The Managing Director’s Service Agreement

What is a managing director service agreement, and what is it not?

In the case of a managing director of a GmbH, the position as a corporate officer and the employment relationship must be legally distinguished. The first level is the appointment as a corporate officer under Section 6 of the German Limited Liability Companies Act (GmbHG), an act under company law which establishes the power of representation vis-à-vis third parties and is entered in the commercial register. The second is the employment relationship established by the managing director service agreement, which governs the internal contractual relationship – that is, remuneration, duties, term and termination. This distinction is known as the ‘separation theory’ and has tangible consequences: dismissal from the position as a director does not automatically terminate the employment contract. This must be terminated, rescinded or brought to an end separately by means of a valid linkage clause.

The contract is a contract of service for the management of business affairs pursuant to Sections 611 and 675 of the German Civil Code (BGB). In principle, the managing director is not an employee. The Federal Labour Court treats external managing directors as employees only in very rare exceptional cases, for example where the company also prescribes the specific nature of their work in detail, thereby depriving them of any entrepreneurial discretion. The standard arrangement remains the independent service contract. No specific statutory form is required. However, for reasons of evidence, taxation and corporate governance, the contract should always be concluded in writing and on the basis of a valid shareholders' resolution.

Is a managing director service agreement necessary?

A written managing director service agreement is not strictly necessary. The position of managing director arises from the appointment, not from the contract of employment, and a limited liability company (GmbH) is capable of acting even without a formalised service agreement. However, anyone who chooses not to draw up such a service agreement leaves key issues to be determined by the relevant statutory provisions and subsequent interpretation. Without such provisions, there is no reliable basis for determining the level of remuneration, profit-sharing, holiday entitlement, secondary employment, non-compete covenants or notice periods; and in the event of a dispute, the court will decide on the basis of general principles, not on the basis of the intentions of the parties involved.

For the controlling shareholder-managing director, there is an additional tax-related consideration. According to established case law of the Federal Fiscal Court (BFH), a hidden distribution of profits (vGA) within the meaning of Section 8(3), second sentence, of the Corporation Tax Act (KStG) exists if remuneration is not provided in a clear, unambiguous manner, in advance, in a manner that is legally valid under civil law, and actually as agreed. These four conditions are cumulative; the absence of any one of them is sufficient to constitute a vGA. A written contract is not mandatory under civil law; however, in view of the cumulative requirements, it is effectively indispensable under tax law and provides protection only if it is concluded before the start of the financial year, is sufficiently specific and is based on a valid shareholders' resolution in accordance with Section 46 No. 5 of the German Limited Liability Companies Act (GmbHG). If the contract is missing or is negligently drafted, there is a risk that the distribution will be treated as a hidden profit distribution, resulting in corresponding back-taxation. The contract is therefore the basis for tax recognition. Whilst it is not legally necessary, in practice it is virtually indispensable.

What must be included in a managing director service agreement?

A robust managing director service agreement must explicitly cover the following points. Each of these regularly becomes a point of contention during consultations if it is omitted or is vague.

Duties and representation. The scope of management responsibilities, the allocation of portfolios where there are several managing directors, requirements for approval of extraordinary transactions, as well as consistency with the articles of association, rules of procedure and, where necessary, an exemption from Section 181 of the German Civil Code (BGB).

Remuneration and profit-sharing. Fixed salary, payment dates, continued payment of salary in the event of illness, and the calculation of any profit-sharing bonus. The profit-sharing bonus should be linked to a verifiable metric, agreed upon before the start of the relevant period and structured in such a way that it stands up to an arm’s-length test. The basis for calculation, loss carry-forwards, extraordinary effects and the maximum amount must be expressly regulated.

Fringe benefits. A company car, including for private use; contributions towards health and pension insurance; a company pension scheme; and a commitment to provide D&O insurance for directors’ and officers’ liability.

Non-compete covenant. A contractual non-compete covenant for the duration of the contract and – if desired – a post-contractual non-compete covenant with clear substantive, geographical and temporal limits.

Term and termination. Fixed-term or indefinite term, ordinary notice periods, the right to terminate the contract for cause, and any linkage clause tying the contract to the director’s position.

Severance pay and limitation periods. Provisions regarding severance pay in the event of early termination, as well as limitation periods within which both parties must assert their claims.

These points merely form the core. In addition, particular attention must be paid to D&O cover, allocation of responsibilities, compliance obligations, data protection, intellectual property, change of control, release from duties, return of documents and the consequences of a release from duties. The specific terms will depend on whether the managing director is an external managing director or a shareholder-managing director, as social security, tax and negotiating positions differ significantly.

