The Schwarz system: Don’t you face up to 12 years for “employing” freelancers?

The Shvarc system, otherwise known as the “employment” of freelancers or contractors, is a topic that has been resonating in the Slovak business environment for decades. The main motive why entrepreneurs prefer sole traders over employees is the obvious tax-tax advantages. However, such an arrangement poses several challenges related to levies, taxes, but also criminal law. At Highgate, we have been addressing this issue for a long time on the legal, regulatory as well as tax and levy side. That is why we have recently held a comprehensive conference on this topic and on setting up relations with contractors ( more information about the conference). V rámci prednášok sa Peter Varga zameral na široké spektrum problémov a poskytol komplexný pohľad na situáciu, ktorá sa dotýka nielen podnikateľov, ale aj fyzických osôb. Ak by ste mali akékoľvek otázky, chceli si pozrieť záznam z konferencie, mali záujem o komplexné služby alebo konzultáciu, sme Vám k dispozícii.

Identification of the shvarc system

In the past we have analysed in detail the history and advantages or disadvantages associated with the shvarc system, which you can read about in our article The Schwartz System: Do you want to work as a freelancer or employ freelancers? Be careful not to get knocked on the door by Cobra or the CID.

The issue of the shvarc system is often perceived as a hunt for a fictitious sole trader (but also a one-person SRO), i.e. a self-employed person (self-employed person) without own employees who does not meet at least two of the following criteria:

• autonomy – has more than one client for whom he works,
• subcontracting – it has the possibility to employ staff if necessary,
• Decision-making power – it is capable of important decisions regarding its planning.

Although this definition is vague and neglects many variables, the state tries to identify and punish such tradesmen because they are “robbing” the public finances, failing to pay pension contributions and other compulsory contributions.

Let’s look at this issue from a different angle. Why is the shvarcsystem so controversial? And what are its real advantages and disadvantages for sole traders and employers? These questions open the way for an interesting debate and bring new perspectives to old problems.

Read more to find out how you can safely navigate the world of the shvarcsystem without unnecessary risks.

Motivation for the use of tradesmen

In Slovakia, the number of sole traders is constantly growing, which brings us to the question: what motivates people to become sole traders?

One of the main reasons for this is the significant disproportion between the tax and levy obligations of sole traders and employees. This imbalance in the tax system creates more financially favourable conditions for sole traders, which naturally attracts many who are looking for ways to optimise their income. However, the state is looking at this phenomenon critically and intervening to prevent abuse of the system. It should be noted that if there is such a disparity in the law between the different regimes, the intervention of the state is legitimate.

At the conference, Peter Varga addressed this topic from a different perspective. He stressed that if the tax system were more neutral, the decision of individuals to become a sole trader or an employee would not be considered fraudulent. It would not be an attempt to avoid tax, but a free choice of the legal form that best suited individual needs. In situations where the individual expects social insurance benefits (mainly a pension), the optics are more neutral for a change. Be that as it may, it is the knowledge of the complex perspective of taxes, levies and social insurance benefits that is a prerequisite for a greater likelihood of defending a business relationship with a contractor. In other words, it can be argued from the case law that legal analysis alone is not sufficient and that legal analysis must reflect the existence or non-existence of a financial disproportion in the adjustment of the relationship. These are also the conclusions of our conference.

In the absence of a disproportion, we would be on a level that would allow a freer choice of the appropriate legal form for a particular natural person. Within the relevant legal models, employment, single-person LLCs, trades, but also IP relationships and other forms of cooperation, such as silent partnerships, were presented in more detail. Watch the video recording of the conference to learn more about why working as a sole trader is so attractive and what advantages and disadvantages it brings for both employers and sole traders. A deeper look at the motivations for using sole traders and the contractual freedom in choosing the legal form is presented by Peter Varga in the video from the Švarc system conference : “Employing freelancers” – where is the limit?

Comparison of tax and levy obligations

The motivation of market participants on the part of employees is to seek other forms in order to increase their income. For better clarification, we also provide a summary of the tax rates, the basic models that frame the issue

Effective levy rate: Who pays less?

At the conference, we made a detailed comparison of levy rates for different working regimes based on an income of €1,000 gross salary for an employee and €1,000 on an invoice for a sole trader (other alternatives were also discussed).

The results clearly show that the effective tax and deduction rate for an employee is 42%, while a sole trader who uses the deduction holiday pays only a tiny 10%. When compared to a managing director with. r. o. we can see that this scheme is not so advantageous, since with the executive remuneration of the minimum subsistence level, i.e. j. 269 € per month, which is the most efficient in terms of minimum health levies, and we assume that it pays 15% corporation tax, so the effective levy rate is 28%. From the above, we can seem to understand why the incidence of sole traders in Slovakia is so high. To clarify, we provide a brief summary.

Peter Varga at the conference explained in detail the individual items and evaluated the changes in the effective tax-tax rate with increasing wages/remuneration, the obligation of a sole trader to pay social contributions , including the possibilities for SROs to reduce the tax burden through the standard ways in practice for small SROs to optimize (legal/illegal) taxes (e.g. purchase of a car, etc.) and thus reduce the % of the effective tax rate in this table.

