Taxation of Associations and Directors' Liability

Associations are often active in the field of sports, culture and the social sector and, as a result, they make an important contribution to the general good. The tax system takes account of this fact by granting non-profit associations tax benefits because of their objectives being worthy of support. However, the status of an association with tax privileges depends on a series of formal and material preconditions to be fulfilled by the respective association.

Frequently, this causes difficulties for the responsible parties (usually the association's board of directors), in particular, because there is often a fluid boundary between an activity with tax privileges and an activity subject to taxation. In this context, we as attorneys and tax advisers frequently experience the situation that, for understandable reasons, the directors lack problem awareness. This is dangerous because while ignorance might protect you against punishment it does not protect you against a personal liability claim by the tax office or other creditors against the members of the board of directors.

Taxation of associations: In terms of tax liability, the board of directors of an association has the same liability as a managing director of a limited liability company.

As a result, the responsible directors must be particularly cautious: In case of violations of tax obligations, the directors might be personally liable with their private assets. In case of violations of tax obligations, the directors might be personally liable with their private assets. In deviation from a - probably - common perception, in case of a liability the members of the board of directors cannot be released from their liability on account of the fact that they have taken over the work on the board of directors in an honorary capacity and free of charge. In deviation from a - probably - common perception, in case of a liability the members of the board of directors cannot be released from their liability on account of the fact that they have taken over the work on the board of directors in an honorary capacity and free of charge. Moreover, the law restricting the liability of chairmen of associations working in an honorary capacity which has been adopted recently (German Federal Gazette 2009, 3161) does not change the liability in the field of taxation legislation since this only refers to liability according to civil law.

Below, as lawyers, tax advisers and tax law experts, we report from our day-to-day expertise on the principles applicable to the taxation of associations, in which tax obligations concern the boards of associations, when a personal liability of the board of directors might be triggered and, finally, how the personal liability of the board of directors can be restricted.

Which principles apply with regard to the taxation of associations?

Associations are entities under private law (art. 21 ff. German Civil Code). As such, they are subject to corporation tax, trade tax and sales tax, etc. on principle. Exceptions for corporation tax and trade tax depend on whether or not the association in question is tax-privileged. Which preconditions must be fulfilled for the recognition of the tax relief in detail is provided for in the so-called non-profit tax law, art. 51 ff. of the German Fiscal Code (AO).

Object worthy of support - charitable or benevolent or religious

According to this the association must exclusively and directly pursue a charitable, benevolent or religious objective. The law specifies in art. 52 to 54 AP how exactly these specified objects are defined.

According to this, a charitable object applies if the activity of the association is intended to "selflessly benefit the public in a material, spiritual or moral field". For example, this includes supporting science and research, promoting arts and culture, supporting sports as well as cultural traditions, such as e.g. a carnival.

Benevolent objects are fulfilled if the activity of the association is intended to selflessly support people in need of particular help either in a personal or a financial respect. Based on this definition, benevolent objects can e.g. include the care of and support for ill, aged or handicapped people, the care of addicts and the establishment of a telephone help line.

Finally, church objectives are valid if a religious community which is a body under public law is supported selflessly. According to the case law, this e.g. includes the organisation of church conferences, training of clerics in theological colleges or the promotion of mission work - even if such is performed abroad.

Mandatory requirements for the on-going business management: Selflessness - exclusiveness - directness

In order to satisfy the objectives and intention of the non-profit law, the law, however, stipulates a number of further conditions which need to be fulfilled to permit recognition of the tax-privileged status.

According to the principle of selflessness established in art. 55 AO, own financial purposes and, in particular, commercial or other income-generating purposes must not be pursued first and foremost. Notice should be taken here of the fact that commercial viability is not banned in general. It must, however, not take centre stage. Any incidental commercial activity, such as, for example, the sale of sports items during an event or the operation of an association restaurant, as such does not cause the tax-privileged status to lapse.

The principle of selflessness also includes the obligation to use funds promptly. According to this, the tax-privileged association is obliged to use its funds promptly for the tax-privileged purposes, i.e. usually within the next two calendar years. However, there are exceptions to the principle of the prompt use of funds (art. 62 AO). Reserves are permitted under certain preconditions. Moreover, many donations are exempt from the principle of the prompt use of funds.

