A firm in partnership is an entity that is formed by two or more parties who agree to bear the profits and losses of one business. It is governed by the Indian Partnership Act of 1932 and is based on principles of trust, cooperation, and a written agreement, which is mutually agreed upon amongst the partners, known as the partnership deed. In a partnership firm, partners may be of various types – dormant or sleeping partner, active partner, nominal partner, minor partner, partner only in profits, specific partner, implied partner or a partner by conduct, etc. Partners supply capital, expertise, and effort, and they are jointly responsible for the management of the firm’s affairs and liabilities. They are both agents and principals of the firm. This form of business organisation is popular, particularly with small and medium-sized businesses, because it is simple, allows for easy management, and entails collective decision-making.
What is Partners’ Remuneration?
Partner remuneration is the compensation that a partnership firm pays to its working partners for the services they provide in managing and conducting the business. It can be a salary, bonus, commission, or other monetary reward. It is different from the share in profit that all partners enjoy and is paid to encourage active participation in the day-to-day activities of the business.
According to the Income Tax Act of 1961, Section 40(b), the partners’ remuneration is allowed as a deduction from the taxable income of a firm if certain requirements are met. It must be authorised by the partnership deed, be paid only to working partners, and should not cross the specified threshold as per the book profit of the firm.
The intention of such remuneration is to provide an equitable incentive to partners contributing time, effort, and skill over and above capital contributions. Unreasonable or unsubordinated payments are disallowed to avoid tax evasion. The remuneration to the partner is chargeable to tax as “Business Income” under the head “Income from business and profession” under the Income Tax Act, 1961.
Proper structuring of partner remuneration provides for compliance, transparency, and equitable remuneration, and maximises the tax obligation of the firm.
Conditions or Rules to Calculate Partners’ Remuneration
The compensation of partners should follow the provisions detailed in both the Partnership Deed and the Income Tax Act, 1961. Remuneration is allowed only for partners actively involved in the business, and only if the remuneration is properly authorized, measured, and within the assigned limits can deductions be made. Proper calculation and documentation are required to avoid disallowance under tax assessment. The allocation of remuneration to partners in a partnership firm in India is largely governed by the Partnership Deed signed by the partners and the Income Tax Act of 1961. Remuneration given to partners can be claimed as a deduction by the firm in accordance with certain rules and regulations laid out in Section 40(b) of the Income Tax Act, 1961. The following is an elaborate explanation:
1. Significance of the Partnership Deed
The partnership deed has to clearly sanction the payment of remuneration to working partners. The deed needs to clearly state:
- The quantum of remuneration payable or
- The formula for calculating remuneration (for example, a percentage of book profit).
- If the deed is unclear or ambiguous, no remuneration deduction will be allowed under tax law.
2. Eligibility – Working Partner
Only working partners (actual participants in the firm’s business) are entitled to receive remuneration. Sleeping or non-working partners are not entitled to any remuneration for tax deduction purposes.
3. Maximum Permissible Remuneration [as per Section 40(b)(v)]
The Income Tax Act, 1961 prescribes ceilings on remuneration payable and deductible from income of the firm. This is determined as a percentage of the firm’s “book profit” and computed as below:
If the book profit is:
| Book Profit (₹) | Highest Permissible Remuneration |
|---|---|
| Loss or up to ₹3,00,000 | ₹1,50,000 or 90% of book profit, whichever is higher |
| Above ₹3,00,000 | ₹1,50,000 + 60% of the amount of book profit exceeding ₹3,00,000 |
Note:
Book profit refers to net profit according to the Profit & Loss Account, before partners’ remuneration and after making provision for tax disallowances/allowances. The above thresholds are computed for the aggregate remuneration due to all working partners collectively.
Section 40(b) of the Income Tax Act, 1961
Section 40(b) of the Income Tax Act, 1961 deals with deductions of expenses incurred on payments made by a firm of partners to partners and includes:
- Remuneration (salaries, bonuses, commissions)
- Capital interest
This section imposes limitations and restrictions on such payments when the firm intends to claim them as deductions as business expenses.
Objective:
Section 40(b) seeks to counteract tax evasion by prohibiting excessive profits for partners and allowing only genuine and reasonable deductions from the income of the firm.