What is the difference between a managing director service agreement and an employment contract?

The difference determines the level of protection afforded to the managing director. An employee is bound by instructions and enjoys full protection under employment law. The managing director manages the company as an organ of the company and is thereby bound by the law, the articles of association, shareholders' resolutions and lawful instructions from the shareholders. However, the personal dependence and integration typical of employees do not generally apply. 

Legally, an employment contract constitutes an employment relationship under Section 611a of the German Civil Code (BGB), whereas a managing director service agreement is a contract for services under Sections 611 and 675 BGB. The Protection Against Unfair Dismissal Act applies to employees as soon as the company meets the size threshold and the qualifying period has been fulfilled. Under Section 14(1)(1) of the Protection Against Dismissal Act (KSchG), it does not apply to managing directors from the outset. The legal proceedings also differ, as disputes arising from the employment relationship are decided by the labour court, whereas those arising from the managing director service agreement are generally decided by the ordinary courts.

With regard to statutory annual leave, employees are subject to the Federal Annual Leave Act, whilst managing directors must, in principle, arrange their annual leave by contract. However, in the case of an external managing director, the Federal Labour Court (BAG) has clarified that the minimum holiday entitlement under Article 7 of Directive 2003/88/EC can be enforced by way of an interpretation of Section 7(4) of the Federal Holiday Act (BUrlG) that complies with the Directive, even in the absence of national employee status, provided that the managing director is classified as an employee under the EU-law definition of an employee. The post-contractual non-compete covenant for employees is governed by Sections 74 et seq. of the German Commercial Code (HGB) and mandatorily requires the payment of compensation during the non-compete period. These provisions do not apply to managing directors, meaning that the scope and remuneration of a non-competition period may be freely negotiated.

For an external managing director, contractual protection is particularly important. Under Section 38(1) of the German Limited Liability Companies Act (GmbHG), the position as a director may, in principle, be terminated at any time by dismissal, whilst general protection against dismissal does not normally apply. This is precisely why notice periods, severance pay provisions and a fair termination clause are the actual subject of negotiation in the contract.

Who draws up a managing director service agreement and who signs it?

In practice, the drafting – that is, the preparation of the content – is usually carried out by a solicitor specialising in company law or employment law, whether on behalf of the company or the managing director. Templates found online or generated by contract generators cover standard scenarios, but fall short precisely in the areas where costs can mount up: social security status, calculation of profit-sharing, non-compete covenants and tie-in clauses. A template is a starting point, not a finished contract.

In the case of a GmbH, the authority to conclude the contract – that is, to sign on behalf of the company – lies not with the managing director themselves, but with the shareholders' meeting. Pursuant to Section 46(5) of the German Limited Liability Companies Act (GmbHG) and the associated ‘annex competence’, the shareholders decide on the conclusion, amendment and termination of the employment contract. Upon execution, an authorised shareholder or another managing director may sign as the authorised representative of the shareholders' meeting, but not by virtue of their own corporate authority. In the case of a GmbH subject to co-determination, the supervisory board takes the place of the shareholders' meeting (Section 52(1) of the German Limited Liability Companies Act (GmbHG) in conjunction with Section 112 of the German Stock Corporation Act (AktG)).

In the case of a single-member GmbH, Section 181 of the German Civil Code (BGB) applies by operation of law (Section 35(3), first sentence, of the GmbHG). An exemption is only possible by provision in the articles of association; a simple shareholders' resolution without a basis in the articles of association is not sufficient. In addition, there are two parallel documentation requirements: the immediate recording of the resolution (Section 48(3) of the GmbHG) and the recording of the legal transaction itself (Section 35(3), second sentence, of the GmbHG). A lack of a basis in the articles of association or a failure to record the resolution jeopardises the validity of the contract under civil law and its recognition for tax purposes.

When is a managing director exempt from social security contributions?

The classification under social security law is the most costly source of error. A non-shareholding managing director is, in principle, an employee and is therefore subject to social security contributions. In the case of a managing director who is also a shareholder, it depends on the legal authority held. According to established case law of the Federal Social Court, the decisive factor is whether the managing director, as a controlling shareholder or at least one holding a blocking minority, is able to reject instructions with which he or she does not agree at any time.

A shareholder-managing director is generally not considered to be in dependent employment if they hold more than 50 per cent of the share capital; in the case of a stake of exactly 50 per cent, the requisite legal authority is also deemed to exist, as no resolutions can be passed against him unless the articles of association provide for alternative majority voting mechanisms. Where the shareholding is lower, a comprehensive blocking minority enshrined in the articles of association is sufficient; this must not be limited to specific areas but must cover the entire business activity, including instructions to the managing director.