You can subscribe to the full video recording of the conference here:

Legal and regulatory challenges

At the conference, we also highlighted the legal risks associated with the shvarc system. This issue of illegal employment and dependent work is under scrutiny and falls under the jurisdiction of not only the tax authorities, but also the Labour Inspectorate, the Social Insurance Institution and, until recently, the Social Welfare and Family Labour Office. Employers who resort to this employment model risk heavy fines and even criminal prosecution. In order to define some kind of boundary, it is also necessary to analyse the different legal concepts that we may encounter in this issue.

In the case of the Labour Inspectorate and illegal employment, as a concept that is regulated by law č. 82/2005 Coll. on undeclared work and illegal employment, which defines several types of undeclared work, but primarily prohibits the classic shvarcsystem. It is understood by law as dependent work performed by an individual for an entrepreneur without an employment relationship or a state employment relationship existing between them. The performance of work by a self-employed person for an entrepreneur cannot in all circumstances be subsumed under the definition of a shvarcsystem. The essence is that the cumulative fulfilment of the features of dependent work found in Art. 2 of the Labour Code, under which it is the work performed:

• In the relationship of superiority of the employer and subordination of the employee;
• The employee performs it personally for the employer;
• As instructed by the employer;
• On behalf of the employer; and
• The employee performs work at the time specified by the employer.

In the case of tax administration and tax authorities, the issue is that of dependent activities, which is regulated in Section 5 of the Income Tax Act. Simply put, a dependent activity is a situation where a person is obliged to follow the instructions or orders of the payer of the income. A mechanical interpretation of dependent activity could lead to the erroneous conclusion that any instruction or direction given to someone is a dependent activity. Such an interpretation would not only be totally illogical, but more importantly, it would not reflect the state of affairs and the purpose which the legislature sought to achieve by the above formulation.

It is important to understand that the concept of dependent activity is broader than the concept of dependent work. This means that all dependent work is dependent activity, but not all dependent activity is dependent work. This distinction is key in controlling and sanctioning the shvarcsystem.

Controls and penalties: what can you expect in the scarcity system?

The Shvarcsystem is under the strict supervision of a number of supervisory authorities. The main institutions carrying out controls are:

• The Labour Inspectorate, which controls illegal employment under Art. on illegal employment;
• The tax authority controlling the dependent activity pursuant to Art. on income tax;
• Social Insurance Institution, which refers to the Income Tax Act.

Each of these authorities has the authority to carry out separate inspection activities, but we know from decision-making practice and findings that inspections are often initiated by the Labour Inspectorate. If it finds a breach of duty and determines that an offence has been committed, it issues a report and informs the Social Insurance Institution.

Employers who violate their obligations face heavy fines not only from the Labour Inspectorate but also from the Social Insurance Institution. The Labour Inspectorate can impose a fine of between EUR 2 000 and EUR 200 000 under the law. The Social Insurance Institution may impose a fine of up to EUR 16 600 and may also impose a penalty of 0.05% for each day of non-payment of insurance premiums, which amounts to 18% per year.

The penalties imposed by the tax office are different and this is related to the fact that the tax office has the power to carry out an audit even several periods back, which makes it impossible to determine the maximum amount and could therefore lead to liquidation consequences for the company. During the conference, Peter Varga spoke about the possibilities of how to avoid such liquidating sanctions from the tax office.

The law also defines non-monetary sanctions such as:

• Inability to obtain subsidies from the state budget;
• Inability to participate in public procurement;
• Inclusion in a public list of persons fined for illegal employment;
• And others.

Professor of criminal law Tomáš Strémy in a discussion with Petr Varga at the conference also spoke about the criminal aspect of the shvarcsystem. In extreme cases, a prison sentence of up to 12 years can be imposed. More about the criminal aspect of the shvarcsystem can be found in the video from the conference Shvarc system: “Employing freelancers” – where is the line?

Legal vs. factual: What does reality say?

In law, the principle is that the state of the law must correspond to the state of the facts. Simply put, the contract must reflect the actual situation. You cannot have a contract to do job A if the employee is actually doing job B. This is often referred to as a legal sham. For a better understanding and preparation of employment contracts, here are some of the indicators that should, or should not, be included in contracts. For example, such indicators are:

• Instructions: clear instructions regarding the work to be done.
• Representability: the ability of an employee to be represented.
• Project: work on specific projects.
• Holidays: rules on holidays and time off.
• Penalties: possible penalties for non-compliance.

These indicators can serve as an aid in assessing and proving the true nature of the contractual relationship in a dispute with the tax authorities or the Labour Inspectorate. When setting up relationships for clients, we focus on several details that neither an entrepreneur nor an attorney who does not deal with taxes and levies in detail will notice at first glance. If you would like to If you are interested or would like to assess/set up relationships at your company, let us know.

The shvarcsystem may seem at first glance to be an attractive employment model, but it hides a number of risks and potential negative consequences. At our conference, we offered an in-depth look at this issue, highlighted the importance of complying with laws and regulations, provided advice on how sanctions can be avoided, and opened a discussion on the opportunities and challenges associated with this model.

If you have any questions or need professional assistance in this area, please do not hesitate to contact us. We are here to help you find the best solutions for your business.