Contracts Between Close Relatives: Tax Recognition and Key Considerations

Contracts within the family are a proven means of tax planning. Whether it's a rental agreement with a child attending university, a loan to a brother, or an employment relationship with a spouse – such agreements can be recognized for tax purposes and lead to significant savings within the family unit. However, the tax office scrutinizes these arrangements particularly critically. Those who know and follow the rules are on the safe side.

Who is considered a close relative?

The Fiscal Code (AO) includes the following as close relatives: spouses, registered partners, and fiancés; relatives and in-laws in a direct line such as children, grandchildren, and grandparents; siblings and half-siblings; children of siblings (nephews and nieces); spouses of siblings and siblings of spouses (brothers-in-law and sisters-in-law); uncles and aunts as well as foster parents and foster children.

The principles also apply to separated or divorced spouses, provided there are no indications of conflicting interests – for example, if hidden maintenance is provided through excessive payments. Similarly, agreements between a partnership and the relatives of a controlling partner are examined accordingly.

The Basic Principle: The Arm's Length Comparison

The central criterion for examining all contracts between close relatives is the so-called arm's length comparison. It requires that both the content and the actual execution of an agreement correspond to what unrelated third parties would agree under comparable circumstances – and this must be the case throughout the entire contract duration.

The tax office only recognizes a contract if three conditions are met: The contract must be legally valid, it must be implemented as agreed, and both the content and execution must correspond to what is customary among unrelated parties.

Since there is often no natural conflict of interest within the family, as is naturally the case with unrelated contracting parties, there is a risk that tax-favorable arrangements are not seriously intended but only agreed on paper. This is precisely what the tax office examines.

Practical Basic Rules

Contracts between relatives should always be concluded in writing, even if civil law does not require this in every case. The best way to prove the actual execution is through bank statements that clearly document the payment flows. Cash payments should therefore be avoided. Retroactive agreements are generally not recognized. And: You bear the burden of proof for the content and execution of the contract with the tax office.

Minor children must be represented by a court-appointed supplementary guardian in contracts that involve obligations – even if a parent is a contracting party.

Rental Agreements with Close Relatives

Requirements for Tax Recognition

In rental agreements between relatives, the tax office examines whether the agreement is seriously intended and customary among unrelated parties based on an overall assessment. The following criteria play a significant role:

The rental agreement must be clearly and unambiguously formulated and contain all essential components of a rental relationship: address, location and size of the rental area, amount of rent (cold or warm rent must be clearly determined), ancillary costs, and the main obligations of both parties. Subsequent contract amendments are subject to the same requirements.

The rent must be paid regularly and punctually – in the agreed form and at the agreed times. Annual or lump-sum payments for several months contradict what is customary among unrelated parties. It is also not recognized if the landlord provides the tenant with the money for the rent in advance or if the paid rent flows back shortly thereafter.

Certain arrangements necessarily lead to non-recognition, so-called knockout criteria: A rental relationship between partners of a non-marital partnership over the jointly occupied apartment is not recognized. Neither is the reciprocal renting of equivalent apartments among relatives, the renting of non-separated living spaces in the parental home to adult dependent children, or cases where the rent is not actually paid.

Discounted Renting to Relatives

Renting below the local market rent is quite common among relatives and is permissible for tax purposes – but only up to a certain lower limit.

If the agreed rent is at least 50 percent of the local market rent, the rental is considered fully remunerated for tax purposes. Advertising costs – such as interest on debt, depreciation, and maintenance expenses – can be deducted in full from rental income.

If the rent is below 50 percent of the local rent, the rental must be split into a remunerated and a non-remunerated part. Advertising costs are then only partially deductible.

If no rent is agreed, there are no income tax purposes – advertising costs cannot be claimed accordingly.

To determine the local market rent, the rent index of the respective municipality and evaluations of relevant real estate portals are particularly suitable. It is advisable to include a sufficient buffer to the 50-percent limit when agreeing on the rent so that the limit is not inadvertently fallen below during general rent increases.

Rental relationships with children attending university, where parents provide an apartment at the place of study, are recognized for tax purposes if the general requirements are met – even if the child pays the rent from the cash maintenance provided by the parents.

Employment Contracts with Close Relatives

Tax Advantages and Risks

By concluding an employment contract between a self-employed parent and the child, income is shifted within the family. The paid remuneration reduces the entrepreneur's profit as a business expense – and thus also the trade tax. The child's employee lump sum of 1,000 euros applies, and the child's lower progression results in an overall lower tax burden. In addition, tax-free salary components can be utilized.

However, the tax office checks whether the contract is actually carried out and whether the conditions are customary among unrelated parties.

Formal Requirements

For an employment contract with close relatives to be recognized for tax purposes, the following points must be met:

The contract must be clearly and unambiguously formulated. It must contain all essential components of an employment contract: type and scope of activity, working hours, amount of salary, vacation entitlement, and regulations on continued payment of wages in case of illness. The amount of remuneration must be appropriate and withstand an internal company comparison with employees without a relative status. Retroactive agreements and subsequent special payments not agreed upon at the beginning of the year are not recognized.

The salary must be actually and punctually paid – preferably into a separate account of the employed relative, which they can freely dispose of. Tax and social security contributions must be withheld and paid. In employment relationships with spouses, a separate account for salary payments is recommended, even if a joint account is permissible under civil law.

No valid employment contract can be concluded with children under 14 years of age. Employment relationships with children under 15 years are generally prohibited due to the Youth Employment Protection Act. The provisions of the Minimum Wage Act must be complied with and documented.