In addition, care has to be taken to ensure that the tax-privileged purpose is pursued exclusively (art. 56 AO) and directly (art. 57 AO). Exclusiveness applies if the promotion of the tax-privileged purpose is not only one objective among others but the main aim of the association. As has already been mentioned above, a tax-privileged association may also operate commercially provided this activity remains incidental. The principle of directness on the other hand is complied with if the tax-privileged purpose is pursued by the association itself in principle. In this case too, the law permits assistants to be called in

This mandatory principles (selflessness - exclusiveness - directness) must be complied with by the management. In this context, management includes all activities and steps which have to be attributed to the association. In order to furnish proof of proper business management, the board of directors has to keep corresponding records. For example, because of the requirement of the prompt use of funds, the board of directors has to keep a so-called "use-of-funds statement". This statement is to indicate which funds are used for which purposes. With the help of this documentation the tax office can establish that funds have not been misused or that funds have not accumulated - as this is not permitted.

Establishment of the principles in the articles of association

In addition, the law establishes requirements regarding the content (art. 59 AO) and form (art. 60 AO) of the articles of association. According to these, the articles of association must indicate "which purpose the entity pursues, that this purpose complies with the requirements of art. 52 to 55 and that it is pursued exclusively and directly" (art. 59 AO). In addition, the purpose of the articles of association must be specified with such precision that an examination whether the preconditions for tax privileges as per the articles of association are fulfilled (art. 60 para. 1 AO) is possible.

In principle, the purpose of the articles of association and the supported group of persons should be specified in as much detail as possible, for example, according to a case law example, the term "blind persons" should be selected instead of "in particular blind persons".

Moreover, the fact that since 2009 the articles of association must include the specifications of the sample articles of association (annex 1 to AO) - at least in terms of their contents - as a matter of necessity has to be taken into account; with a literal adoption of these specifications not being required according to case law.

Particular care has to be employed in the wording of the articles of association since they constitute the precondition for granting of tax privileges. If the articles of association do not comply or no longer comply with the statutory requirements, e.g. after an amendment, the non-profit status might be denied for the assessment period concerned. As a result of this, the association might face unforeseen tax claims which can perhaps not be paid from the current resources under certain circumstances. Therefore, it is recommend that you call in a lawyer/tax law expert/tax adviser upon the new establishment of an association or in the event of amendments of the articles of association to ensure that the requirements of the non-profit law are complied with.

Determination of tax exemption

The law does not provide for a separate procedure in which the status of a tax-privileged association is granted. The decision on tax exemption is increasingly taken individually in every assessment procedure for the respective tax. For example, in the year 01 the decision is taken whether the association is granted non-profit status as a corporation and whether, as a result, it is exempt from tax under the corporation tax assessment for 01.

In order to give tax-privileged corporations clarity on their legal position and their status, a separate procedure was introduced in art. 60a AO with the German Law strengthening honorary positions in 2013. This procedure permits the binding specification that the articles of association comply with the statutory requirements. However, the fact that the procedure only refers to the articles of association instead of the question of whether the association is really managed in accordance with the articles of association has to be taken into account. As a result, the procedure according to art. 60a AI does not replace the confirmation of tax exemption as such. As has been outlined, this is effected with the help of the respective annual tax assessment.

Implications of the recognition of the tax-privileged status - or the four spheres of income in tax-privileged associations and their taxation

If the association was recognised as a non-profit - and hence tax-privileged - association, it is exempt from the payment of a large number of taxes (corporation tax, trade tax and land tax, etc.) on principle Under certain conditions, however, a tax liability might be applicable again. This might be the case, in particular, if the association operates commercially.

For this reason, the income of tax-privileged associations are divided into four different income spheres:

The first sphere of income comprises the non-material field of work. Revenue from those activities which are directly intended to fulfil the tax-privileged objective are allocated to the non-material field of work. This e.g. comprises membership fees, donations or other grants. Revenues from this field are tax-free.

The second sphere of income comprises the field of asset management. This applies if assets are used, if e.g. capital assets are invested at interest or if real estate is let or leased out (art. 14 sentence 3 AO). As a result, income from this field can include: Rents, lease payments, interest and dividends. Again, income from this field is not subject to tax liability.

The third income sphere concerns the field of the commercial activities of an association. If the association generates revenue from commercial activities, it loses "the tax privilege for the taxation bases to be allocated to the business operations in as far as the commercial business operations do not constitute a special-purpose operation within the meaning of art. 65 to 68 AO" in accordance with art. 64 AO. As a result, we have to differentiate between tax-liable commercial business operations and the tax-free special-purpose operation.

The question of when a special-purpose operation applies is settled in art. 65 ff. AO. In principle, three preconditions have to be fulfilled for the assumption of a special-purpose operation. First of all the commercial operation must serve the purpose of the fulfilment of the tax-privileged purposes. Secondly the attainment of the purposes as per the articles of association must be impossible without the respective activity in question. Thirdly this activity must not excessively compete with tax-liable companies - the so-called "competition clause". According to this, the following e.g. have to be classified as special-purpose operations: Carnival sessions of associations promoting cultural traditions or the sale of products manufactured at sheltered workshops. However, serving of beer in a beer tent in the framework of an association anniversary does not constitute a special-purpose operation according to case-law.

