An agreement, if confirmed, would take Germany a step closer to a new government after more than four months of political uncertainty that has weakened Germany's role in worldwide affairs and raised questions about how long Merkel will stay in her job.
German Chancellor Angela Merkel, leader of the Christian Democratic Union party (left) and Martin Schulz, leader of the Social Democrat Party (SPD), exit the stage following a news conference in Berlin on February 7, 2018.
Germany has been in limbo since an inconclusive September election left Merkel and her CDU/CSU bloc without a ruling majority, leading to the longest coalition negotiations in postwar history and weakening the veteran chancellor's leadership.
The CDU and the SPD have been in coalition talks since the first week of January after the collapse of Merkel's attempt to form a coalition with the pro-business Free Democrats and the Green party.
In the end the SPD, her former coalition partners, came to her rescue.
Merkel has made some major concessions to get the deal done and secure her fourth term.
A deal will require approval in a ballot of the Social Democrats' members, many of whom are skeptical about renewing the alliance that has governed Germany since 2013 after a disastrous election result in September. Negotiators ended their meeting in the SPD party headquarters and agreed to resume talks - initially expected to conclude on Sunday - at the party headquarters of Merkel's conservatives in Berlin on Tuesday.
Merkel's Christian Democratic Union, under the agreement, would gain the economy ministry while giving up the interior and finance spots.
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While Merkel sets policy guidelines for the government as chancellor, SPD-led finance and foreign ministries will allow Schulz to make good on his pledge to deepen euro-area cooperation and reach out to France's Emmanuel Macron, who says the 19-country currency bloc should have a joint budget and finance minister. But after more than four months of talks, crises and restarts, coalition talks in Berlin have gone down to the wire in a stand-off over health and labour market reform.
Observers expect the referendum to be tight, with the SPD's left and youth wings fiercely opposed to another four years governing in Merkel 's shadow.
Despite their campaign promise to terminate Turkey's European Union membership process, the parties' coalition agreement avoided any radical proposals.
The parties had seen their popularity drop after being in coalition on and off since 2005.
The SPD will have to vote the deal before it can be officially finalised.
Failure to reach an agreement, or a rejection by Social Democrat members, would leave a minority government under Mrs Merkel or a new election as the only viable options.
An Insa poll on Monday showed mounting pressure on Schulz, with support for the SPD dropping to just 17%, well below its election result of 20.5%, the party's worst since Germany became a federal republic in 1949.