Understanding Partner Compensation and Its Tax Implications
This article clarifies the rules for partner remuneration and interest deductions under Section 40(b) of the Income Tax Act. It explains the conditions partnership firms must meet to claim these expenses and outlines the maximum deductible limits based on book profits for different financial years. The content also covers the tax treatment of these payments for both the firm and individual partners, including nuances for representative capacity and profit sharing.
Partnership firms distribute profits among partners according to the partnership deed. Partners can be active participants, known as working partners, or merely capital contributors, referred to as silent partners. Compensation, including salaries, bonuses, commissions, or interest, is governed by the deed's remuneration clause and falls under specific tax regulations outlined in Section 40(b) of the Income Tax Act.
Defining Partner Compensation
Partner compensation encompasses salaries, bonuses, or commissions paid by a partnership firm to its partners. These payments acknowledge a partner's contribution, much like employee salaries.
The forms of compensation partners can receive for their involvement include:
- Remuneration
- Interest on invested capital
- A share of the firm's profits
Tax Deducted at Source on Partner Compensation
According to Section 194T, tax is deducted at source (TDS) at a rate of 10% on payments such as salaries, remuneration, bonuses, or commissions made by a firm to a partner if the total annual payment surpasses Rs. 20,000.
Deductibility of Partner Remuneration
Partnership firms are permitted to treat interest and remuneration paid to partners as deductible expenses when calculating their 'Profits and Gains from Business and Profession' (PGBP). Nevertheless, Section 40(b) of the Income Tax Act imposes a cap on the maximum amount of interest and remuneration that can be claimed as a deduction. This deduction is not applicable if the partnership opts for presumptive taxation under Section 44AD or Section 44ADA.
Section 40(b) of the Income Tax Act: Partner Remuneration and Interest Limits
Section 40(b) of the Income Tax Act sets an upper limit on the compensation and interest on capital that can be disbursed to a partner. Amounts paid above this specified limit are not eligible for tax deduction.
Conditions for Deducting Partner Remuneration
Partner remuneration, comprising salary, bonus, and commission, must meet certain criteria to be eligible for deduction:
- It must be paid exclusively to working partners.
- The partnership deed must explicitly authorize the remuneration, detailing either the specific amount or the calculation method. Without such provisions, no deduction is permissible. Often, deeds broadly allow partner salaries up to the maximum limit specified by this section to ensure deductibility.
- The remuneration must pertain to the period from the partnership's inception date, as stated in the partnership deed, and not any earlier period.
- The remuneration amount must adhere to the allowable limits, which are discussed in the subsequent section.
- Interest on a partner's capital is capped at a maximum simple interest rate of 12% per annum.
- The remuneration must correspond to the term of the existing partnership deed. If the deed is renewed, the revised terms will apply for the new period.
Maximum Deductible Partner Remuneration
Section 40(b) outlines the maximum permissible deduction for partner remuneration. It is crucial to note that this limit applies to the collective salary for all partners, not individual partners. The limits for Financial Year 2024-2025 are presented below:
| Book Profit (FY 2024-2025) | Limit |
|---|---|
| On the first Rs.3,00,000 of book profit or loss | Rs.1,50,000 or 90% of the book profit, whichever is higher |
| On the remaining balance of book profit | 60% of the book profit |
For Financial Year 2025-26 and subsequent years, the following revised limits will be applicable:
| Book Profit (FY 2025-26 onwards) | Limit |
|---|---|
| On the first Rs.6,00,000 of book profit or loss | Rs.3,00,000 or 90% of the book profit, whichever is higher |
| On the remaining balance of book profit | 60% of the book profit |
The calculation of book profits is determined as follows:
| Book Profit Calculation | Amount |
|---|---|
| (i) Profit as per Profit & Loss account (P&L) | xxxx |
| (ii) Add: Remuneration to partners, if debited in the P&L above | xxxx |
| (iii) Add: Interest paid to partners, if debited in the P&L above | xxxx |
| (iv) Less: Interest as allowed under Section 40(b) | xxxx |
| Book Profits | xxxx |
Essentially, 'Book Profit' refers to the 'Profits and Gains from Business and Profession' (PGBP) figure before any partner remuneration is accounted for.
