For many founders and startups, setting up a small business is the first step toward self-employment. It offers a host of benefits compared to other business types, including exemption from some accounting regulations. In this article, we will explain what a small business is, what advantages and disadvantages it brings, and how to register one. We will also explore the difference between small business operators and small-scale entrepreneurs, and we’ll take a look at small businesses’ tax obligations.

What’s in this article?

• What is a small business?
  
• What is the difference between small business operators and small-scale entrepreneurs?
  
• What are the advantages of setting up a small business?
  
• What are the disadvantages of setting up a small business?
  
• How do you register a small business?
  
• What tax obligations apply to small businesses?
  

What is a small business?

A small business is a commercial entity that is particularly effective when starting a new venture. Small business operators are not classed as commercial businesses. This means they do not have to be entered in the Commercial Register, and they are not subject to the provisions of the German Commercial Code (HGB). As a result, some of the regulations and obligations that businesses must normally abide by do not apply. The legal wording of the HGB says a small business may be appropriate if “the type or scope of the business does not require a business operation set up in a commercial way” (Section 1 Paragraph 2 of the German Commercial Code). This means that if the business volume is relatively small, the administrative effort required to meet the provisions of the Commercial Code is not worth it—neither for the small business operator nor the tax office. All independent and entrepreneurial activities are considered to be a business. This includes industrial and handicraft businesses as well as most service providers. However, as a self-employed activity, a business is considered separate to freelance work.

A small business can only take one of two legal formations: a sole proprietorship or a partnership under civil law for two or three people (GbR). Both share a common characteristic—that they are easy to set up, and they can be started with modest financial resources. Therefore, they are well-suited as an “entry level” introduction to self-employment. All other legal formations are excluded for a small business, since they are only possible within the legal framework of the German Commercial Code.

A further important requirement for small businesses is the legally defined maximum annual income limit. These may not exceed €600,000 in sales and €60,000 in profits. Typical small businesses include examples such as family-run restaurants, ice cream parlors, or newsstands. Small businesses are often run by people who are self-employed on a part-time or seasonal basis, and therefore achieve lower sales.

What is the difference between small business operators and small scale entrepreneurs?

There is a clear difference between a small business operator and a small scale entrepreneur. The latter covers both traders and freelancers, as well as those working in agriculture and forestry. Small scale entrepreneurs may not exceed a turnover of €22,000 in the previous year or €50,000 in the current year. If these sales limits are not exceeded, the small scale entrepreneur rule applies, which exempts small scale entrepreneurs from having to pay value-added tax (VAT). However, small businesses can also use this rule if they also have a corresponding turnover.

The restriction on annual turnover for small businesses means that all small scale entrepreneurs who run a business are automatically considered to be small business operators. However, not all small business operators are automatically small scale entrepreneurs. This is only the case if you take advantage of the small scale entrepreneur rule. They are then exempt from paying VAT, which is generally not the case for small businesses. In summary, a small business is a legal formation, while small scale entrepreneurs are primarily discussed in the context of tax.

What are the advantages of setting up a small business?

Compared to other business structures, a small business offers a number of advantages: first, you can set up a small business informally and in a cost-effective way. You do not need any startup capital. In addition, a small business can also be run as a secondary activity—for example, in parallel with formal employment. In this case, the law restricts you to working a maximum of 20 hours per week on the secondary activity. The salary for your secondary activity must not exceed that of your primary employment. The background to this is that your secondary profession continues to be covered by the social insurance from your employer in your main job.

In addition, simplified accounting rules apply. As small businesses are not classified as merchants if they are not entered in the commercial register, they remain legally private individuals and are subject to the German Civil Code (BGB) rather than the German Commercial Code (HGB). As a result, they are not obliged to keep double-entry accounts if they generate less than €80,000 profit or €800,000 turnover per year—an income statement is sufficient. Small businesses that exceed these limits with their profit or turnover are obliged to use double-entry bookkeeping and prepare a balance sheet including a profit and loss statement.

Furthermore, there is no requirement to submit a preliminary VAT return if the annual tax payment does not exceed €1,000. In this case, the tax office will accept the annual VAT return. If the tax burden for the previous year is between €1,000 and €7,500, you must submit quarterly VAT returns. These are required retrospectively by the 10th calendar day of April, July, October, and January. If your annual tax burden exceeds €7,500, you must submit a monthly VAT return. This should be done on an advance basis by the 10th calendar day of the following month. Additionally, small businesses are not required to take inventory or publish their annual financial statements. Overall, these exemptions result in a significant time saving. Another advantage: small business operators do not have to pay unemployment and pension insurance contributions. However, health insurance remains mandatory.

