When are Directors of a Limited Liability Companies “Employees”?
The idea that a director of a company could be a “dependent employee” is foreign to many shareholders. When audits are carried out by pension insurance institutes, many limited liability companies (Gesellschaften mit beschränkter Haftung, GmbHs) and their shareholding directors can be in for an expensive shock: if the pension insurance institute finds that the director is in fact a dependent employee and was subject to social security contributions, back payments for the past four years and (where intent is presumed) up to 30 years could be due, together with a penalty for late payment (1% of the amount in arrears for each month of late payment; § 24 Social Insurance Code IV (Sozialgesetzbuch, SGB)). The risk is a cost explosion, especially if the company and its directors have failed to adapt their shareholder and service agreements to the legal changes that have applied since 2012 and the changes to the audit practice of pension insurance institutes which was adopted in 2014.
In 2012, the Federal Social Court of Germany (Bundessozialgericht – BSG) handed down a judgment, which changed its position on shareholder-directors (BSG judgment of 29 August 2012 – Case No. B 12 KR 25/10 R; cited in juris). It was only in April 2014 that the umbrella organisations of the social security institutes adapted their audit practice. Since then, various judgments have further limited the possibility of using agreements in order to avoid directors being subject to social security obligations. The full force of these changes will be felt in audits in 2018. The following article, therefore, provides an overview of the social security obligations of directors of limited liability companies.
A distinction must be made between a director, who only holds a position on the executive board, while other directors or executive staff members handle daily business, and a director, who manages current operations and has concluded an appropriate employment or service agreement with the company for this purpose. The issue of social security obligations only arises in the latter case. This obligation is based on § 7 SGB IV, which requires a company to pay and deduct social security contributions where that director is in an employment relationship in which he is dependent on directives.
As far as the law on limited liability companies and the appointment of managing directors are concerned, the focus is on the ability of the general meeting of shareholders to issue directives.
A third-party director is employed, but does not hold any shares in the company. He is dependent on the directives issued by the general meeting of shareholders. The fact that a GmbH has an obligation to pay and deduct social security contributions for their third-party directors for health, nursing care, pension and unemployment insurance is undisputed. Where the maximum assessable earnings (so called "Beitragsbemessungsgrenze") are exceeded, the obligation to pay health and nursing insurance no longer applies, while the pension and unemployment insurance obligation remains. For the latter, the maximum assessable earnings only limit the amount of contributions to be paid, it does not exclude the obligation as such.
In comparison, the director, who also holds the majority of the shares in the company, is not a dependent employee – he holds a majority of the votes of the general meeting of shareholders and is not viewed as dependent on any directives that are issued. He is also not subject to the obligation to pay social security contributions.
The difficulty arises with respect to directors, who only have a minority shareholding in the company that they represent. If the wording of the contract indicates that it is an “employment contract”, an audit will normally come to the conclusion that there is an obligation to pay social security. Still, even a director, who has signed an independent service agreement, may still not be off the hook: regardless of the wording of the contract, the fact that a majority of the shareholders can issue directives, which the director must follow and implement, speaks in favour of a dependent employment relationship.
However, in practice, such control may not be exercised. Legally, the director’s approval may be required or an existing right may not be exercised for other reasons – such as due to considerations about the family situation or the director’s paramount knowledge and expertise ( so-called "mind and soul" of the company), which are essential for the operation of the business (e.g. the wife formally holds the shares, but does not have any real industry knowledge herself, while the husband, who is also the director, does have the knowledge).
For many years, the BSG has also recognised that non-legal circumstances, such as the “mind and soul” argument or family considerations, negate any need for the director to follow directives and, therefore, any obligation to pay social security contributions. Judgments in 2012 and 2015 put an end to such arguments: the BSG now takes the approach that legal barriers are the only thing capable of negating a dependency on directives. Any other approach would be inconsistent with the principle of predictability of the obligation of the GmbH to pay and deduct contributions. Paramount industry knowledge and expertise and family considerations are therefore insufficient grounds to avoid an obligation to pay social security contributions.
