You’ve probably thought about starting a business with your best friends. If you do, you might wonder how your earnings as a partner would be taxed in India. Check out the guide below for more information.
What is a Partnership Firm?
A partnership firm is a business owned by several individuals who agree to work together. These individuals sign a document called a partnership deed, which outlines important details about the business and the roles of each partner.
When starting a partnership business, it’s essential to have a partnership agreement in place. This agreement serves as a contract between the partners and clarifies key aspects, such as:
- The names of the partners and who will be the managing partner
- The responsibilities and roles of each partner
- The share of profits or losses each partner will receive
- The salary, bonus, commission, or remuneration for partners
- The interest to be paid on the capital invested by each partner
- The duration of the partnership and what happens in the event of a partner’s death, resignation, or retirement
Since drafting a partnership deed requires legal knowledge and compliance, it’s often a good idea to get help from a professional, such as a lawyer or an accountant. The agreement can also affect the business’s taxable income, as some expenses may or may not be allowed based on the terms of the agreement.
In India, many professionals, including chartered accountants, cost accountants, company secretaries, lawyers, architects, contractors, IT professionals, retail businesses, wholesalers, and other service providers, run their businesses or professions as partnerships.
Partners earn money from the firm in three ways:
- Share of Profits
- Salary or Remuneration
- Interest on their investments or loans
Understanding Limited Liability Partnership (LLP): A Safer Option for Business Owners
You can also choose to form a Limited Liability Partnership (LLP) instead of a traditional partnership. An LLP combines the flexibility of a partnership with the benefits of limited liability.
In an LLP, each partner’s liability is limited to the amount they invest in the business, which means their personal assets are protected from the company’s debts. This makes it a safer option compared to a regular partnership, where all partners share personal liability for the business’s obligations.
An LLP is ideal for those looking to limit their personal risk while still enjoying the benefits of a partnership business structure. It is commonly used by professionals and businesses who want to grow without exposing themselves to significant financial risks.
Tax Assessment of a Partnership Firm: Key Conditions and Implications
A business will be assessed to tax as a partnership firm if the following conditions are met:
- The partners have signed a partnership deed that complies with the Partnership Act 1932.
- The partnership deed clearly specifies each partner’s share in the business.
If a partnership firm fails to meet these conditions under Section 184 of the Income Tax Act, no deductions will be allowed for any payments made to the partners, such as interest, salary, bonus, commission, or remuneration.
However, this does not mean that the business will not be recognized as a partnership firm for tax purposes. The firm will still be assessed as a partnership firm. The only difference is that any payments made to the partners (like interest or salary) will be disallowed under Section 40(b) of the Income Tax Act, 1961.
If these deductions are disallowed, the amounts paid to the partners will not be taxed in their hands.
Basic Exemption Limit for Partnership Firms: What You Need to Know
A partnership firm does not have a basic exemption limit, unlike individuals. The basic exemption limit refers to the amount of income up to which a person is not required to pay tax. Any income above this limit is taxable.
For example, for an individual below 60 years of age, the basic exemption limit for the financial years 2023-24 and 2024-25 was Rs. 2,50,000. This means that an individual with income up to Rs. 2,50,000 does not need to pay tax.
However, for a partnership firm, if the business makes a profit during the financial year, the income will be taxable, as there is no exemption limit. If the firm incurs a loss, that loss can be carried forward to the next year to offset future taxable profits.
Maximum Permissible Remuneration to Partners: Tax Deduction Rules
When calculating the taxable income of a partnership firm, the firm must determine the maximum permissible remuneration (such as salary, bonus, commission, or any other payment) that can be paid to partners. This is governed by Section 40(b) of the Income Tax Act, 1961.
Here’s how it works:
- Maximum Limit for Deduction: The salary, bonus, commission, or remuneration paid to partners can only be deducted from business income if it falls within the maximum permissible limit set by Section 40(b).
- Excess Payment: If the firm pays more than the permissible limit, the excess amount will not be allowed as a tax deduction. It will be disallowed while calculating the taxable business income.
- Less Than the Permissible Limit: If the firm pays less than the maximum limit, the entire amount paid to the partners will be allowed as a business expenditure.
- Conditions to be Met: If the conditions specified in Section 40(b) are not met, then the entire amount paid to the partners may be disallowed as a tax deduction.
In simple terms, the salary, bonus, commission, or any remuneration paid to partners will be deductible for tax purposes only if it is clearly stated in the partnership deed and is paid to working partners. The deduction is allowed to the extent of the lower of the following:
- The amount mentioned in the partnership deed.