If the association generates income or other commercial benefits through its activities and if these activities cannot be allocated to any special-purpose operation, the association loses its tax privilege with regard to such income. As a result, this income is liable to tax and, hence, subject to corporation, trade or property tax. The latter, however, applies subject to the exemption limit specified in art. 64 para. 3 AO of EUR 35,000.00 (gross, i.e. including sales tax). If this exemption limit is exceeded, the entire amount (i.e. from EUR 35,001.00) is subject to taxation. This means that this amount is not a tax-free allowance. Of course, this does not affect tax-free allowances of any kind, such as e.g. the tax-free allowance of EUR 5,000.00 regarding corporation tax (Kst.) and trade tax (GewSt.) according to art. 11 para. 1 no. 2 KSTG [German Corporation Tax Act] in conjunction with art. 3 no. 6 GewStG [German Trade Tax Act].

Taxation of associations: sales tax and payroll tax 

In contrast to the tax exemptions from income taxes, the association regularly has to pay sales tax for the services provided by it. Even though individual exemptions might apply under strict preconditions, the association usually has to state and pay sales tax. Under certain circumstances this also applies in the so-called non-material field.

In many cases, however, the reduced tax rate of 7% applies to services by the association (art. 12 para. 2 UStG [Sales Tax Act]). However, special care is necessary with regard to this since the preconditions for granting of the reduced tax rate are increasingly construed narrowly on account of their incompatibility with higher ranking European law so that in the applicable jurisdiction services from the fields of asset management and special-purpose operations were partly assigned the full tax rate (art. 12 para. 1 UStG). For example, the Federal Fiscal Court decided that "accommodation and catering services which a non-profit association provides in connection with tax-free seminars are not subject to the reduced tax rate". Therefore, in case of uncertainties regarding the correct sales tax treatment of services offered, it is urgently recommended that you consult with a lawyer/tax law expert/tax adviser to avoid any subsequent payments - which can be very dangerous financially.

In the framework of sales tax, the question of input tax deduction also arises regularly. The tax offices often use this aspect as one of the focuses of their audit, in particular, if the sales tax returns show input tax rebate claims. Since, in principle, the right to deduct input tax depends on whether or not the services of the association are subject to a tax liability, this can also lead to uncertainty in terms of liability which can be resolved with the help of a lawyer/tax law expert/tax adviser.

If the association employs employees, the non-profit association like any other employer has to withhold and pay over income tax in accordance with art. 38 para. 1, 1a para.1 EStG [German Income Tax Act]. In this context, care has to be taken to ensure that the prescribed form and the deadlines prescribed by law are complied with.

Board of directors of the association: Tax responsibilities and personal liability

Which concrete tax obligations does the board of directors of an association have and when is this personal liability triggered?

Legal entities operate through their bodies and are represented by these. For this reason, the tax obligations concern the members of the board of directors as bodies of the association (art. 34 AO). These obligations are comprehensive and include accounting, recording, tax declaration, information, presentation, tax withholding and payment obligations. In addition, the board of directors shall ensure that the taxes which the association owes are paid fully and in due time from the available resources. 

If the available resources are not sufficient to pay all tax liabilities in due time, the following principles apply: Withholding taxes, such as e.g. income tax, have to be paid as a matter of priority. In case of doubt, the association is obliged to reduce the net wages in order to be able to pay the corresponding wage tax. In other types of tax, the principle of proportionate repayment applies. According to this, the association has to repay the liabilities to the tax office to the same extent to which it pays other liabilities.

If the board of directors violates one of the obligations listed above, it is liable pursuant to art. 69 AO "in as far as claims under the tax liability are not assessed or fulfilled or in as far as such are not assessed or fulfilled in due time or in as far as tax rebates or tax reimbursements are not paid without a legal reason as a result of this". So, if the board of directors does not submit a tax assessment or if it submits such an assessment too late or if it does not pay tax liabilities which have fallen due, the liability specified in art. 69 AO regarding premeditation or gross negligence might apply.

In this context, a premeditated violation of obligations applies if the board of directors is aware of the tax responsibilities and if it intends to violate these or, at least, knowingly accepts the violation of such. Moreover, whosoever neglects the duty of care which he or she is obliged to and capable of based on his/her personal knowledge and skills and under consideration of the concrete circumstances to an unusually high degree.

