§ 40(1) of the Income Tax Act (Flat-Rate Treatment)

The flat-rate method under Section 40(1), first sentence, No. 1 of the Income Tax Act (EStG) is the second option for taxing supplementary health insurance on a flat-rate basis above the 50-euro exemption limit. The employer is responsible for withholding income tax, though not at a fixed rate, but at an average rate determined individually for its business. In most scenarios, this is the most cost-effective of the four options—but also the one requiring the most administrative preparation.

The key advantage: Exemption from social security contributions

Unlike under Section 37b of the Income Tax Act (EStG), the contribution is not subject to social security taxes. This means that neither the employer’s nor the employee’s share applies.

The effect is twofold: The employer saves on its share, and the employee receives the benefit in full because no personal contribution is deducted. It is precisely this second point that makes this option much easier to communicate to the workforce than Section 37b of the Income Tax Act (EStG).

The average rate

Instead of a rate set by law, an average rate is used that reflects the tax burden on the affected employees. It therefore depends on the company’s salary structure: In a company where most employees have lower incomes, the rate is lower than in one with high salary levels.

Practical implication: It is not possible to make a general statement about how favorable this option is. The comparison with Section 37b of the Income Tax Act (EStG) must be calculated for each specific business—and the outcome may vary from year to year, since the rate is recalculated annually.

The Application Process

This option requires an application. The average rate must be applied for at the tax office, and the calculation must be presented in a transparent manner. This has two implications for planning:

• Background: This makes it difficult to implement the measure on short notice or during the fiscal year. Anyone wishing to start in the next quarter will generally have no choice but to comply with Section 37b of the Income Tax Act (EStG).
• Recurring effort: The annual recalculation ties up payroll accounting resources on an ongoing basis—a factor that must be taken into account in the cost-benefit analysis.

The Two Limits

1,000 euros per employee per year. This option no longer applies for higher annual contributions. To put this in perspective: the limit is reached with a monthly contribution of 83 euros. For most budget levels, the actual contribution is significantly lower, so the limit rarely poses a problem in practice—but it certainly does for high budgets with extensive add-on modules.

Only your own employees. Freelancers, business partners, or similar recipients cannot be included using this option.

Requirement: Treatment as other income

This option requires that the contribution be treated as other income, rather than as regular wages. How this is reflected in the actual pay stub and what impact it has on social security exemption must be clarified with the payroll department before a decision is made. This point is the most common stumbling block during implementation—and it determines whether the main advantage of this option is realized at all.

When Does It Become Worth the Effort?

Experience shows that the application process becomes worthwhile once a company has about 20 employees. The logic behind this is simple: The effort involved—the application, documentation, and annual reassessment—remains largely the same, regardless of whether 15 or 150 people are insured. The savings on social security contributions, on the other hand, increase with each insured person.

Below this threshold, the administrative burden is often out of proportion to the savings. Above it, the picture changes significantly.

A Direct Comparison with Section 37b of the Income Tax Act (EStG)

• Social Security: Section 40(1) is exempt from contributions; Section 37b requires contributions from both parties — the most important difference
• Motion: § 40(1) is required; § 37b is not
• Rate: § 40(1) is determined individually and annually; § 37b is fixed at 30 percent
• Maximum amount: § 40(1) at 1,000 euros, § 37b at 10,000 euros per person per year
• Eligible Recipients: § 40(1) applies only to the employer's own employees; § 37b applies to others as well

Conclusion

Section 40(1) of the Income Tax Act (EStG) is the more favorable but more time-consuming option. It is worthwhile for larger workforces and annual contributions of up to 1,000 euros per person, provided there is sufficient lead time for the application process. Those who want to get started quickly, exceed these limits, or wish to include individuals outside their own workforce are better off using Section 37b of the Income Tax Act (EStG).

This article provides a general overview and is not a substitute for tax advice in specific cases. Section 40 of the German Income Tax Act (EStG), as currently amended, applies.