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October 13, 2020

Know all about Income Tax on Partnership Firm & LLP

by CA Shivam Jaiswal in Income Tax

Know all about Income Tax on Partnership Firm & LLP

What do you mean by a Partnership Firm?

A partnership firm is an organization of two or more persons to carry on a business in the capacity of co-owners with a view to earn profit. Each such person is called a partner. All the partners share the profits and losses in proportion of their respective ownership or as agreed between them. These firms are governed by the Indian Partnership Act, 1932.

Section 4 of Indian Partnership Act of 1932 defines firm as “Persons who have entered into partnership with one another are called individually “partners” and collectively “a firm”, and the name under which their business is carried on is called the “firm name”. The firm shall include a limited liability partnership as defined in the Limited Liability Partnership Act, 2008.

What are the characteristics of a partnership firm?

A partnership firm generally displays the following features:

  • Membership: At least 2 persons are required to begin a partnership while the maximum number of members is 100. All the individuals entering into partnership must be legally competent to enter into a partnership contract. Thus, minors, insolvent and lunatic persons cannot become members, but a minor can be admitted to partnership, to share profits.
  • Unlimited liability: The members of a partnership have unlimited liability, i.e. they arejointly and individually liable for the firm’s debts and obligations. If business assets are not adequate to repay liabilities, personal assets of all or any partner can be claimed by the creditors to realise the outstanding amount.
  • Sharing of profit and loss: The main purpose of the partnership is to share profit in the agreed ratio. In the absence of any agreement between partners, the business profits or losses are divided equally among all the partners.
  • Mutual Agency: The partnership business is undertaken by all the partners or any of the partners, who acts on behalf of all the partners. So, every partner is a principal as well as an agent.
  • Voluntary Registration: The registration of partnership is not mandatory, but it is recommended, as it offers certain benefits For instance in case of any conflict among partners, any partner can file suit against other partner or if there is any dispute between firm and outside party, then also the firm can file a case against that party.
  • Continuity: There is a lack of continuity in partnership. Death, bankruptcy, retirement or insanity of any partner can lead the partnership to end.
  • Contractual Relationship: The relation subsisting between partners is due to the contract, which may beoral, written or implied.

What do you mean by a Limited Liability Partnership (LLP)

A limited liability partnership is a partnership in which some or all partners have limited liabilities. It therefore can exhibit elements of partnerships and corporations. LLP is an alternative corporate business form that gives the benefits of limited liability of a company and the flexibility of a partnership. No partner is liable on account of the independent or un-authorized actions of other partners, thus individual partners are shielded from joint liability created by another partner’s wrongful business decisions or misconduct. Mutual rights and duties of the partners within a LLP are governed by an agreement between the partners.

What is the applicable tax rate for a firm?

  • A firm is liable to pay tax at the flat rate of 30% on its total income.
  • The amount of income-tax @30% shall be further increased by a surcharge at the rate of 12% of such tax, where total income exceeds Rs 1 crore. However, the surcharge shall be subject to marginal relief.
  • The amount of income-tax and the applicable surcharge, shall be further increased by education cess and secondary and higher education cess calculated at the rate of 4% respectively of such income-tax and surcharge.
  • Provisions of Alternate Minimum Tax (AMT) are applicable to a firm. Tax payable by a firm cannot be less than 18.5% (increased by Surcharge and HEC) of “adjusted total income” as per section 115JC.

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Is remuneration to partners deductible under Income Tax?

Section 40(b) of Income Tax Act places some restrictions and conditions on the deduction of expenses available to an assessee assessable as a partnership firm in relation to the remuneration and interest payable to the partners of such firm. The deductions regarding salary to partners and any payment of interest to partners cannot exceed the monetary limits specified u/s 40(b) and are available subject to the fulfilment of conditions mentioned therein.

Remuneration includes salary, bonus, commission. The following conditions must be satisfied before claiming any deduction in respect of salary, bonus, commission or other remuneration payable to partner by a partnership firm.

  • Such remuneration should be paid only to the working partner. Explanation 4 to section 40(b) defines working partner as one who is actively engaged in conducting the affairs of the business or profession of the firm of which he is a partner. To be a working partner, the partner has to be actively engaged in conducting the affairs of the business or profession of the firm. 
  • It should be authorized by the Partnership Deed. Also, the amount of salary or manner of its computation is to be mentioned in the deed. If there is not any such provision in deed then no deduction is allowed.
  • It should not pertain to a period prior to Partnership Deed
  • It should not exceed the permissible limit.

