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Taxation of Partnerships

Taxation of Partnerships

Partnership is the most common form of business organisation in India. Partnership firms are governed by the provisions of the Indian Partnership Act,1932. The Act lays down the rules relating to formation of partnership, the rights and duties of partners and dissolution of partnership. It defines partnership as a "relationship between persons who have agreed to share the profits of business carried on by all or any of them acting for all". This definition gives three minimum requirements to constitute a partnership :

  • There must be an agreement entered into orally or in writing by the persons who desire to form a partnership.

  • The object of the agreement must be to share the profits of business intended to be carried on by the partnership.

  • The business must be carried on by all the partners or by any of them acting for all of them.

Under the Act, persons who have entered into partnership with one another are individually called as 'partners' and collectively as 'firm' and the name under which they run their business is called the 'firm name'.


Provisions for taxation of Partnership Firms

Partnership firm is subjected to taxation under the Income Tax Act,1961. It is the umbrella Act for all the matters relating to income tax and empowers the Central Board of Direct Taxes (CBDT) to formulate rules (The Income Tax Rules,1962) for implementing the provisions of the Act. The CBDT is a part of Department of Revenue in the Ministry of Finance. It has been charged with all the matters relating to various direct taxes in India and is responsible for administration of direct tax laws through the Income Tax Department. The Income Tax Act is subjected to annual amendments by the Finance Act, which mentions the 'rates' of income tax and other taxes for the corresponding year.

Under the Income Tax Act, the Partnership firm is taxed as a separate entity, distinct from the partners. In the Act, there is no distinction between assessment of a registered and unregistered firms. However, the partnership must be evidenced by a partnership deed. The partnership deed is a blue print of the rights and liabilities of partners as to their capital, profit sharing ratio, drawings, interest on capital, commission, salary, etc, terms and conditions as to working, functioning and dissolution of the partnership business.

Under the Act, a partnership firm may be assessed either as a partnership firm or as an association of persons(AOP). If the firm satisfies the following conditions, it will be assessed as a partnership firm, otherwise it will be assessed as an AOP :

  • The firm is evidenced by an instrument i.e. there is a written partnership deed.

  • The individual shares of the partners are very clearly specified in the deed.

  • A certified copy of partnership deed must accompany the return of income of the firm of the previous year in which the partnership was formed.

  • If during a previous year, a change takes place in the constitution of the firm or in the profit sharing ratio of the partners, a certified copy of the revised partnership deed shall be submitted along with the return of income of the previous years in question.

  • There should not be any failure on the part of the firm while attending to notices given by the Income Tax Officer for completion of the assessment of the firm.

It is more beneficial to be assessed as a partnership firm than as an AOP, since a partnership firm can claim the following additional deductions which the AOP cannot claim :

  • Interest paid to partners, provided such interest is authorised by the partnership deed.

  • Any salary, bonus, commission, or remuneration (by whatever name called) to a partner will be allowed as a deduction if it is paid to a working partner who is an individual. The remuneration paid to such a partner must be authorised by the partnership deed and the amount of remuneration must not exceed the given limits.


Assessment of Partners of a firm

The share of the partner (including a minor admitted for the benefit of the firm), in the income of the firm is not included in computing his total income i.e. his share in the total income of the firm shall be exempt from tax [section 10(2A) of the Act].

If conditions of section 184 and section 40(b) of the Act are satisfied, then any interest, salary, bonus, commission or remuneration paid/payable by the firm to the partners is taxable in the hands of partners (to the extent these are allowed as deduction in the hands of the firm).

The points to be noted are :

  • Remuneration from a firm is not taxable under the head "Salaries". Hence, standard deductions cannot be claimed in respect of such remuneration.

  • Any expenditure incurred in order to earn such income can be claimed as a deduction from such income. For example, if a partner borrows money to make his capital contribution to the firm and he is paid interest on his capital contribution, the amount of such interest will be taxed under the head "Profits and gains of business or profession", but the interest paid by him on the borrowed money will have to allowed as a deduction.

  • If the whole or a part of salary/interest is not allowed as deduction in the hands of the firm , than the whole or that part of salary/ interest is not taxable in the hands of the partners. In other words, in the hands of partners the entire remuneration/ interest (excluding the amount disallowed under section 40(b) and/or section184 of the Act) is chargeable to tax.


Compute Taxable Income of a firm

Steps for Computation of taxable income of a firm :
  • Find out the firms income under the different heads of income, ignoring the prescribed exemptions. The heads of income are :

    • Income from House Property

    • Profits and Gains of Business or Profession

    • Capital Gains

    • Income from other sources including interest on securities,winnings from lotteries,races,puzzles,etc. ('Salary' income head is not included)

  • The payment of remuneration and interest to partners is deductible if conditions of section 184 and section 40(b) of the Income Tax Act are satisfied. Any salary, bonus, commission or remuneration which is due to or received by partners is allowed as a deduction from income of the partnership firm and the same is taxable in the hands of partners.

  • Make adjustments on account of brought forward losses/ disallowances of interests, salary, etc paid by firm to its partners. The total income so obtained is the "gross total income".

  • From the "gross total income", make the prescribed deductions and the balancing amount is the "net income" of the firm.



Other Categories

Taxation of Individuals
Who is liable to pay income tax
Sources of Income
Income from Salaries
Income from Capital Gains
Income from House property
Income from Profits & gains of business or profession
Income from other sources
Taxation of Partnerships
Customs Duties (Import Duty and Export Tax)
Wealth Tax
Taxation of Corporates
Taxation of Agents
Excise Duty
Permanent Account Number (PAN)
Taxation of other forms of business entities
Taxation of Trusts
Taxation of Small Scale Industries
Joint Venture Companies
Cooperative Societies
Taxation of Representative offices
Service Tax
Value Added Tax (VAT)


India has a well developed tax structure. The power to levy taxes and duties is distributed among the three
tiers of Government, in accordance with the provisions of the Indian Constitution. The main taxes/duties that
the Union Government is empowered to levy are:- Income Tax (except tax on agricultural income,
which the State Governments can levy), Customs duties, Central Excise and Sales Tax and Service Tax. The principal taxes levied by the State Governments are:- Sales Tax (tax on intra-State sale of goods), Stamp Duty (duty on transfer of property), State Excise (duty on manufacture of alcohol), Land Revenue (levy on land used for agricultural/non-agricultural purposes), Duty on Entertainment and Tax on Professions & Callings. The Local Bodies are empowered to levy tax on properties (buildings, etc.), Octroi (tax on entry of goods for use/consumption within areas of the Local Bodies), Tax on Markets and Tax/User Charges for utilities like water supply, drainage, etc.

In the wake of economic reforms, the tax system in India has under gone a radical change, in line with the
liberal policy. Some of the changes include:- rationalization of tax structure; progressive reduction in peak
rates of customs duty; reduction in corporate tax rate; customs duties to be aligned with ASEAN levels;
introduction of value added tax; widening of the tax base; tax laws have been simplified to ensure better compliance. Tax policy in India provides tax holidays in the form of concessions for various types of investments. These include incentives to priority sectors and to industries located in special area/ regions. Tax incentives are available also for those engaged in development of infrastructure.