The first payments to the relevant Chamber of Commerce and Industry (IHK) or Chamber of Crafts (HWK) can also be suspended in full for two years. It can remain partially suspended for a further two years, provided the small business’s annual profit is less than €25,000, and no income has been generated from other commercial enterprises, self-employment, agriculture, or forestry in the five years preceding the setup of the small business. In addition, you are always considered exempt from chamber contributions if your annual profit is less than €5,200 (see Section 3 of the IHK Act).

What are the disadvantages of setting up a small business?

Small business operators may consider it a disadvantage to be restricted in their choice of legal formation. As described above, a small business may only choose from sole proprietorship or a partnership. There are also legal requirements for business names: this must clearly indicate that the small business operator and their business are practically identical. Therefore, the business name must contain the small business operator’s personal first and last name. However, you can choose to add a fictitious name or descriptor—such as “John Smith Cocktail Bar.”

Due to their established legal formations, small business operators bear unlimited liability with their private assets. There is no way for a small business to limit this risk. Should you wish to do this, you must consider setting up a private limited company (GmbH), or limited liability company. A further financial disadvantage of a small business is that if there are high acquisition costs or investments, you cannot claim any input tax deduction.

Furthermore, you may find that potential business partners prefer to enter into business relationships with commercial businesses. Small businesses are not always considered equal. This can also reduce your chances of success with investors.

How do you register a small business?

You can register a small business with the relevant trade office. This can be done in person or online. The latter saves time, but it may not be possible in all cities and districts. The registration process for small businesses does not differ from any other form of business. There is no particular small business license or form for registering a small business. The small business operator must simply complete a “normal” business registration. According to the German Industrial Code (GewO), this must be done before business activities commence (Section 14 of the GewO).

Anyone starting a business as a team should also draw up a written partnership agreement (GbR-Vertrag) before business activities commence. This is strongly recommended, even though it is not required by law and the basic agreements are regulated by the German Civil Code. However, especially when considering personal liability, you are advised to make agreements that apply, for example, in situations of conflict, in the event of insolvency, or when the partnership is dissolved. You should also carefully consider whether to carry out accounting activities with or without the support of an advisor. Regardless of how you choose to handle your accounting, you must open a business bank account in order to separate private and business income.

After registering with the trade office and paying your fee—between €15 and €60, depending on the district—small business operators will receive a form for registering their small business for tax purposes. The small business operator must fill out this form, which is used in the next step to register the small business with the tax office.

You are obliged to register with the Chamber of Commerce or Chamber of Crafts, as small business operators must become members of one of those bodies. You are also obliged to register with the employers’ liability insurance association. However, you will only need to pay contributions here if your small business has employees. If this is the case, you must also request a company number from the employment agency, and register the employees with the respective health insurance companies.

Entry in the Commercial Register is not required, but it can be done voluntarily. However, as qualified businesses, small business operators are subject to all the rights and obligations of businesses.

What tax obligations apply to small businesses?

A small business brings convenience and exemptions, but small business operators must also take several tax obligations into account. First, small business operators are required to maintain robust accounts in accordance with general due diligence obligations. Among other things, this means that all business transactions taking place across the small businesses must be recorded. The type and size of the transactions must always be transparent. The influence of the transactions on the businesses’ general earnings and financial position must be clear at all times. In practice, this means that the business must retain all relevant documents and receipts for trade and taxes. You are advised to store incoming and outgoing invoices separately—either physically or digitally.

Profit is taxed as part of a small business operator’s income tax. On top of income tax, you must pay trade tax—this is the case for all traders. However, there is a tax allowance of €24,500. If you fall below this limit, your small business is exempt from paying trade tax. Provided that no small business rules are used, you must also pay VAT for the small business. However, you have the option of applying for cash-based taxation: this means that the VAT on customer invoices is only due once the customer has paid their invoice. If your small business employs workers, you must also register for and pay employment taxes. If you operate company vehicles, you will also need to pay vehicle tax.

For more information about starting a business or business accounting, visit the Stripe More resources portal. If you are looking for professional support for your financial processes, please contact our sales team.