What is the permissible deduction specified u/s 40(b)?

Remuneration to partners should be within the permissible limits as mentioned below. This limit is for total salary to all partners and not per partner.

Book ProfitAmount deductible as remuneration under section 40(b)
If book profit is negativeRs. 1,50,000
If book profit is positive: 
On first Rs. 3 lakh of book profitRs. 1,50,000 or 90% of book profit whichever is more
On the balance of book profit60% of book profit

For instance, if the Book profit = Rs. 9 Lakhs
Then Maximum salary allowed as deduction = 3,00,000*90% + 6,00,000*60% = Rs. 6.3 lakhs

How are book profits computed?

Book Profits are computed with the help of a simple formula as given below:

Book Profits = Profit as per Profit & Loss a/c + Remuneration to partners if debited to Profit and loss a/c + Brought forward business loss, deduction under section 80C to 80U if debited to profit and loss a/c – Income under house property, capital gain, other sources if credited to profit and loss a/c

Can a partnership firm claim deduction of interest paid on partner’s capital?

Interest is paid to partners who have introduced the capital whether by way of cash or any other mode. Non-cash capital (tangible or intangible) is evaluated in monetary terms at the time of its introduction. The interest is payable on the amount provided under the capital clause of the Partnership Deed.

For deduction of interest following conditions must be satisfied:

  • Payment of Interest must be authorized by the partnership deed and It should be related to the period of the partnership deed.
  • The rate of interest should not exceed 12%. If the amount of interest exceeds 12% of the capital then such excess amount is disallowed.
  • If a person is a partner in a firm on behalf or for the benefit of any other person then any interest paid to such person otherwise as a representative capacity shall not be taken into account for the purpose of this section. Interest paid to such person as a representative capacity and to person so represented is taken into account.
  • If interest is paid to a partner on behalf or for the benefit of any other person then such interest is not disallowed under this section.
  • If the firm receives interest on drawings from a partner then it is taxable in the hands of the firm

How is remuneration or interest taxed in the hands of the partners?

  • The amounts which are deductible as Remuneration or Interest in the hands of the firm under Section 40(b) are taxable in the hands of the partner which are receiving such amounts under the head Profit from business/profession.
  • However, if the amount is disallowed in the hands of the firm, then such amounts are exempt in the hands of a partner.
  • The partner’s share in the total income of firm will be exempt in his hands and will not be included in his total income.
  • On account of this exemption, he will not be entitled to set-off his share in the firm’s loss against his other personal income.

Is it mandatory of a firm to file return of income?

  • Yes, it is mandatory for every partnership firm to file the return of income irrespective of amount of income or loss in ITR 5.
  • ITR 5 is an attachment less form and there is no requirement for submitting any documents or statements along with a partnership firm tax return.
  • However, the taxpayer must save all records pertaining to the business and produce the same before tax authorities when requested.

Is e-Filing of return mandatory?

It is mandatory for a firm to file return of income electronically with or without digital signature. A partnership firm may also file return of income under Electronic Verification Code. However, a firm liable to get its accounts audited under section 44AB shall furnish the return electronically under digital signature.

Is tax audit of a Partnership Firm (not opting for presumptive taxation) mandatory when the partnership firm has incurred losses?

Although no compulsory audit is provided by the Indian Partnership Act, 1932 but in practice most of the partnership firms get their accounts audited as per the provisions of the Income Tax Act, 1961. Tax Audit of partnership firm is mandatory if the turnover/ gross receipt exceeds Rs 1 Crore in case of business and Rs 50 lakhs in case of profession. So, if a partnership firm’s turnover/receipts exceed the limit, they will have to conduct tax audit even if the same results into a loss.

Is tax audit of a Partnership Firm carrying on business (opting presumptive taxation scheme under section 44AD) has a business loss?

Tax audit will not be mandatory when the partnership firm has a business loss but the income is below the basic threshold limit.

Tax audit will be mandatory when the partnership firm declares taxable income below the limits prescribed under the presumptive tax scheme and has income exceeding the basic threshold limit.

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