Activities That Do Not Withstand an Arm's Length Comparison

Assistance usually provided on a family law basis – such as cleaning the home office, entertaining business friends in the private home, or preparing travel expense reports – is not suitable as the basis of a tax-recognized employment contract. A significantly excessive salary for simple tasks also speaks against the seriousness of the contract.

However, activities that are not usually remunerated on an employment contract basis due to their minor nature or peculiarity – such as monitoring the telephone and answering machine or callback support by the spouse from home – are recognized.

Household-Related Employment Relationships

A household-related employment relationship between cohabiting spouses or between parents and children living in the household is generally not recognized by the tax office, as family law obligations cannot be the subject of a tax-effective contract.

It is different if relatives live in their own household – for example, the grandmother living in the neighboring town who cooks in the household on weekdays. Such employment relationships are recognized if the contract is legally valid and the agreements correspond to what is customary among unrelated parties.

Loan Agreements Among Close Relatives

The arm's length comparison also applies to loans among relatives. The conditions customary between a borrower and a credit institution serve as a benchmark.

Requirements for Tax Recognition

A loan agreement between close relatives is recognized for tax purposes if a clear agreement on the term as well as the type and timing of repayment has been made, the interest is paid punctually on the agreed due dates, and the repayment claim is sufficiently secured – for example, by a mortgage or land charge registered in the land register, a bank guarantee, security transfer, or assignment of claims.

If sufficient security is lacking, this must be reflected in a correspondingly higher interest rate. Individual unusual clauses are not objected to as long as the chances and risks are distributed overall as they would be among unrelated parties.

The Risk of the Gift Loan

Special caution is required if a monetary gift is linked to the condition that the recipient returns the received amount as a loan. Such an arrangement is not recognized by the tax office – neither as a gift nor as a loan. It is then a sham transaction for tax purposes.

The tax office assumes a dependency between the gift and the loan, especially if both agreements are contained in the same document, if the gift is made with the condition of return as a loan, or if the gift is made under the suspensive condition of return. A close temporal sequence of both agreements is an indication but does not necessarily exclude tax recognition in every case.

Asset Transfer to Children in the Context of Anticipated Inheritance

The transfer of assets to children during one's lifetime – the so-called anticipated inheritance – often pursues several goals simultaneously: regulating business succession, avoiding inheritance disputes, providing for old age, and reducing inheritance and income tax.

Transfer of Financial Assets

When securities or savings deposits are transferred to children, it constitutes gifts. The resulting capital gains are then attributed to the child and taxed there. If the child has no own income, capital gains remain tax-free up to an amount of nearly 10,000 euros due to the basic allowance and saver’s allowance.

For the gift to be recognized for tax purposes, the capital must be permanently transferred. The balance must not flow back to parent accounts, and the final detachment from parental assets must be clearly recognizable. The child must be able to freely decide over their capital after the transfer. If parents continue to manage the transferred assets as their own – for example, through withdrawals or transfers from the children's accounts – the capital gains are still attributed to the parents.

It is also detrimental if the parents reserve a right of revocation, if the assets are only transferred temporarily, or if the income flows to parental accounts or is used for joint living expenses.

A peculiarity with minors: Parents may handle the gift themselves if it is not associated with any obligations for the child. However, if the gift involves burdens – such as an assumed mortgage – a supplementary guardian is mandatory.

Transfer of Business Assets

In the transfer of business assets, ensuring business continuity and the successor's professional qualification often take precedence over tax aspects. The possible arrangements are so diverse that individual advice is indispensable.

However, some essential principles apply generally: The asset transfer is made with regard to future inheritance. The contract must clearly regulate the scope of the transferred assets, the amount of any maintenance service, and the payment modalities. Maintenance services must be agreed upon for the recipient's lifetime and oriented to the transferor's need for maintenance – not the value of the business. Otherwise, it is considered a sale for tax purposes, leading to the disclosure of hidden reserves.

The transferred assets must generate sufficient income to finance the maintenance services. Recipients of maintenance services can include the transferor themselves, their spouse, registered partner, or siblings.

Pension, Permanent Burden, and Usufruct

Maintenance services to the transferor can be agreed upon as a pension or as a permanent burden. Pensions are paid with fixed amounts for the entire duration – an adjustment to the cost of living index is permissible. Permanent burdens, on the other hand, can be adjusted in amount if the economic situation of the transferor or recipient changes. Pensions are considered with the yield share, permanent burdens with the full payment amount.

In usufruct, ownership and usage rights are separated: The assets are transferred to the child, but the parents reserve the right to receive the income – either proportionately from the business income or from specific income-generating items such as the business building. The usufructuary should also be allocated the expenses associated with the assets so that these can be claimed for tax purposes.

Sale to Minor Children

When concluding purchase contracts between parents and minor children, the appointment of a supplementary guardian by the district court is always mandatory, as parents cannot simultaneously act as contracting parties and legal representatives of the child. A purchase contract concluded without a supplementary guardian is provisionally invalid and not recognized for tax purposes. Subsequent approval by a supplementary guardian only takes effect for tax purposes from the time of approval.

Conclusion

Contracts between close relatives are a legitimate and effective instrument of tax planning – if implemented consistently and carefully. The crucial question you should ask yourself with every agreement: Would I conclude this contract in the same way with an unrelated party? If the answer is yes, the chances of tax recognition are good.

Written contracts, clear regulations, punctual and verifiable payments, and compliance with civil law formal requirements are the foundations. Since the tax office scrutinizes arrangements within the family particularly critically, individual tax advice before concluding a contract is recommended in any case.

This article is for general information purposes and does not replace individual tax or legal advice. For your specific case, we are happy to assist you in a personal consultation.