- The maximum permissible limit as calculated under Section 40(b).
Is Interest on Partner’s Capital Tax Deductible?
Similar to salary, bonus, commission, or remuneration paid to partners, the interest on partner’s capital is also allowed as a business expense (tax deduction) only if certain conditions are met, as per Section 40(b) of the Income Tax Act, 1961.
Here’s how it works:
- Maximum Interest Limit: Under Section 40(b), the interest on a partner’s capital is allowed as a business deduction up to a maximum limit of 12% per annum. The interest is calculated at a simple rate.
- Interest Rate Above 12%: If the partnership deed specifies an interest rate higher than 12%, for example, 15%, then only 12% will be allowed as a deduction. The extra 3% will be disallowed and cannot be claimed as a tax deduction.
- Interest Payment Below 12%: If the interest paid is less than 12%, the entire amount paid will be allowed as a tax deduction.
- Conditions Under Section 40(b): If the conditions specified in Section 40(b) are not met, the entire amount paid as interest on partner’s capital will be disallowed.
In Simple Terms, Interest on a partner’s capital will be tax-deductible only if it is clearly mentioned in the partnership deed. The deduction will be allowed for the lower of the following two amounts:
- The percentage of interest mentioned in the partnership deed.
- 12% per annum (as per Section 40(b)).
So, if the partnership deed specifies an interest rate higher than 12%, only 12% will be deductible.
Conditions for Claiming Deduction Under Section 40(b)
A firm can claim a deduction for the remuneration paid to its partners if it meets the following conditions:
- Paid to a Working Partner: The remuneration must be given to a working partner, who is someone actively involved in managing the business.
- Authorized by the Partnership Deed: The payment must be approved in the partnership deed, which should specify the amount or how it will be calculated.
- Not for a Past Period: The remuneration must not cover any time before the partnership deed was created.
- Within Allowed Limits: The amount paid must not exceed the limits set by Section 40(b).
- Exclusion for Presumptive Income: The firm cannot claim this deduction if its income is taxed based on presumptive income under Sections 44AD or 44ADA.
Permissible Limits Under Section 40(b)
When paying remuneration to partners, the total amount must stay within certain limits. If it exceeds these limits, the firm cannot deduct that payment from its taxable income.
Limits:
The limit applies to the total remuneration for all partners combined, not individually.
If Book Profit is Negative, the maximum permissible remuneration is ₹1,50,000.
If Book Profit is Positive, the limits are based on the book profit as follows:
- For the First ₹3 Lakhs of Book Profit, you can choose either ₹1,50,000, or 90% of ₹3 lakhs (which is ₹2,70,000). The higher amount is allowed, so in this case, it’s ₹2,70,000.
- For the Remaining Book Profit, 60% of the amount over ₹3 lakhs.
Example Calculation:
If the book profit is ₹15 lakhs:
- For the first ₹3 lakhs: Choose between ₹1,50,000 or ₹2,70,000 (90% of ₹3 lakhs). The allowed amount is ₹2,70,000.
- For the remaining ₹12 lakhs (₹15 lakhs – ₹3 lakhs): 60% of ₹12 lakhs = ₹7,20,000.
- Total Remuneration Allowed: ₹2,70,000 + ₹7,20,000 = ₹9,90,000.
How to Calculate Book Profits:
- Start with the profit from the Profit & Loss account.
- Add:
- Remuneration and interest paid to partners (if included in the Profit & Loss account).
- Any carried forward business losses.
- Deductions under sections 80C to 80U (if included in the Profit & Loss account).
- Subtract:
- Income from house property, capital gains, and other sources (if included in the Profit & Loss account).
- Interest paid up to 12% as per Section 40(b).
TDS on Remuneration
The firm does not need to deduct tax at source (TDS) under Section 192 for this remuneration. Instead, it is treated as income under ‘Profits & Gains of Business or Profession’ (Section 28(v)), not as salary.
Tax on Interest Paid to Partners
The interest a firm pays to its partners on their capital or loans can be deducted from its taxable income according to Section 40(b) of the Income Tax Act.
Tax, Surcharge, and Cess on Partnership Firm’s Income: How it Works
To calculate the tax liability of a partnership firm, follow these steps:
- Calculate Gross Total Income: First, determine the gross total income of the firm under different income heads, excluding any exempted incomes.
- Apply Deductions: Deduct any applicable deductions under sections like 80G, 80GGA, 80GGC, 80-IA, 80JJA, etc., to calculate the total income of the firm.
