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’.

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.

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

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