Sole Proprietorship

Sole Proprietorship: Legal Form with Pitfalls in Taxation and Sale

Few legal forms are as popular in Germany as the sole proprietorship: over 3 million self-employed individuals operate as sole traders, ranging from freelancers to medium-sized businesses. This is hardly surprising, given that the formation process is simple, the structure is straightforward, and liability is clearly defined. However, when it comes to taxation and especially the sale of a sole proprietorship, there are several particularities to consider that differ from partnerships or corporations.

In this article, we highlight the most important tax aspects of the sole proprietorship. We explain how profits are determined, which taxes apply, and what planning options exist. Special attention is given to the scenarios of business cessation and sale: What impact do these have on taxation? And how can the sale proceeds be optimized through smart planning? Practical examples illustrate the opportunities and pitfalls.

Taxation of the Sole Proprietorship: Transparency Principle and Retention Issue

Unlike corporations, a sole proprietorship is not a separate tax entity. Instead, the so-called transparency principle applies: the business’s profit is directly attributed to the owner and subject to their personal income tax. The progressive tax rate applies here: the higher the total profit, the higher the tax rate, which can reach up to 45% (plus solidarity surcharge and, if applicable, church tax).

A challenge in this context is the so-called retention issue: unlike corporations, the profits of a sole proprietorship cannot be indefinitely “parked” within the business. Although there is a tax exemption of €24,500 (§ 11 para. 1 sentence 3 no. 1 EStG), any amount above this is mandatorily taxed—even if the funds are needed for investments. Therefore, forward-looking profit planning is essential.

Business Cessation and Sale: Tax Consequences to Consider

A sole proprietorship ends either through cessation or sale. Both options have different tax consequences that must be taken into account.

In the case of business cessation, all hidden reserves are dissolved and taxed. This means the difference between the book value and the fair market value of business assets (e.g., machinery, real estate) is treated as a cessation gain and subject to income tax. This also applies to self-created intangible assets such as goodwill. Fortunately, there is a tax exemption of €45,000 for the cessation gain (§ 16 para. 4 EStG).

More advantageous is often the sale of the sole proprietorship as a whole. Special tax benefits apply here, such as the reduced tax rate under § 34 para. 3 EStG (56% of the average tax rate, max. 45%). However, this requires a business sale for consideration that meets certain criteria (e.g., essential business assets). Splitting the transaction into multiple asset deals is often disadvantageous from a tax perspective.

Practical Example: Sale of a Sole Proprietorship

Let’s assume owner A wants to sell her sole proprietorship, which she has operated for 10 years. The book value of the business assets is €500,000, and the fair market value is €1,000,000. A has additional income of €50,000. The buyer is willing to pay €800,000.

Option 1: Business Cessation

A ceases her business and sells the assets to the buyer. The cessation gain is:

Fair market value: €1,000,000

• Book value: €500,000
  = Cessation gain: €500,000

Taxes (simplified, excluding solidarity surcharge and church tax):

• Exemption under § 16 para. 4 EStG: €45,000
• Taxable amount: €455,000
• Income tax rate (progressive): 45%
• Tax burden: €204,750

A thus receives €800,000 sale proceeds minus €204,750 taxes, totaling €595,250.

Option 2: Business Sale

A sells her business as a whole. The capital gain is:

Sale proceeds: €800,000

• Book value: €500,000
  = Capital gain: €300,000

Taxes:

• Regular income: €50,000
• 56% of €300,000 = €168,000
• Income tax rate (progressive): 42%
• Tax burden: €70,560

A receives €800,000 sale proceeds minus €70,560 taxes, i.e., €729,440.

This example shows that selling the business as a whole can significantly reduce the tax burden. However, the requirements of § 34 EStG must be met, which calls for careful contract drafting.

Conclusion: Plan Early, Consult Experts

Taxation of a sole proprietorship presents many opportunities but also risks. Those who want to optimize their tax burden and maximize sale proceeds must plan early and set the right course. This includes smart profit planning, utilizing exemptions and tax benefits, and skillful contract structuring at exit.

Given the complexity of the subject, professional assistance is indispensable. Tax advisors and auditors can help develop the best individual strategy and avoid costly mistakes. This investment usually pays off quickly—not only financially but also through increased security and predictability. This way, sole proprietors can optimally monetize their life’s work and confidently embark on a new chapter.