Why the Hassle?

The motivation for disguised employment is varied, including savings on social security contributions, avoidance of employee rights, reduced administrative burden and tax savings. However, the consequences can be severe, ranging from additional payments of social security contributions, tax implications, employment law issues and fines or penalties.

Identifying Potential Risks in the Due Diligence Process

Identifying disguised employment is often challenging as the line between legitimate self-employment and disguised employment is blurred, and many arrangements fall into a grey area. Ultimately, it is the overall picture that determines whether an arrangement can still be categorized as self-employment or actually constitutes to dependent (disguised) employment.

The criteria for identifying disguised employment relationships include, in particular, their integration into the customer's work organization, their entrepreneurial initiative and risk, and their personal and economic dependence on the customer.

Thus, within the due diligence process, it is crucial not only to review the contractual arrangements with the independent contractors and freelancers, but also how services are actually provided on a day-to-day basis. The review should include:

1. Industry and company-specific characteristics:

• Is the target company's industry particularly susceptible to disguised employment arrangements (e.g., IT, construction, logistics, media, nursing care, education)?
• Does the target company have internal guidelines or compliance structures for dealing with independent contractors and freelancers?

2. Review of contracts with freelancers and independent contractors:

• Analysis of contracts for indications of dependent employment (e.g. customer's right of instruction, fixed working hours, place of work, holidays, sick leave, reporting obligations, use of company infrastructure).
• Review of remuneration agreement (e.g. hourly rate vs. fixed fees).
• Duration and the scope of engagement.
• Permission to also provide services to other customers.

3. Assessment of the actual work performed:

• Review of actual integration of independent contractors/freelancers into internal processes, teams, meetings, use of email addresses, access authorizations, etc.
• Inspection of workplaces to determine if freelancers use fixed workstations or company equipment.
• Confirming if freelancers are not only allowed to provide services to other customers but have other customers.
• Comparison of contractual agreements with actual practice.

4. Review of status determination procedures and previous social security/tax audits (if any):

• Confirming if status determination procedures (“Statusfeststellungsverfahren”) have already been completed or initiated with the social security authorities to obtain legal certainty, if an individual actually qualifies as self-employed.
• Review of social security and wage tax audit reports if arrangements with freelancers or independent contractors were relevant in the past.

5. Quantitative Analysis:

• Determining the number of individuals formally engaged as self-employed, the amount of their fees and the duration of the engagement.
• Identifying individuals with a particularly high risk (e.g., long-term engagement, only one client, heavily integrated into company structures).

Further complexity is added if the target company works not only with domestic independent contractors or freelancers, but also with individuals based abroad.

Mitigating Risks from Disguised Employment Arrangements in the Acquisition Process

Depending on how serious the identified risks are (in terms of probability of occurrence and financial exposure), the following measures may be taken to manage the buyer’s exposure.

• Representations and warranties: The seller should provide comprehensive warranties that all individuals engaged as self-employed are correctly classified and that no disguised employment arrangements exist. Breaches of these warranties give rise to liability claims by the buyer.
• Indemnification: The seller undertakes to indemnify and hold the buyer harmless from all costs, damages, and liabilities arising from disguised employments that existed before closing.
• Purchase price adjustment: In the case of significant and quantifiable risks from disguised employments, a direct reduction of the purchase price can be agreed upon.
• Escrow account: A portion of the purchase price can be held in escrow for a certain period to cover potential additional payments or other costs arising from disguised employments that are claimed after closing.
• Conditions precedent: In very serious cases, it can be agreed as a last resort that resolving identified disguised employment issues before closing is a condition for the transaction to proceed. In practice, however, this is rarely the case.

Post-Closing Actions

Once the acquisition has been completed, the following measures should be taken to eliminate existing risks from potential disguised employment arrangements:

• Status rectification: For individuals classified as disguised employees, their status should be corrected immediately, e.g., by offering employment contracts.
• Proactive status determination: For unclear future contractual relationships, a status determination procedure can be initiated proactively with the social security authorities to obtain legal certainty.
• Implementation of clear guidelines: Introduction of internal compliance rules for engaging freelancers and independent contractors to avoid future disguised employment issues.
• Assertion of indemnity claims: In the event of authorities raising retroactive claims, the buyer may seek recourse against the seller in accordance with the contractual agreements.

The identification and assessment of disguised employment arrangements require specialized expertise in labor law, social security law and tax law. Therefore, it is essential to involve experienced tax advisors with expertise not only in M&A, but also a deep knowledge of employment tax and social security law throughout the acquisition process.