A subjective standard of care is applied so that in principle the subjective skills of the respective member of the management board matter here. However, we cannot draw the conclusion from this that ignorance or incapacity relieves directors of responsibility. In its settled case law, the Federal Finance Court uses a particularly strict standard of liability. The board of directors cannot invoke its own incapacity or ignorance with regard to the execution of its tasks. If it does not feel able to cope with the task, the case law requires the board of directors to refrain from taking such an office or to resign from such. To make sure such a situation does not arise it is advantageous if the management board has the required knowledge under tax legislation. In case of doubt the expert advice of a lawyer/tax law expert/tax adviser should be sought in any case.

If the preconditions of art. 69 AO are fulfilled, the board of directors is fully liable with its private assets. The tax authority can enforce its claim by issuing a liability statement according to art. 191 para. 1 sentence 1 AO. On this basis, action can be taken against the member of the board of directors concerned without requiring a prior unsuccessful enforcement into the assets of the association.

What options are there limiting the personal liability of the board of directors?

According to the current status of the case law, a complete exclusion of the liability risk of the management board is not possible, which contributes to the particular significance and urgency of this issue for the parties concerned. However, there are various options intended to, at least, limit the liability risk.

Distribution of responsibilities

If the board of directors consists of several members, the principle of overall responsibility shall apply first. This means that all members of the board of directors are, in principle, responsible for all matters of the association - including the tax liabilities. If there is a violation of obligations within the meaning of art. 69 AO, all members of the board of directors shall automatically be liable.

This comprehensive liability of the members of the board of directors can be limited by an effective distribution of responsibilities. According to the case law, a clear and written agreement regarding the distribution of responsibilities entered into in advance and which specified precisely which member is in charge of which field is required. In such an agreement, the compliance with the association's tax obligations can be transferred to a member of the management board with the consequence that, in principle, only this specific member is liable for violations of duties.

However, such an agreement does not completely free the other members of the management board from their responsibility. They still have to ensure that the fulfilment of the tax tasks is transferred to a competent member. In addition, the responsibility for ensuring that the association is adequately organised and that the person who was entrusted with the task is supervised sufficiently also continues to apply.

Establishment of a voluntary self-monitoring system ("compliance system")

In addition, the liability risk can largely be minimised by setting up a voluntary monitoring system. For example, the execution of regular random sampling with the help of a lawyer/tax law expert/tax adviser is recommended in order to exclude violations of obligations in particular in liability-sensitive fields.

Resignation

Since, in principle, the liability according to art. 69, 34 AO only extends to violations of obligations which occurred during the term of office, a resignation as an "immediate measure in crisis situations" offers the possibility to, at least, restrict liability for the future.

Prior coordination with the tax authority

Moreover, it is recommended that the articles of association, amendments of the articles of association, essential contract designations and fundamental design projects be coordinated with the tax administration. This can be achieved either through non-binding statements or through a request for a legally binding statement of the requirements regarding the articles of association in accordance with art. 60 a AO. In this context, the fiscal authority checks whether the articles of association comply with the statutory requirements regarding the non-profit status and that entails, in particular, ascertaining whether the association really pursues a tax-privileged objective and whether the articles of association are properly designed in this respect. This statement can lead to more legal certainty. However, this finding does not replace the tax assessment rendered every year. Only the tax assessment provides final information on whether or not the association was considered as being tax privileged during the assessment period.

Liability insurance/ D&O insurance

Furthermore, the liability risk can also be reduced by taking out a corresponding insurance. In the literature, reference is frequently made to the so-called D&O insurance (directors and officers insurance) in this respect. This is a special financial liability insurance policy taken out by companies for their bodies. In practice, this insurance is often taken out for corporate bodies of joint-stock companies or limited liability companies. In principle, however, it can also be considered in the field of directors liability. Since the insurance premiums are usually relatively high, these insurances are frequently only taken out in particularly liability-prone cases in practice.

Which penal law consequences might arise in case of violations of obligations?

Associations are subject to taxation like other legal entities. If the tax obligations of the association are not fulfilled (in due time) or if these are only fulfilled incompletely, this also has (criminal) tax law consequences, in particular, in the event if a tax is not assessed or in the event that a tax is assessed too low (art. 369, 370, 378 AO). Since there is no corporate or association criminal law in Germany, the investigation measures of the tax investigation department and the tax offices concern the respectively responsible directors personally. This means if the board of directors acts grossly negligently or even with premeditation in the violation of the association's tax obligations, it is not only liable with the assets for the damage caused. In addition to this, the board of directors can and will be sentenced to a corresponding fine or term of imprisonment.

Voluntary self-disclosure in tax matters as a way out

If a director finds out that the tax obligations are not fulfilled properly or have not been fulfilled properly by one of his predecessors in the past, he or she has the option of voluntary self-disclosure to avoid penalty. This should definitely also be prepared together with a lawyer specialising in this field/tax law expert/tax adviser in order not to jeopardise the immunity from prosecution.