Liability traps for tax advisors in connection with the one-off tax reduction for extraordinary income

The general answer is: yes. Taxpayers are not required to notify the tax office of the tax office’s errors or to file a corrected return pursuant to Art. 153 AO (German General Tax Code). This applies at least in the event of “correct tax returns”, i.e., if the returns were complete and correct and did not cause the tax office’s mistake (German Federal Tax Court (“BFH”), decision of December 4, 2012 – VIII R 50/10, BFHE 239, 495, BStBl. 2014, II 222).  

However, caution is required in each individual case, as any failure to correct an incorrect assessment by amendment or objection may prove disadvantageous for the taxpayer in individual cases and thus result in the tax advisor’s liability.  

In a recent case decided by the Lübeck Regional Court (decision of January 11, 2024 – 15 O 72/23) the taxpayer’s (a doctor) delight about the tax relief arbitrarily granted by the tax office pursuant to Art. 34 (3) sentence 1 EStG (German Income Tax Act) faded ten years later when he sold his joint practice and realized that this reduction to which he was entitled only once had already been used up. His tax advisor had apparently not informed him of such fact when advising him on the original, incorrect assessment notice issued by the tax office. In a recent judgment, the Lübeck Regional Court therefore sentenced the tax consulting firm to pay damages of around 220,000 euros. 

Legal background – tax reduction for extraordinary income 

For certain extraordinary income pursuant to Art. 34 (2) EStG (for example, one-off capital gains, compensation payments, remuneration for multi-year services), German income tax law provides for the application of a reduced tax rate pursuant to Art. 34 (1) EStG (“one-fifth rule”). The application of such one-fifth rule results in a mitigation of progressive taxation by spreading such income over five years, ultimately resulting in an application of the tax rate which would be applied if one fifth of such extraordinary income accrued during every assessment period.  

In case of capital gains, however, the more extensive special rate reduction pursuant to Art. 34 (3) EStG can be claimed as an alternative upon the taxpayer’s application. A taxpayer is entitled to such special reduction only once in a lifetime and for only one sales transaction (Art. 34 (3) sentence 4 and 5 EStG). It further requires for the taxpayer to have reached the age of 55 or to qualify as permanently incapable to perform their occupation under German social security law (Art. 34 (3) sentence 1 EStG).  

Tax advisor’s consulting error in connection with erroneous granting of tax reduction by the tax office 

In the decided case, the tax office had erroneously applied, without the taxpayer’s application, the special rate reduction pursuant to Art. 34 (3) EStG and thus assessed a lower additional payment of taxes in favor of the doctor. When reviewing such assessment notice, the tax consultant advised the doctor not to object to such tax assessment notice and let it become final despite the erroneously applied rate reduction in order to avoid a higher additional tax payment. He did inform the doctor that, despite the actually erroneous preferential treatment, the taxpayer was not obliged to file a correction with the tax office as the submitted tax returns had been correct; however, he failed to inform the taxpayer that the tax reduction pursuant to Art. 34 (3) EStG could be claimed only once in a lifetime and was thus no longer available for future capital gains.  

Ten years later, the doctor claimed for the reduced tax rate pursuant to Art. 34 (3) EStG to be applied on the sale of his joint practice. However, the tax office rejected such claim by referring to the already used privileged treatment, which could be granted only once in a lifetime. Any legal remedies were unsuccessful. Finally, the German Federal Tax Court confirmed the tax office’s opinion that the one-off tax reduction was considered to have been used up even if it had been granted unjustly (BFH, decision of September 28, 2021 – VIII R 2/19, BFHE 274, 443, BStBl. II 2022, 169).  

Tax consulting firm’s liability for damages 

Before the Lübeck Local Court, the doctor claimed damages from the tax consultancy which employed the tax advisor. The tax advisor should have recommended filing an objection against the original, erroneous assessment notice in order to retain the tax reduction for future capital gains which might result in a significantly higher relief. In any case, he should have been explicitly informed about such possibility.  

The tax advisor defended himself against the claim for damages by arguing that, until the BFH’s decision in this case, he could not have known that the reduced tax rate was used up even if it had not been applied for. There had not been any court decisions in this regard yet.  

The Lübeck Regional Court, however, upheld the doctor’s claim. The tax advisor should have informed the doctor that the reduced tax rate can only be claimed once in a lifetime. This was clearly stipulated in the laws, without the granting’s background being relevant. Due to such clear regulation, the tax advisor had been obliged to inform about the risk that the relief might be deemed used up at a later stage even if it had not been applied for. Since he had failed to do so, the doctor was entitled to be compensated for the resulting tax loss of approximately EUR 220,000 in connection with his joint practice’s sale.  

Consequences for practice 

The case emphasizes that any tax consulting in connection with an objection against tax assessment notices must take into account not only the immediate effects of the decision but also possible remote and consequential effects. The tax advisor’s recommendation not to file an objection against the tax assessment notice with the erroneously granted tax reduction was, per se, advantageous for the client. However, in combination with the practice’s sale many years later, the consumption of the one-off application option had a negative economic effect for the client. According to the Lübeck Regional Court’s decision, the obligation to inform the client applied even if the legal situation had previously not been clarified by BFH case law. In light of the quite complex tax regulations, this results in great exposure to possible claims for damages by clients and tax advisors must examine possible remote and consequential effects and include a corresponding reference in their documentation.