize potential issues.