Under the Income-tax act, 1961, lawmakers have prescribed the different methods for the computation of tax liability for different entities. In this article, we will discuss the taxation of partnership firms. We will discuss the income tax rates applicable for partnership firms, maximum remuneration allowed to partners in the firm, conditions for allowance of remuneration and interest on capital and other ancillary matters. A firm shall be assessed as a firm if there is a partnership deed as an instrument and an individual share of the partner is specified in the instrument.
So, let’s begin:
Income Tax rates applicable for Partnership firms for the Assessment year 2020-21:
Tax Rates: 30% on total Income Plus 12% surcharge (Where the total income exceeds Rs.1 Crore) Plus 4% Health and Education Cess.
In case of capital gain, Long term capital gain and short term capital gain shall be taxed at the rate as prescribed under section 112, 111A and 112A.
Note: there is no change made in the Tax rates applicable for Partnership firms.
Let’s take the example for better understanding of the income tax rates:
For the financial year 2019-20, Bhatia associates & Co. has the total income of Rs.50 Lakhs, in this case, the tax liability for them shall be calculated as follows:
|Tax @ 30%
|Surcharge @ 12%
|Cess @ 4%
There is one more concept which is marginal relief, although this concept is common that means it not only applies to partnership firms rather it will be applicable for all the types of the assessee. But as per my opinion, it is important for you to understand
Let’s understand this by an example:
Total Income is 1 Crore in case 1 and 1.01 crore in Case 2
|Tax @ 30%
|Surcharge @ 12%
|Cess @ 4%
If you look at the tax liability, you will notice that by increasing the income of Rs.1 Lakhs, the liability of the assessee is increasing by Rs.4.09 Lakhs. Hence, it was found that there were some mistakes in our system so, to rectify this, the lawmaker introduces the concept of Marginal relief. In this case, where the tax amount is being increased at the rate more than the increase in the income then the liability shall be calculated in the following manner:
Tax on Rs. 1 Crore plus Rs.1 Lakhs that means: 31,20,000 Plus 1,00,000 In our given case.
Now, you can refer to our previous articles for the detailed study about the marginal relief. Now, let’s study other provisions of the taxation of partnership firms.
The shares of the partners in the total income of the firm is exempt in the hands of partners under section 10(2A).
Remuneration and interest paid to the partners are allowed as a deduction to the firm subject to the limits and conditions specified in section 40(b).
Remuneration and interest received by the partners shall be taxed in their hands as PGBP under section 28 of the income tax act, 1961. However, salaries and interest which have not been allowed under section 40(b) or section 184(5) shall not be added to the income of the partners under section 28(v).
Remuneration to Partnership firms
As per the Income-tax Act, remuneration given to Non-working partners is not allowed to the firms or LLP.
As per Explanation 4 to section 40(b), The working partner is the partner who is actively engaged in conducting the affairs of the business or profession of the firm in which he is a partner as the case may be.
Section 40(b): Payment of interest, salary, commission, bonus or remuneration made by the firm to its partners
Interest and remuneration paid to the partners by a firm are not deductible. However, the interest and remuneration paid to the partners by a firm are deductible if all the following conditions are satisfied:
- As we have discussed above that it is necessary that the payment of interest, salary, bonus, commission or whatever name is called, the payment must be made to the working partner.
- The remuneration shall be admissible in the partnership deed whether through by specifying the amount or it describes the method of calculation of remuneration to the partners.
- The remuneration should not pertain to the period prior to the partnership deed that means it should not be given to the partners on a retrospective basis.
- The payment of interest calculated to the partners shall not exceed the rate of 12% simple interest per annum.
Hence, if the interest is being given at a higher rate, then such a high amount shall not be allowed as a deduction to the firms.
The payment of remuneration should not exceed the following amount:
|On the first Rs.3 Lakhs of book profits or in case of loss
|The maximum remuneration shall be the
At the rate of 90% of the book profit,
whichever is more.
|On the balance of book profits
|At the rate of 60% of books profits
Following adjustments shall be made in the Net profit under the head PGBP, computing the book profits:
- Only the income under the head PGBP is to be taken.
