Business Split

What is a business split?

Business split (German: Betriebsaufspaltung) refers in tax law to the division of an economically unified business between an asset-holding company (Besitzunternehmen) and an operating company (Betriebsunternehmen) that are controlled by the same person or group of persons. The asset-holding company, often the founder personally, holds an important asset such as a plot of land or a patent and makes it available for use to the operating company, usually a GmbH (German limited liability company). If the asset is essential for the business, the letting no longer counts for tax purposes as private asset management but as a trade or business.

The classic case is the entrepreneur who holds land privately and lets it to their GmbH. In technology companies, it also occurs when founders personally hold patents, software or trademarks and make them available to the GmbH for use. It usually becomes significant on changes of structure: in the funding round, on a sale, in business succession and in due diligence.

Requirements of a business split

Material interdependence

The asset made available must be an essential operating asset (wesentliche Betriebsgrundlage) for the operating company, that is, economically indispensable for the business. For land, case law holds it sufficient that it is of particular weight to the business in terms of space and function. This regularly applies to office buildings in which the business activity takes place. Intangible assets such as patents, software or trademarks can likewise be essential operating assets if the business rests on them. Payment is not decisive: even a free provision to an operating GmbH can suffice, because case law then sees the intention to make a profit in the expected distributions.

Personal interdependence

The same person or group of persons must be able to impose its will in both companies. As a rule, this means the majority of voting rights both in the operating GmbH and in the asset-holding company. If the articles of association of an asset-holding company require unanimity and a shareholder who does not hold shares in the operating company participates there, personal interdependence can be missing. If both requirements are met, the business split exists without any application or intention being required.

Forms of business split

• Genuine and non-genuine business split: In the genuine form, an existing business is divided, for example a sole proprietorship whose operations pass to a new GmbH while the land stays with the owner. In the non-genuine form, both companies arise separately, for example if a shareholder later acquires a building and lets it to their GmbH. For tax purposes, both are treated alike.
• Co-entrepreneurial business split: The asset-holding and operating companies are partnerships, for example a letting civil-law partnership (GbR) and an operating limited partnership (KG).
• Corporate business split: The asset-holding company is a corporation, for example a founder's holding GmbH that lets land to the operating GmbH and directly holds the majority in it.
• Reverse business split: A corporation as asset-holding company makes an essential operating asset available to a partnership by which it is controlled.

The trade tax consequences of the corporate and the reverse form continue to occupy the courts to this day and in any case belong in the tax review.

Tax consequences of a business split

The asset-holding company earns income from a trade or business instead of from letting and leasing and is subject to trade tax (a type of income tax). If the owner of the asset-holding company is a natural person, trade tax is credited in whole or in part against their income tax under Section 35 of the German Income Tax Act (Einkommensteuergesetz, EStG). The asset made available becomes business assets. The same applies to the shares in the operating GmbH; they belong to the necessary business assets of the asset-holding company. Increases in value of both items thus remain captured for tax purposes (tax-entangled). Unlike with private assets, land held as business assets cannot be sold free of tax even after ten years.

Dividends of the operating GmbH fall at the asset-holding company under the partial-income method instead of the flat-rate withholding tax. The rent must withstand an arm's-length test: an excessive rent leads to a hidden profit distribution at the GmbH, a rent that is too low restricts the deduction of expenses at the asset-holding company. Between the GmbH and its controlling shareholder, the tax office recognises the lease only if it was clearly agreed in advance and is actually performed.

Termination and hidden reserves

The business split ends if one of the two requirements ceases to apply: the tenancy ends, the land is sold, or the controlling person loses the majority of votes in one of the two companies. Typical triggers are the sale of the shares, a gift to relatives, an inheritance and dilution in a capital increase.

If the interdependence falls away, the asset-holding company is generally regarded as discontinued. All assets of the business assets are deemed transferred to private assets at fair market value. The hidden reserves of the land and those of the shares in the operating GmbH are then taxed, even though no proceeds flow. Structures such as contributing the assets to a commercially structured partnership can preserve the status as business assets. They must be implemented before the interdependence falls away and have their own requirements and consequences.

Liability and insolvency

One motive for the separation is to keep the land out of the liability pool of the operating GmbH. This protection is limited. If the land serves as collateral for loans of the GmbH or the shareholder has given a guarantee, it is still economically liable. The insolvency administrator can continue to use an object that a shareholder has made available to the company for up to one year from the opening of proceedings under Section 135(3) of the German Insolvency Code (Insolvenzordnung, InsO). The prerequisite is that the object is of considerable importance for continuing the business; the shareholder receives compensation for this.

