Discrimination: Employer's compensation completely tax-free
Under the General Equal Treatment Act (AGG), discrimination on grounds of race or ethnic origin, gender, religion or belief, disability, age, or sexual identity is prohibited (§ 1 AGG). If the prohibition of discrimination is violated, the employer is obliged to compensate for the resulting damage. The person affected can claim an appropriate monetary compensation (§ 15 para. 2 AGG). The question is how such compensation is treated for tax purposes. Recently, the Rhineland-Palatinate Fiscal Court ruled that compensation paid by an employer to an employee due to discrimination, bullying, or sexual harassment is tax-free and not taxable wages. This applies even if the employer denied the alleged discrimination and only agreed to the payment in a court settlement. Tax-free means that the payment is not subject to social security contributions (Rhineland-Palatinate Fiscal Court, 21.3.2017, 5 K 1594/14).
The case: An employee filed a unfair dismissal claim against the termination of her employment for "personal reasons", also seeking compensation for discrimination due to her disability. A few weeks before the dismissal, the Office for Social Affairs had determined a physical disability of 30%.
Before the Labour Court in Kaiserslautern, the employee and her employer reached a settlement in which "compensation according to § 15 AGG" of 10.000 Euro was agreed, and the employment relationship was terminated by mutual consent. The tax office wanted to treat the compensation as taxable wages.
According to the tax judges, the settlement reached at the Labour Court indicates that the payment was not compensation for material damages under § 15 para. 1 AGG (e.g. lost wages) but for non-material damages under § 15 para. 2 AGG due to discrimination against the claimant as a disabled person. Such compensation payments are tax-free and not to be classified as wages. The claimant's employer had denied the discrimination.
However, as part of the settlement, he was willing to pay compensation for (only) alleged discrimination. Such income does not have the character of wages and is therefore tax-free.
The compensation is not only tax and social security-free, but it is also not included in the progression clause, so it does not lead to a higher tax rate for other income.
The Federal Administrative Court has just awarded young civil servants compensation for age-discriminatory pay because their pay violated the prohibition of age discrimination. The court derived the entitlement to compensation from § 15 para. 2 AGG (Federal Administrative Court rulings of 6.4.2017, 2 C 11.16 and 2 C 12.16). The pay regulations disadvantaged younger civil servants solely because of their age (ECJ ruling of 19.6.2014, C-501/12).
Discrimination: Employer's compensation completely tax-free
What are remunerations for multi-year work?
A payment or advance payment for multi-year employment (e.g. severance payments) can be taxed at a reduced rate in the year of payment using the five-year method. The key factor is that the employment spans two calendar years.
The so-called five-year rule benefits extraordinary income under German tax law (§ 34 EStG). These so-called "income subject to preferential tax rates" are income earned over several years but realised and taxed in a single year.
What are remunerations for multi-year work?
Severance payment and one-fifth rule: When does the reduced tax rate apply?
In the event of early termination of employment, employees often receive a severance payment. Since 2006, this is no longer subject to a tax allowance, but it can still be taxed at a reduced rate under the so-called fifth rule (§ 34 EStG) – under certain conditions.
Conditions for applying the fifth rule
For the reduced taxation to apply, the following conditions must be met:
- The severance payment is paid in a lump sum in one calendar year.
- The annual income with severance payment must be higher than the income that would have been earned if the employment had continued uninterrupted.
The aim of this regulation is to mitigate the progressive effect of the income tax rate when exceptionally high income is received in one year due to the severance payment.
No tax advantage for low severance payment
The fifth rule does not apply automatically. This is shown by a ruling of the Federal Fiscal Court on 08.04.2014 (Az. IX R 33/13):
With a gross salary in the previous year of around 140.000 Euro and a severance payment of 43.000 Euro, there is no “lump sum” increase in income.
→ The fifth rule is not applicable.
Reason: The income in the severance year was not higher than if the employment had continued as normal. Therefore, there was no progressive tax disadvantage.
Comparison calculation: “Actual amount” vs. “Target amount”
Whether the fifth rule is applicable is checked by means of a comparison calculation:
- Actual amount: Actual income in the year of the severance payment (including severance payment)
- Target amount: Fictional income if employment had continued until the end of the year (e.g. based on the previous year's income)
Note:
If the severance payment does not exceed the lost income until the end of the year, further income may be taken into account that would not have been received without the termination of employment – e.g. unemployment benefit.
Example:
Mr M. ended his employment in June 2025 and received a severance payment of 35.000 Euro. His regular annual income would have been 70.000 Euro.
In the severance year, he only earns 25.000 Euro in wages plus the severance payment. The total income is 60.000 Euro – and thus below the income if he had continued working without interruption.
The fifth rule cannot be applied as there is no progressive disadvantage.
Severance payment and one-fifth rule: When does the reduced tax rate apply?
Voluntary resignation: Is the severance payment subject to the one-fifth rule?
Ending an employment relationship is often accompanied by a severance payment, especially if the employer terminates the contract. This severance payment may be tax-advantaged through the so-called one-fifth rule. But what applies if you resign yourself or if a termination agreement is initiated by you?
What is the one-fifth rule?
The one-fifth rule (§ 34 EStG) is a tax benefit for extraordinary income, which includes severance payments (§ 24 No. 1a EStG). It ensures that this income is taxed at a reduced rate to avoid excessive tax burdens due to the lump sum payment.
Conditions for the tax benefit
For the one-fifth rule to be applied, the severance payment must be related to an extraordinary event – typically termination by the employer or an amicable solution under pressure or conflict.
No tax benefit for voluntary resignation
Important: If you resign without external pressure or without prompting from the employer, the tax benefit will not be granted.
This applies in particular if you resign of your own accord without any conflict or financial hardship.
Exception: Termination agreement in a conflict situation
However, the Münster Finance Court has ruled that a tax benefit is also possible if the employee initiates the termination agreement themselves but acts under pressure:
- In the case decided, the employee was in conflict with the employer over their reclassification.
- They proposed the termination agreement themselves but acted to avoid further disputes.
- The court saw this as a sufficient conflict situation to justify the application of the one-fifth rule.
(FG Münster, 17.03.2017, Az. 1 K 3037/14 E, confirmed by BFH, judgment of 13.03.2018, IX R 16/17, BStBl 2018 II p. 709)
BFH confirms: No actual pressure required for amicable solution
The Federal Finance Court (BFH) clarified: If the employer and employee amicably terminate the employment relationship and a severance payment is made, it is not absolutely necessary for the employee to have been under recognisable pressure. The amicable solution itself is sufficient for the tax benefit.
When does the tax benefit lapse despite severance pay?
The BFH ruled in another judgment (06.12.2021, IX R 10/21):
- If a severance payment is not paid in one year but spread over several years, the one-fifth rule lapses.
- This also applies if there are partial payments (e.g. severance pay and starting bonus) made for the same event.
Special case: Sprint bonus
A so-called sprint bonus, paid when an employee voluntarily leaves early, can be considered compensation and subject to the one-fifth rule.
(Hessian FG, court order of 31.05.2021, Az. 10 K 1597/20)
Conclusion
Even on your own initiative, a severance payment can be tax-advantaged – the decisive factor is the actual conflict situation or an amicable solution between the parties. However, it is important that the payment is made in one year and recognised as compensation.
Voluntary resignation: Is the severance payment subject to the one-fifth rule?