- The current year and brought forward depreciation is to be deducted.
- Brought forward losses shall not be deducted.
- Chapter VI A deductions shall also be not deducted
- Remuneration if already debited to the profit and loss account then it shall be added back in the profit and loss account.
- Interest paid to the partners, to the extent allowed to the partners is not to be added back. However, in excess of interest shall have to be added back to the profit and loss account.
Cases where the remuneration and interest paid to partners be disallowed even if the conditions under section 40(b) are satisfied
- Failure on part of the firm as referred to in section 144.
- As per section 185, Non-compliance with the technical requirements of section 184 of the firm and partners.
Such salary shall not be taxable in the hands of the partner.
Section 187: Change in the constitution of the firms
Where during the course of the assessment under section 143/144/147/153A, it is found that a change has occurred in the constitution of the firm, the assessment shall be made on the firm as constituted at the time of making the assessment.
Note: There is a change in the constitution of the firm in the following 2 cases:
- One or more partners cease to be partner/one or more new partners are admitted and
- One or more partners before the change, continue as a partner after the change in the respective profit sharing ratio.
Although, Clause (a) shall not be applicable where the firms have been dissolved at the time of death of any of the partners.
Section 78: Set off of carrying forward loss in the case where there is a change in the constitution of the firm:
It will apply only in case of retirement/ Death of partner and not in case of new admission of a partner. Set off of carried forward losses of retired/deceased partner shall be allowed only to the extent that it does not exceed such partner’s share in profits of the firm in relevant previous years.
Now lets summaries the allowability of remuneration and interest to the partners
|Allowability of remuneration
|Allowability of Interest
|Allowed to working partners
|Allowed to working/Non-working partners
|Type of Partners
|The partner should be individual only
|Any type of partners
|The remuneration must be authorized by the Partnership Deed
|interest also must be authorized by the Partnership Deed
|In a partnership deed:
Whether it is mentioned the amount of remuneration payable to each partner or
It lays down the method of calculation of remuneration of each partner
|Rate of interest shall be required to be specified in the partnership deed
|Remuneration shall not be allowed as deduction if it has been given on a retrospective basis
|Interest also cannot be given to partners on a retrospective basis.
Income exempt from Tax
Share in the total income of the firms shall be exempt in the hands of the partners because it has already been taxed in the hands of the firm:
It is clarified that the total income of the firm includes income which is exempt and deductible under various provisions of the act. It is therefore further clarified that the income of the firms is taxed in the hands of the firm only. Hence, the entire profit credited to the capital accounts of the partners would be exempt from tax in the hands of the partners even the income chargeable to tax becomes Nil in the hands of the firm on account of any exemption or deduction. For Example:
|Total Income of the firm before deduction under chapter VI A
|Deductions under Chapter VI-A
Let’s say the profits as per the books of account are also Rs.100 Lakhs. There are 2 partners of the firm sharing the profits equally. Now, Rs.50 Lakhs is credited to the capital account of each partner of the firm. CBDT has clarified, though the total income of the firms is Nil then also such income shall not be taxed in the hands of the partners and shall be treated as exempted in the hands of partners under section 10(2A).
Important Case study:
Whether the remuneration of the partner can be disallowed as per section 40A(2) where it meets the conditions as mentioned under section 40(b).
As per the case of CIT Vs. Great city manufacturing, the Assessing Officer has disallowed the remuneration of the partner in the hands of the firms by stating that the remuneration is being unreasonable and excessive in which the order has been passed against the assessing officer.
Crux: Where the firm is giving remuneration to its partners which fulfill the conditions as mentioned under section 40(b) then such remuneration shall be allowed to the firm even if such amount if unreasonable and excessive as described under section 40A(2) of the Income-tax act.
I hope this article will help you to understand the taxation of partnership firm in a better way. Even if you have any queries then you can contact us. We will be happy to assist you.