German Federal Court of Justice strengthens management participations in private equity structures

Legal development and practical relevance

The decision further develops the existing case law on manager and employee participation models. While the BGH had already recognised in its decisions of 19 September 2005 and 7 May 2007 that early termination clauses may be permissible where special objective reasons exist, the current judgment expressly applies these principles to modern private equity structures for the first time (para. 50).

This is of significant practical importance, as the validity of an termination clause largely depends on whether it can be objectively justified by a legitimate interest of the company or of the co-shareholders. In this respect, the BGH acknowledges that management participation programmes serve legitimate retention, motivation and incentive purposes and that the participation may be functionally linked to the management activity (para. 50).

At the same time, the BGH clarifies that the admissibility of such models is not limited to traditional management participations involving only small capital commitments or limited economic risk. Rather, market value-based management investments in private equity structures, under which managers bear genuine downside risk, may likewise provide the required objective justification (para. 55).

For private equity practice, the particular significance of the decision lies in the fact that the BGH expressly recognises the economic structure of typical management participation programmes, under which management is intended to participate in the future increase in value of the company and, in particular, in a subsequent exit (para. 50).

Of particular importance is the finding that participation in future disposal proceeds is not to be given less weight than participation in current profits (para. 51). The BGH thereby confirms a central feature of typical private equity structures, where the economic focus is regularly on the exit rather than on ongoing distributions.

Funds and investors thus gain additional legal certainty for structures designed to ensure that economic participation and operational responsibility remain permanently aligned.

Tax classification of management participations

However, the relevance of the judgment is likely to extend well beyond the corporate law issue. The BGH describes the management investment as an equity participation arrangement involving an independent capital risk and a seperate profit opportunity and, at the same time, recognises that management participations may be pooled through a joint management participation vehicle, even where managers from different portfolio companies are combined within that vehicle (paras. 50, 53, 55).

This corresponds to the market practice of numerous private equity fund structures. For the tax debate on the distinction between employment income and income from an equity or capital participation, the judgment provides additional arguments supporting the autonomy of the participation relationship vis-à-vis the employment relationship.

The equivalence of exit participation and participation in ongoing profits argues against the assumption that the return is solely remuneration for services rendered (para. 51). Similarly, the emphasis on acquisition at market value and the actual risk of loss supports the argument that management investments may, from an economic perspective, be structured as genuine capital participations (para. 55).

These statements are consistent with the recent case law of the German Federal Fiscal Court (Bundesfinanzhof, “BFH”) on the tax treatment of management participations. The judgment is therefore likely to be relied upon increasingly in the future to support the autonomy of the management’s private investment sphere vis-à-vis the employment relationship.

This applies in particular in light of the BFH judgment of 14 December 2023, in which the BFH clarified that arm’s-length disposal proceeds from an employee or management participation do not, as a matter of principle, constitute employment income merely because the participation was acquired in connection with the employment relationship.

The same applies to the judgments of 21 October 2025, in which the BFH emphasised the importance of the participation arrangement having independent economic substance and further curtailed the previously applied overall assessment in favour of a clearer separation between the employment sphere and the investment sphere.

Where a participation relationship has actually been implemented and involves an independent profit opportunity and genuine risk of loss, the resulting income should, as a matter of principle, be allocated to the relevant income category of the participation relationship and not to the employment relationship.

Conclusion

With its decision, the BGH strengthens the legal framework for management participation programmes in private equity structures and provides additional legal certainty for funds, investors and management teams. The recognition of arm’s-length management investments involving genuine risk of loss, as well as the emphasis placed on exit participation as a central element of such participation models, is likely to be of considerable practical relevance.

At the same time, the implications of the judgment extend beyond corporate law issues. The decision provides additional arguments supporting the separate tax treatment of management participations and is consistent with the current BFH case law on the distinction between employment income and income from an equity or capital participation. For private equity structures, the judgment is therefore likely to have considerable relevance from both a corporate law and a tax perspective.

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