Illustrative Partner Remuneration Calculations
Below are examples illustrating the computation of partner remuneration for Financial Year 2024-25:
| Situation | Book Profit/ (Loss) | Calculation | Max Remuneration Allowed |
|---|---|---|---|
| 1 | Rs. 9,00,000 | (Higher of Rs.1,50,000 or Rs. 3,00,000 * 90%) + Rs. 6,00,000 * 60% | Rs 6,30,000 |
| 2 | Rs. 7,00,000 | (Higher of Rs.1,50,000 or Rs. 3,00,000 * 90%) + Rs. 4,00,000 * 60% | Rs 5,10,000 |
| 3 | Rs. 2,00,000 | Higher of Rs.1,50,000 or Rs. 2,00,000 * 90% | Rs 1,80,000 |
| 4 | (Rs. 2,00,000) | Higher of Rs.1,50,000 or Rs. 0 * 90% | Rs 1,50,000 |
For Financial Year 2025-26 and subsequent periods, partner remuneration is computed as follows:
| Situation | Book Profit/ (Loss) | Calculation | Max Remuneration Allowed |
|---|---|---|---|
| 1 | Rs. 900,000 | (Higher of Rs.3,00,000 or Rs. 6,00,000 * 90%) + Rs. 3,00,000 * 60% | Rs 7,20,000 |
It is important to note that remuneration allowed as a deductible expense for the partnership firm becomes taxable income for the recipient partner under the category "Income from Business or Profession". Conversely, if the remuneration is disallowed as an expense for the firm, it will not be subject to tax in the hands of the partners.
Criteria for Deducting Partner Interest Payments
Interest on Partner's Capital
For interest payments to partners to be eligible for tax deduction, these conditions must be satisfied:
- The partnership deed must explicitly authorize the interest payment.
- The interest rate must not exceed 12%. Any amount paid above this 12% threshold will be disallowed for deduction.
- This deduction is not permitted if the partnership firm opts for presumptive taxation under Section 44AD or Section 44ADA.
- The interest must relate to the period commencing from the date the partnership was established, as specified in the partnership deed, and not for any earlier duration.
Partners Acting in a Representative Role
When an individual acts as a partner in a representative capacity (meaning they represent another entity rather than themselves), any interest paid directly to that individual in their personal capacity by the firm is exempt from the standard disallowance conditions and maximum limits. Consequently, the full interest amount qualifies as a deduction.
Key Considerations for Partner Remuneration and Interest
When remuneration or interest is deemed 'not allowed,' it specifically implies that it cannot be claimed as a deduction when computing the firm's net taxable profit. However, the firm is still permitted to disburse such payments to partners in cash, as no restrictions exist under the Partnership Act for this. Amounts deductible by the firm as remuneration or interest under Section 40(b) become taxable for the receiving partner under the income head "Profit from Business/Profession." Conversely, if an amount is disallowed as an expense for the firm, it is exempt from tax for the partner. Notably, partnership firms are not required to deduct TDS (Tax Deducted at Source) on salaries or interest paid or credited to a partner, even when these amounts are taxable for the partner.
Profit Sharing Among Partners
The share of profit represents the proportion of profits allocated to partners, irrespective of their status as working or sleeping partners. Partners collectively determine the profit-sharing ratio. If the partnership deed lacks such a specification, profits are typically distributed equally. This agreed ratio also applies to the division of losses. It is not mandatory to distribute the entire profit; a portion may be allocated to reserves and surplus. Crucially, the share of profit received by any partner, whether active or inactive, is exempt from tax under Section 10(2A) of the Income Tax Act.