Where the shareholding is exactly 50 per cent, the necessary legal authority generally exists because no resolutions can be passed against the shareholder-managing director, provided the articles of association do not provide for alternative mechanisms. The specific provisions of the articles of association are therefore decisive. Voting agreements, veto rights under the law of obligations or a de facto strong position are generally insufficient if they do not confer the necessary legal authority under company law.

Anyone relying on exemption from social security contributions should clearly secure the legal authority in the articles of association, have the relevant clause in the articles of association entered in the commercial register and, in case of doubt, apply at an early stage for a status determination procedure under Section 7a of Book IV of the Social Code (SGB IV). The risk of a back-payment claim extends four years back in time in accordance with Section 25(1), first sentence, of SGB IV; in the case of wilful non-payment (whereby conditional intent is sufficient, i.e. considering the contribution obligation to be possible whilst knowingly accepting non-payment), the period is extended to 30 years after the end of the year in which the contribution became due. Anyone who fails to initiate a status determination procedure whilst doubts remain risks having this omission interpreted as conditional intent.

The general protection against dismissal under the Protection Against Dismissal Act does not apply to either external or shareholder-managing directors (Section 14(1)(1) of the Protection Against Dismissal Act). From a tax perspective, the risk is low for non-shareholder managing directors, whereas for shareholder managing directors, remuneration that is not clearly regulated may be treated as a hidden distribution of profits. Accordingly, the focus of the contract shifts. For a non-shareholder managing director, the focus is on termination and severance pay; for a shareholder managing director, it is on remuneration, profit-sharing and the safeguarding of legal authority.

How much does a managing director service agreement cost?

The question of cost can only be answered reliably in terms of a range, as the effort involved depends on the complexity of the matter. A solicitor charges either in accordance with the Lawyers’ Fees Act (RVG) or on the basis of a fee agreement. When billing under the RVG, the fee is calculated based on the value of the matter, which depends on the level of remuneration. The higher the agreed annual remuneration, the higher the administrative fee under No. 2300 VV RVG. In practice, however, many law firms work with pre-agreed fixed prices or fees based on time spent when drafting contracts. 

A notary is not normally required for the managing director service agreement as such. Notarial fees may, however, arise if, at the same time, the articles of association, powers of representation, shareholdings or other provisions under company law requiring notarisation are amended.

The costs of a bespoke contract are minimal compared to the sums at stake should social security status, profit-sharing or non-compete covenants later prove to be invalid. An incorrect status can trigger back-payments of contributions in the five- to six-figure range. An invalid non-compete covenant allows a departing managing director to work for a competitor. Reviewing an existing draft before signing is therefore the most cost-effective safeguard.

How does one terminate a managing director service agreement?

Termination follows the ‘separation theory’ and takes place on two levels. At the corporate level, the shareholders' meeting may, in principle, remove the managing director at any time pursuant to section 38 of the German Limited Liability Companies Act (GmbHG). At the contractual level, the employment relationship ends only upon notice of termination, by means of a termination agreement, or upon expiry of the term.

The Federal Labour Court (BAG) applies Section 621 of the German Civil Code (BGB) to an external managing director as an employee (BAG judgment of 11 June 2020 – 2 AZR 374/19; official headnote). By contrast, the Federal Court of Justice (BGH) has consistently upheld the analogous application of Section 622(1) and (2) of the German Civil Code (BGB) in its established case law, specifically in respect of managing directors who are not majority shareholders (Federal Court of Justice (BGH) judgment of 5 November 2024 – II ZR 35/23; official headnote, explicitly distinguishing itself from the BAG judgment). The two chambers are thus in explicit contradiction with one another. Section 5(1), third sentence, of the Labour Court Act (ArbGG) assigns disputes arising from the employment relationship to the ordinary courts in all cases, meaning that, in practice, the Federal Court of Justice’s line of reasoning is decisive. Either party may terminate the contract for cause under Section 626 of the German Civil Code (BGB); the two-week notice period under Section 626(2) BGB also applies in the case of contractually agreed grounds for termination (Federal Court of Justice (BGH) judgment of 5 November 2024 – II ZR 35/23).

Contracts with managing directors are concluded for a fixed term or indefinitely, depending on the parties’ interests. A linkage clause may link the employment contract to the position as a director. If the managing director is removed from office, the clause provides that the removal is deemed to be ordinary termination with effect from the next possible date. Anyone wishing to resign should carefully check the contractual notice periods before taking any action.