For a minority shareholder, this means that practically the only argument, which can negate any dependence on directives, is a legal restriction on the right to issue directives. The BSG takes a restrictive approach even in this respect, as the judgments from 2015 and 2016 reveal (BSG judgments of 11 November 2015 in case B 12 KR 10/04 and 29 June 2016 in case B 12 KR 5/14 – both cited in juris).
One typical such legal restriction is veto rights that are granted to minority shareholders under a shareholder agreement. When such rights give the shareholder-director the legal possibility, where he disagrees, to prevent the adoption of any directives on the type, location or substance of his activities, then such rights can negate the otherwise assumed dependence on directives. Accordingly, minority veto rights, which are limited to just a few subject matters, are insufficient.
The problem comes where the arrangements are not set out in the shareholder agreement, such as where veto rights over shareholder resolutions are instead provided for in the director’s employment contract. The BSG has criticised the fact that such rules can be terminated and therefore can be revoked at any time. This is not consistent with the principle of predictability of the obligation to pay contributions. The same applies to vote pooling agreements ("Stimmbindungsverträge").
Also trust agreements must at least be notarised; without notarisation they are irrelevant from a social security contributions law perspective. No rule without exception: In a judgment rendered in 2017, a shareholder had transferred his shares to his wife to hold in trust, and had been appointed director of the company. The trustee agreement allowed him to have significant influence over shareholder resolutions, but the agreement was not notarised. Thus, it could have been irrelevant according to what has been said above. Still, the state social court (Landessozialgericht – LSG) of Schleswig-Holstein held that there was not a dependent employment situation in this case as the trustee agreement was concluded before the company had been founded; at this point in time the form requirement of § 15(4) of the Limited Liability Companies Act (GmbH-Gesetz) had not yet been applicable (Judgement of 2 May 2017 in case Az L 5 KR 40/17 B ER, cited in juris). However, as a precaution, any such trust agreement should be notarised later on when the foundation of the GmbH has been formally completed, in order to ensure that the obligation to pay social security contributions can still be negated. This applies respectively to the case of a so-called Unternehmergesellschaft (UG, "Mini-GmbH").
The bottom line: Comprehensive veto rights for minority shareholders or voting agreements should be included in the shareholder agreement or should be notarised if these are to be used to negate the obligation on minority shareholders, who are also directors, to pay social security contributions. The (minority) shareholder-director should otherwise be registered with a social security insurance institution. To do nothing and rely instead on the fact that the company is managed by a director, who is also the “mind and soul” of the company, can result in a very rude awakening.
Retroactive social security contributions are generally due immediately and can be enforced at law, even where the audit notice is being contested and there are related on-going court proceedings. Only in exceptional cases is it possible to suspend both payment and enforcement through interim injunctions until the legal dispute has been resolved. If contributions have to be paid retroactively, they must also be considered retroactively in the director’s tax.
Where claims for payment are made by the authorities for the period prior to April 2014, when the social security insurance institutes issued their notice of the change of approach, and those claims rely instead on the changed jurisprudence of the BSG, an attempt should be made by the companies to invoke legitimate expectations before the authorities and courts. Before the change to the audit practice, the authorities had not raised any claims for contributions on the basis of the changed case law. Any retroactive claim stemming from the period before the issue of the notice of the changed approach in April 2014 therefore seems inappropriate. This issue is still controversial and is yet to be decided by the courts. An attempt to argue this position could at least reduce the amount of retroactive contributions as a result of negotiations with the social security insurance institutions.
To the extent that any past positive status assessments previously given by the authorities are available, these should also be presented to the auditing authorities and the social courts because auditing authorities must observe such assessments, as long as they have not formally been repealed.
If you have any questions related to this topic, please feel free to contact
Dr Roland Klein (Lawyer, Licensed Specialist for Labour Law).