Prefer to hand over difficult assignments and special projects to freelancers? It is often a good option to take advantage of the special knowledge and skills of flexible contractors. However, this approach poses a mostly underestimated risk for many companies: so-called ”false self-employment”. As a matter of fact, the proportion of cases in which false self-employment was identified by the DRV (German pension insurance) has doubled since 2007, despite an increase of 35% in audited cases (as of 2019). In most cases, high repayments are the consequence, which can significantly threaten the existence of both the client and the contractor.
Here we want to clarify how false self-employment is defined, what criteria constitute false self-employment, how the examination of the contractual relationship proceeds and what consequences await the client and contractor in the worst case - for you to always remain on the safe side!
In order to really understand false self-employment, basic terms such as employee, freelancer or employment relationship should be defined first.
Employee: While following given instructions, an employee is obligated to perform work in the service of another party in a personal dependency. These instructions may relate to the content, performance, time and place of the work. A person is bound by instructions if he or she is not essentially free to organize his or her activities and determine his or her working hours. However, the type of activity determines the actual extent of personal dependency.
Freelancer: A self-employed person (also freelancer, contractor, solopreneur) is first and foremost someone who is not permanently employed and can freely determine his or her own working hours. Self-employed persons are not subject to social security contributions and do not have a regular income, but various clients. They act in a self-determined manner and on their own responsibility.
Employment relationship: An employment relationship is a person-related continuing obligation between the always involved two parties: the employee and the employer. As a rule, the employment relationship is established by the signing of the employment contract. However, it can also occur when the employee joins the company, e.g. by starting work. In this case, an employment relationship would therefore exist even without a contract.
False self-employment refers to a relationship between a company (as client) and a freelancer who is defined as contractually self-employed, when in reality this relationship appears to be an employment between employer and employee due to the extent and nature of involving the freelancer in the company, work and directions exercised. As a result, the freelancer would actually be considered an employee subject to compulsory insurance within the meaning of Section 7 (4) of the Fourth Book of the German Social Code (SGB IV).
Seems like a freelancer, when it’s actually an employee!
This leads to the assumption that the state is deliberately deceived in order to save the employer's share of social security contributions and taxes when hiring an employee as freelancer.
In principle, there are no fixed criteria that confirm or refute false self-employment. It rather depends on the concurrence of various circumstances which indicate that the contractor is not self-employed, but rather a dependent employee. Three elements in particular play a special role here.
False self-employment can be expressed by the fact that the freelancer is bound by instructions, i.e. that they receive instructions from their client regarding the performance of work, which they must follow. This would contradict the main characteristics of a self-employed person which is the freedom of decision making in regard to the “how, when and what” of their work. Being bound by instructions could for example be the case if the contractor has to adhere to certain working hours or if the contractor's place of work is specified.
Caution should also be exercised in the case of increased operational integration, as an independent contractor should be clearly identified as an external party and not treated as a team member. For example, the use of the company's equipment, such as tools or digital devices, can strongly indicate false self-employment. A clear case, for example, may be when an employee continues to work for the old employer as a freelancer after the end of the employment relationship. Here, there is a high risk of false self-employment if the same activity is performed under the same circumstances as in the previous employment relationship (same desk, same e-mail address, etc.) The main difference would be: saving income taxes and social security contributions.
One of the decisive criteria for false self-employment is the personal and financial dependence of the allegedly self-employed person on the client. This is because an essential characteristic of a freelancer is that they bear their own entrepreneurial risk since their financial success is uncertain and independent from third parties. There is a particular risk of false self-employment if the freelancer works for only one client over a longer period of time and thus earns the majority of his turnover from the same client. Hence, they are not financially independent as the status of a self-employed person would provide.
A company audit can be conducted either by the tax office or by the German Pension Insurance (DRV), which audits at least once every 4 years. The tax office, on the other hand, checks all tax-relevant facts, usually in the form of an external audit.
If there is any doubt as to whether the freelance assignment is actually a dependent employment relationship, it is advisable to apply for a status determination.
But who carries out procedure and how does it work?
Both contracting parties can apply to the DRV for a status determination in order to obtain legal certainty about a self-employed activity or dependent employment according to § 7a para. 1 sentence 1 SGB IV, without the consent of the other party being necessary. Accordingly, it is sufficient if only one party submits the application. However, the application will only be processed if no other procedure to verify the obligation to insure has been initiated so far (e.g. by a pension insurance institution in the course of a company audit).
Our tip: It is advisable to file the request as early as possible or within one month, because if the request is filed in time, the obligation to insure does not arise until the DRV announces its decision on the existence of an employment relationship subject to insurance. In this way, you can minimize repayments of social security contributions in the event of a determination of false self-employment.