Applicability:
This provision applies only to partnership firms (with Limited Liability Partnerships (LLPs)) that are treated as firms under the Income Tax Act of 1961.
This provision applies only to partnership firms, such as Limited Liability Partnerships (LLPs), that are treated as firms under the Income Tax Act.
Disallowance of certain payments:
The provision prohibits the following payments by a firm to its partners unless certain conditions are fulfilled:
(i) Partner interest payment is permitted, subject to the condition that the yearly rate of interest does not exceed 12%. Interest payments are only allowed if authorised by the partnership deeds. More than 12% interest is not deductible as an expense.
(ii) Partner remuneration (remuneration by way of salary, bonus, commission, or other amounts):
- Restricted to working partners.
- Sanctioned under the partnership deed.
- Paid as per the partnership deed.
- Within the limits as specified below.
Remuneration – Prescribed Limits [Section 40(b)(v)]
The highest remuneration permissible to working partners is:
| Book Profit (₹) | Allowable Remuneration |
|---|---|
| On the first ₹3,00,000 or in case of loss | ₹1,50,000 or 90% of book profit, whichever is higher |
| On the balance book profit | 60% of the balance book profit |
“Book profit” means the net profit as appearing in the Profit and Loss Account (prior to partner’s remuneration), computed after making allowance or disallowance under the tax laws.
Conditions for deduction under this section:
- The partnership deed must expressly provide for interest or remuneration.
- Remuneration shall be paid only to a working partner i.e., who actively takes part in the business of the firm.
- Amount and mode of payment of remuneration must be clearly stated in the deed.
- Interest rate shall not be more than 12% p.a. and any rate in excess shall not be allowed.
- Remuneration paid should be within the limits prescribed under this section.
Landmark Judgements:
- CIT v. Anil Hardware Store (Himachal Pradesh HC): Held that even though the deed mentions remuneration as per Section 40(b), it is sufficient compliance for deduction.
- Brahmaputra Industrial Pvt. Ltd. v. CIT (SC): Payments cannot be excessive or unreasonable under the pretext of remuneration or interest.
Section 40(b) only allows for valid payments to working partners (remuneration and interest) as a deduction in a firm. The interest should not be more than 12%, and remuneration should be within the stipulated limits. The partnership deed is pivotal, and documentation is crucial in order to claim such expenses and not face disallowances while determining the tax.
Illustration or Example
Suppose a partnership firm has two working partners, viz., Partner A and Partner B. The deed of partnership allows remuneration to working partners as per Section 40(b) of the Income Tax Act, 1961. The net profit from the company before deduction of any remuneration is ₹9,00,000. No remuneration has been deducted as yet.
Step by Step Partners Remuneration Calculation:
- Book profit = ₹9,00,000 (not yet debited remuneration).
- Remuneration Limit under Section 40(b)(v): For the first ₹3,00,000 of book profit, the higher of ₹1,50,000 or 90% of ₹3,00,000 is ₹2,70,000. The balance is ₹6,00,000 (₹9,00,000 – ₹3,00,000), which is 60% of ₹6,00,000 or ₹3,60,000.
- Maximum allowable remuneration: ₹2,70,000 + ₹3,60,000 = ₹6,30,000.
If the company pays ₹3,15,000 to Partner A and ₹3,15,000 to Partner B, the aggregate amount (₹6,30,000) is allowed as a deduction under Section 40(b) since it complies with the deed of partnership and tax laws on income. This method ensures compliance and reduces the possibility of disallowance at the time of assessment.
Conclusion
Remuneration in a partnership firm is also important for rewarding the partners for the efforts they put in. Yet, its calculation, as well as deductibility, are subject to the stringent provisions of the Income Tax Act, 1961, specifically Section 40(b). For the remuneration to qualify as a business expense deductible by the firm, it must be clearly approved by the partnership deed, paid only to working partners, and within the legislative limits. The remuneration should be fair and explainable in terms of the book profit of the firm. Failure to adhere to the above provisions might result in the disallowance of remuneration and tax implications for the firm. It is therefore important that firms preserve proper records, maintain legal compliance, and consult tax experts when needed. Well-designed partner remuneration not only motivates partners but also facilitates proper tax planning and financial management in accordance with the law.
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