- Tax Rate on Business Income: The income from the business of the partnership firm is taxed at 30%. However, there are other special tax rates for different types of income:
- Short-Term Capital Gains (under Section 111A): Taxed at 15%.
- Long-Term Capital Gains: Taxed at 20%.
- Winnings from Lottery: Taxed at 30%.
- Other specific types of income may also be taxed at special rates.
- Health and Education Cess: In addition to the basic tax, a health and education cess of 4% is applied on the tax amount. For example, if the tax on business income is calculated at 30%, then an additional 4% of 30% is added, making the total tax rate 31.2% (i.e., 30% + 4% on 30%).
- Surcharge on Income Above Rs. 1 Crore: If the partnership firm’s income exceeds Rs. 1 Crore, a surcharge of 12% is added to the tax liability before applying the health and education cess.
- No Surcharge for Income Below Rs. 1 Crore: If the partnership firm’s income is less than or equal to Rs. 1 Crore, no surcharge is charged.
In Simple Terms:
- Basic tax rate on business income is 30%.
- Health and education cess of 4% is applied on the tax calculated, making the total effective tax rate 31.2% for business income.
- Surcharge of 12% applies if the firm’s income exceeds Rs. 1 Crore, in addition to the tax and cess. No surcharge applies if the income is Rs. 1 Crore or less.
Tax on partner’s Share of Profit
The profit earned by the firm is taxed at the firm level. This means that a partner’s share of the firm’s profits is not taxed again for the partners.
According to Section 10(2A) of the Income Tax Act, partners do not have to pay tax on their share of the profits.
Tax on partner’s Remuneration
Payments like salary, commission, or bonuses to partners are considered their remuneration.
- If the remuneration is within the allowed limits (according to Section 40(b)), the firm can deduct this amount from its taxable income. The partner must pay tax on the remuneration they receive.
- If the remuneration exceeds the allowed limits, the firm cannot deduct this amount from its income and must pay tax on it. However, the partner receiving this excess amount won’t pay tax on it under ‘Profits & Gains of Business or Profession.
Key Points:
- Permissible Amount: The maximum allowable interest is 12% per annum. Any interest paid above this amount cannot be deducted by the firm and will be taxed as excess income. However, this excess interest is not taxed for the partner who receives it.
- Conditions for Deduction: The interest must be authorized in the partnership deed. It cannot relate to any period before the partnership deed was created. The firm can pay interest to both working and non-working partners.
- Presumptive Taxation: The firm cannot claim a deduction for interest if its income is taxed under presumptive taxation rules in Sections 44AD or 44ADA.
- Interest on Drawings: Interest that the firm receives from partners on their withdrawals cannot be used to offset the interest paid to partners on their capital or loans.
Special Cases of Interest Taxability
- Partners in Representative Capacity: If a partner acts on behalf of someone else (like representing a Hindu Undivided Family or HUF), the 12% limit does not apply. They can receive more than 12% interest, as long as it is reasonable.
- Partners in Individual Capacity: If they receive interest in a representative capacity, the normal rules apply.
TDS on Interest Payments
According to Section 194A(3)(iv), the firm does not need to deduct tax at source (TDS) on interest payments to partners. So, TDS is not applicable for these payments.
Deductions Allowed for Partnership Firms
When figuring out income tax, partnership firms can claim certain deductions. Here are some key deductible items:
- Remuneration or Interest: You can deduct remuneration or interest paid to partners, even if it doesn’t match what’s specified in the partnership agreement.
- Payments to Non-Working Partners: Deductions are also allowed for salaries, bonuses, or commissions paid to partners who don’t take part in the daily operations of the firm.
- Transactions Before the Partnership Deed: If payments to partners follow the partnership deed but relate to actions that occurred before the deed was created, they may still qualify for deductions.
By understanding these deductions, partners can effectively manage their taxes while following the rules in the partnership agreement. It’s important to adhere to tax laws and use available deductions correctly.
Income Tax Return Form and Due Date for Partnership Firms
A partnership firm is required to file an Income Tax Return (ITR) in Form ITR-5, regardless of whether the firm has made a profit or incurred a loss.
Steps to File the Return:
- Obtain Permanent Account Number (PAN): The firm must have a Permanent Account Number (PAN) before filing the return.
- Form to Be Filed: Partnership firms must file their return using Form ITR-5, unless they meet specific conditions for other forms.
Due Date for Filing the Return:
- Normal Due Date: The return must be filed by 30th July of the assessment year (the year following the financial year for which the income is assessed).