The application for status determination must be made in writing. On the one hand, the contractual agreements of the activity are checked, on the other hand, further details about the way in which the activity is carried out in the practice must be deposited. You can find the application form, as well as explanations and various necessary attachments here. After the written investigation has been completed, all parties involved must be heard by the DRV before a final decision can be issued. The average processing time is 80 days.
Note: It does not matter how the contract is named or what is regulated in it, if it can be proven that the relationship is in fact similar to employment under social security law.
Of course, it is advisable to draft the freelancer contract in a legally secure manner and to observe the above-mentioned criteria during the assignment.
If false self-employment is confirmed in a check by the DRV or tax authority, it’s not just the client who has to dig deep into his pockets, but the contractor also has to expect consequences that may threaten his livelihood.
From the point in time when false self-employment is established, the contractor is considered to be an employee who is entitled to all common employee rights and who is also subject to social insurance contributions. This means that the contractor is entitled to paid vacation of at least 20 days per year, sick pay and protection against dismissal in accordance with the Dismissal Protection Act (KSchG). In case of doubt, these rights can be sued for by the employee. Clear advantages so far: But on the other hand, the employment relationship also entails employee obligations for the "freshly hired" employee (formerly freelancer). In a nutshell, this means the payment of unpaid social security contributions. Although the employer must also pay for the employee contribution, this can be claimed by deducting it from the remuneration (from up to 3 wage or salary payments).
In addition, freelancers and contractors are often remunerated at a higher rate because, in contrast to employees, they are fully responsible for insurance, taxes and their entrepreneurial risk and are only paid for actual hours worked. If the remuneration received is higher than the usual wage of employees with comparable tasks, the false self-employed person must reimburse the difference between the remuneration received and the usual wage of comparable employees. This becomes particularly expensive if the hourly wage of the allegedly self-employed person is significantly higher than that of the employee.
Since all liability and payment obligations now apply to the client as they do to employers in relation to their dependent employees, repayments of social security contributions must be made retroactively for up to 4 years. In addition, late payment penalties will be charged if the application for status determination is not made within one month. In fact, the employer has a claim against the employee for half of the employee contribution to be paid by him, which, however, can only be made by deduction from the salary of up to 3 months' salary payments. If the employment relationship ceases to exist, the employer must pay the second share himself. Otherwise, the deduction can only be made after 3 months of wage-salary payments have been made, if the deduction has failed through no fault of the employer. In most cases, however, there is of course a contributory negligence on the part of the employer.
An employer has a legal obligation to the tax office to pay the wage tax due on wages to the tax office.
Therefore, if false self-employment is established, the tax office can claim back wage tax payments, which can be levied retroactively for up to 4 years. If a reckless tax evasion (i.e., a misdemeanor) is also determined, the period for repayments may be extended to five years.
As an employee, the allegedly self-employed person may not charge sales tax for his or her work services, since he or she is not an entrepreneur within the meaning of the UstG. Therefore, the employer would theoretically be entitled to reimbursement. However, since the employer as an entrepreneur has deducted from his own VAT liability to the tax office the VAT invoiced by the employee at the time as a freelancer (so-called input tax), this claim does not apply. Thus, in the case of false self-employment, the employer would actually have had to pay more VAT to the tax office, which is why the input tax deduction must be corrected and repaid.
But anyone who thinks that the consequences of false self-employment are limited to financial benefits is sorely mistaken.
Because in the case of intent on the part of the employer, there is also tax evasion, which may not only extend the limitation period to ten years, but can also entail fines, prison sentences and demands for repayment until the criminal act becomes time-barred. Apart from this, anyone who, as an employer, "withholds" an employee's social security contributions from the health insurance fund is liable to prosecution. Employer representatives (i.e. managing directors) may thus even be personally liable for failure to pay the employee's share of the social contribution. If found guilty, the employer representative must expect heavy fines or a prison sentence of up to 5 years.
Since the alleged freelancer is considered an employee if false self-employment is established, they are entitled to all the rights which employees are entitled to: Vacation entitlement, continued payment of remuneration in the event of illness and protection against dismissal. If these circumstances are not resolved by mutual agreement as a result of the status determination, the employer is threatened with a lawsuit and associated legal costs.
It is true that working with freelancers and solopreneurs (self-employed) brings many advantages, as it provides the client with the necessary flexibility and specialized expert knowledge for specific projects. But is this really worth the serious risk of false self-employment? Because supposedly legally secure contractual conditions can be deceptive, since ultimately the practised reality decides who is really self-employed or only pretending to be so. Caution and consistency are always necessary when drawing up freelance contracts and handling them operationally. This is the only way to prevent false self-employment in the long run.
Bonus tip: Don't worry if you still wonder which factors in your company put you at risk of false self-employment. Our practical Freelancer Check gives you a quick and easy first indication of your risk and provides you with best practices and recommendations on how to minimize it in the long run. You can find more information here.
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