Worked example: a business split ends through a Series A

Simplified example without solidarity surcharge and tax-rate reductions: A founder holds 60% in a software GmbH, acquisition cost EUR 15,000, and lets it an office building of their own. A business split exists; the building is carried at EUR 400,000, its fair market value is EUR 1.2 million. In a Series A, investors subscribe new shares for EUR 5 million at a pre-money valuation (company value before the payment) of EUR 15 million. The value of the shares is derived simply from the round valuation, preferential rights of the investors remain disregarded.

• Post-money valuation: 15 plus 5 = EUR 20 million; investors' stake 5 / 20 = 25%
• Founder's stake after the round: 60% × 75% = 45%; the founder loses the majority, the business split ends
• Hidden reserves in the building: 1,200,000 minus 400,000 = EUR 800,000, fully taxable
• Value of the shares: 45% × EUR 20 million = EUR 9 million; hidden reserves 9,000,000 minus 15,000 = EUR 8,985,000, of which 60% taxable = EUR 5,391,000
• Taxable discontinuation gain: 800,000 plus 5,391,000 = EUR 6,191,000
• Income tax at a simplified 45%: 6,191,000 × 45% = EUR 2,785,950

Nothing flows to the founder from the round; the company receives the capital. The taxed value does increase the acquisition cost of the shares for a later sale. The tax of around EUR 2.8 million is, however, payable immediately, although no proceeds flow. Without a structuring before the round, the founder must raise it from other funds.

Distinctions: business split, holding and sale and leaseback

• Holding structure: links companies through shareholdings. In a business split, the link arises from making an asset available and from controlling both sides.
• Sale and leaseback: sale of an asset to an unrelated third party with subsequent lease back. For lack of personal interdependence, no business split arises.
• Private asset management: the normal case of letting without interdependence. The rents are income from letting and leasing without trade tax, and land can be sold free of tax after a holding period of ten years.

Common mistakes

• Unnoticed creation. Founders let office space or license rights to their own GmbH without knowing the tax consequence.
• Termination through the funding round. A capital increase through which founders lose their majority is resolved without checking the business split.
• Rights left with the founder. Patents, software or trademarks in the founder's private assets create a tax risk; investors require their transfer to the company anyway.
• Inappropriate rent. Deviations from the arm's-length test lead to hidden profit distributions or reduced deductions.
• Liability protection overestimated. Land charges, guarantees and the insolvency administrator's right of use weaken the separation of assets and business.

Frequently asked questions

Is the business split regulated by law?

No. It rests on the case law of the Federal Fiscal Court (Bundesfinanzhof), which classifies the letting as commercial via Section 15 EStG; this legal concept has been recognised for tax purposes for decades. Individual provisions presuppose it without defining it.

Can a business split also arise without real estate?

Yes. Patents, software, trademarks or other rights can also be essential operating assets if the GmbH's business rests on them.

How can a business split be avoided?

By one of the two interdependences being absent. The GmbH can acquire the asset itself, or the land belongs to a spouse who does not hold shares in the GmbH; shares of spouses are not simply aggregated for tax purposes. Both routes change who owns the asset and for whose debts it is liable.

What happens on the sale of the operating GmbH?

With the transfer of the shares, personal interdependence falls away, and the asset-holding company is regarded as discontinued. In addition to the disposal gain on the shares, the hidden reserves of the land that continues to be let are taxed.

Does every funding round end the business split?

No, only a round after which the controlling person or group of persons no longer has a majority of votes. Where this limit lies can be calculated in advance from the planning of the shareholdings.

Can the disclosure of hidden reserves before a funding round be avoided?

Often yes, if structuring is done in good time. A common route is the transfer of the assets to a commercially structured partnership, such as a GmbH & Co. KG, before the majority is lost. Which structure fits and what consequences it has is clarified in advance by the tax adviser.

The Roemer Capital view

Early in a mandate, we ask which assets the company uses that do not belong to it: the founders' office space, rights in software or trademarks, vehicles. Whether a business split follows from this is assessed by the client's tax adviser. We make sure that the question is asked before the round and not after the notary appointment.

In addition, we show in the cap table after which round the founders lose their majority. This leaves time to implement a structure before a capital increase or a sale triggers the disclosure of hidden reserves.