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Gift tax in the case of a partner’s financial settlement that is “below fair value”

Partnership agreements frequently contain provisions that provide for financial settlements for outgoing partners that sometimes fall significantly below the actual value of the ownership stake. There can be a variety of reasons for this, for example, a temporary ownership stake in a company for the management without having to finance a high acquisition price and, accordingly, without having to remunerate any hidden reserves for the subsequent departure (the so-called “manager model” or “naked-in/naked-out“). The gift tax treatment can cause problems here.

Permissibility of restrictions on financial settlements

In principle, restrictions on financial settlements are permissible within certain limits, in particular, both with regard to the payment modalities (paying in instalments over several years) as well as with regard to the amount of the settlement. The general principle of good faith establishes the framework. In case law especially, the reasoning is based on whether or not a partner’s right of termination is unduly limited by the restrictions on financial settlements. The manager model has already basically been approved by the Federal Court of Justice.

Problem – A notional gift

The point of reference for the tax problem is the requirement in Section 7(7) of the Inheritance Tax Act (Erbschaftsteuergesetz, ErbStG). According to that, if, in the course of an exit, the ownership stake is transferred to the company or the other partners and the outgoing party receives a financial settlement that is below the assessed value for tax purposes of the ownership stake then this would be deemed to constitute a gift. In that case, it would be assumed that the outgoing party had made a donation to the remaining partners. As the assessed values for tax purposes of ownership stakes now largely approximate market values the legal fiction of gifting could come into play relatively quickly.

However, you should bear in mind that, even in such cases, the exemption provisions for business assets will apply insofar as the respective conditions have been satisfied and the relevant aggregate wage levels and holding periods have been complied with.

Moreover, contractual transfers – thus, the sale of an ownership stake to the remaining partners or the company – are not covered by the concept of a notional gift. In this case, if the purchase price is below the assessed value for tax purposes then, even under the general regulations, it basically cannot be assumed that a donation was made, at any rate, if the contractual parties are not related to each other.

Exception – The manager model

According to the prevailing opinion in the literature, if, upon joining a company, it is known that the stake is supposed to be available only for the period of active work and that, upon departure, solely the acquisition price would ultimately be reimbursed then there would be no gifting within the meaning of Section 7(7) ErbStG. This requirement, in accordance with its intention and purpose, has to be restrictively interpreted as meaning that such cases may not be covered where, from the outset, no regrouping of assets has been planned.

However, the supreme court has not yet confirmed this view. Even the most recent Federal Fiscal Court (Bundesfinanzhof, BFH) ruling from 6.5.2020 (case reference: II R 34/17) on the manager model has not provided any certainty here. In the case in question, the stake of the outgoing party was sold at its nominal value to a trustee. The latter was holding the stake for the remaining partners until such time as a new joiner would in turn acquire the stake at the nominal value. In this case, the court rejected the notion that the remaining partners were liable to pay gift tax because,

  • firstly, it was not the remaining partners who had acquired the stake but instead the trustee. Therefore, what matters for Inheritance and Gift Tax law is ownership under civil law and not beneficial ownership; and,
  • secondly, a purchase price was paid on the basis of a purchase agreement and not a financial settlement based on a partnership agreement.

Outcome: Admittedly, the basic applicability of the concept of a notional gift in cases of the manager model thus still remains open. By the same token, in the specific case, it has now been clearly established that it had been possible to avoid the gift tax problem through a trustee arrangement.

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