- Audit Requirement (Section 44AB): If the firm’s books of accounts need to be audited under Section 44AB of the Income Tax Act, 1961, the due date for filing the return is 31st October of the relevant assessment year and the audit report filing date is 30th September of the relevant assessment year.
- Presumptive Taxation Scheme: ITR-5 is for a partnership firm to file their income tax return. If the partnership firm has opted for the presumptive taxation scheme, it must file the return using ITR-4 instead of ITR-5.
In Simple Terms:
- File ITR-5 if your firm is not under presumptive taxation.
- The normal filing due date is 30th July.
- If an audit is required, the due date is 30th September.
- If the firm uses the presumptive taxation scheme, file using ITR-4.
Applicability of the Presumptive Taxation Scheme for Partnership Firms
A partnership firm can benefit from the presumptive taxation scheme under certain sections of the Income Tax Act, 1961. These sections simplify the process of calculating business income by allowing firms to declare income at a prescribed percentage of their turnover or gross receipts, without having to maintain detailed books of accounts.
Here’s how it works:
Section 44AE (For Goods Transport Agency):
- If the partnership firm operates a goods transport agency, it can declare business income under Section 44AE.
- However, to avail the benefits of this scheme, the firm must meet certain conditions specified in Section 44AE.
Section 44AD (For Business Partnership Firms):
- A partnership firm running a business (except for professions) can opt for the presumptive taxation scheme under Section 44AD.
- Under this section, the firm is required to declare 8% of its total turnover or gross receipts as business income.
Section 44ADA (For Professional Partnership Firms):
- If the partnership firm is involved in a profession (such as legal, medical, or technical services), it can use Section 44ADA.
- For professional firms, the scheme allows the declaration of 50% of the gross receipts or turnover as business income.
In Simple Terms:
- If your firm runs a goods transport agency, use Section 44AE.
- If your firm is a business (other than a profession), use Section 44AD to declare 8% of turnover as income.
- If your firm is a professional partnership (e.g., doctors, lawyers), use Section 44ADA to declare 50% of the gross receipts as income.
These schemes simplify tax filing by allowing firms to declare income based on a fixed percentage of turnover, making it easier to comply with tax regulations.
Applicability of Section 44AB – Tax Audit for Partnership Firms
A partnership firm is required to undergo a tax audit under Section 44AB of the Income Tax Act, 1961 if it meets certain criteria based on its turnover or gross receipts.
If the partnership firm is involved in selling goods, the tax audit is mandatory when its turnover exceeds Rs. 1 Crore in a financial year. If the firm is rendering professional services (e.g., legal, medical, or consultancy services), the limit is Rs. 50 Lakhs for the mandatory audit.
Tax audit is required based on the turnover or gross receipts of the firm, irrespective of whether the firm makes a profit or a loss. For example, if a business has a turnover of Rs. 3 Crore, even if it incurs a loss, it must still undergo a tax audit. Read out article on tax audit to know more.
Who Can Conduct the Audit:
- A Chartered Accountant (CA) in practice must conduct the tax audit.
- After the audit, the audit report in Form 3CB and annexure in Form 3CD, along with the balance sheet and profit and loss account, must be filed online.
TDS Provisions:
Tax Deducted at Source (TDS) provisions are also applicable to partnership firms. If any transactions require tax deduction as per the Income Tax Act, the firm must deduct and deposit the tax with the government on or before the due date. Failure to comply with TDS provisions may lead to interest and penalties.
Other Compliance:
Depending on the type of business, the firm may also need to comply with other tax laws and legal provisions. It is recommended to consult a tax professional or finance expert to ensure full compliance with tax regulations and avoid penalties.
In Simple Terms:
- Tax audit is mandatory for a partnership firm if its turnover exceeds Rs. 1 Crore for businesses or Rs. 50 Lakhs for professionals.
- The audit must be done by a Chartered Accountant and relevant documents like Form 3CB and Form 3CD, balance sheet, and profit and loss account must be submitted online.
- The firm must also comply with TDS provisions, failing which penalties could apply. Always consult a tax expert to stay compliant with all regulations.
Starting a partnership business in India can be rewarding, but understanding the tax rules and regulations is crucial for success. By knowing how to manage your income and remuneration, as well as understanding key deductions and exemptions, you can make better financial decisions for your business.
Remember, consulting with a tax expert or accountant is always a good idea to ensure that you stay compliant with tax laws, updates and minimize your liabilities.
