Partner Salary & Interest Allowed in Partnership Firm – Section 40(b) Explained

As a partner in your own firm, have you ever wondered how much salary you can legally draw? Or what the rules are for the interest on the capital you’ve invested? While you and your partners manage the business, the Income Tax Act, 1961, has very specific regulations governing how you are compensated. Getting this wrong can be costly. This guide is designed to break down the rules for partner salary interest allowed, ensuring your partnership firm remains compliant and tax-efficient.

Incorrectly accounting for partner remuneration and interest can lead to disallowed expenses, a higher tax bill for the firm, and unnecessary compliance headaches. This is precisely where Section 40(b) of the Income Tax Act comes into play. It provides a clear framework that dictates the deductibility of these payments. This comprehensive article will explain the intricacies of Section 40(b) partnership explained in simple, actionable terms, helping you navigate the partnership firm salary regulations India with confidence.

The Foundation: Understanding Your Partnership Structure

Before diving into the tax specifics, it’s essential to understand the legal structure you operate under. The rules of Section 40(b) are built upon the foundation of a properly constituted partnership, and one document, in particular, holds the key to claiming any deductions for partner payments.

What is a Partnership Firm?

A partnership, as defined by the Indian Partnership Act, 1932, is a business structure formed by an agreement between two or more individuals. These individuals, known as partners, come together to carry on a business and agree to share the profits (and losses) generated from it. This structure is popular among small and medium-sized businesses due to its relative simplicity in formation and management compared to a private limited company. For a broader overview, you may find our guide on Taxation 101 for Small Business Owners helpful. The relationship between partners is governed by mutual agreement, which brings us to the most critical document in a partnership’s life.

The Partnership Deed: Your Most Important Document

The Partnership Deed is the constitutional document of your firm. It is a written agreement that outlines the rights, duties, responsibilities, and profit-sharing ratios of all partners. For the purpose of income tax, its importance cannot be overstated.

Crucially, for any salary, bonus, commission, or interest paid to a partner to be allowed as a deductible expense from the firm’s income, it must be explicitly authorized by a written partnership deed. A verbal agreement or an understanding between partners holds absolutely no value in the eyes of the tax authorities. If the deed is silent on remuneration or interest, any such payment made will be fully disallowed, leading to a higher taxable profit for the firm. Therefore, your deed must clearly contain clauses specifying the method of calculating salary for working partners and the rate of interest payable on capital contributions.

Section 40(b) Partnership Explained: The Core Rules

Section 40(b) of the Income Tax Act, 1961, is a specific provision that sets the conditions and limits for deducting payments of salary and interest made by a partnership firm to its partners. Understanding these rules is fundamental to proper tax planning and compliance for any partnership.

What is the Purpose of Section 40(b)?

The primary purpose of this section is to prevent firms from arbitrarily distributing profits to partners under the guise of high salaries or interest, which would unfairly reduce the firm’s taxable income. Since partners are the owners of the firm, there is a potential to allocate large sums as “expenses” to themselves. Section 40(b) creates a standardized, fair framework that balances the firm’s need to compensate its active partners with the government’s need to collect appropriate tax on business profits. It essentially draws a line between a legitimate business expense and a distribution of profit.

Key Conditions for Deductibility

For any payment of salary or interest to a partner to be allowed as a deduction, the firm must satisfy all the following conditions without fail:

Payment to Working Partners Only: Remuneration, which includes salary, bonus, or commission, can only be paid to a “working partner.” A working partner is defined as an individual who is actively engaged in conducting the affairs of the business of the firm. A partner who has only contributed capital but is not involved in day-to-day operations (often called a ‘sleeping partner’) is not eligible to receive a deductible salary.
Authorization in Partnership Deed: As mentioned earlier, the payment of both salary and interest must be clearly provided for and authorized by the partnership deed. The deed should either specify the exact amount of remuneration or lay down the manner of its calculation.
Prospective Application: The terms of the partnership deed authorizing the remuneration cannot be applied retrospectively. This means a salary can only be claimed as a deduction for the period starting from the date the deed authorizing it came into effect. You cannot create a deed in December and use it to claim a salary deduction for the preceding months from April.
Adherence to Prescribed Limits: The amount of partner salary interest allowed must be within the monetary ceilings specified in the Act. Any payment that exceeds these statutory limits will be disallowed. We will explore these limits in detail in the following sections.

Calculating Allowable Partner Salary in India

The calculation of the maximum permissible partner salary, or remuneration, is a two-step process that depends entirely on the firm’s profitability. This calculation is a core part of partnership salary computation in India.

Step 1: Calculate the “Book Profit”

Before applying the limits, you must first determine the firm’s “Book Profit.” This is not simply the net profit from your Profit and Loss (P&L) Account. Book Profit is defined as the net profit as shown in the P&L account for the relevant year, computed in accordance with standard accounting principles, but with certain adjustments.

The most important adjustment is that this profit is calculated before deducting the salary, bonus, or commission paid to the partners. In simple terms, you add back any partner remuneration that has already been debited to the P&L account to arrive at the Book Profit for the purpose of Section 40(b).

Step 2: Apply the Section 40(b) Limits

Once you have the Book Profit figure, you can apply the limits prescribed under Section 40(b) to determine the maximum allowable remuneration. The limits are structured in a two-tier system:

Book Profit Bracket	Maximum Allowable Remuneration
On the first ₹3,00,000 of Book Profit (or in case of a loss)	The higher of ₹1,50,000 OR 90% of the book profit.
On the balance of the Book Profit	60% of the remaining book profit.

This structure ensures that even loss-making firms or firms with very low profits can pay a minimum remuneration of up to ₹1,50,000 to their working partners, provided it is authorized by the deed.

Practical Example of Salary Calculation

Let’s understand this with a clear, worked-out example to see how the earnings of partners in partnership firms are regulated for tax purposes.

Scenario: ABC & Co., a partnership firm, has three working partners. For the financial year, the firm’s net profit after deducting all expenses, including a total partner salary of ₹6,00,000, is ₹1,00,000.
Step 1: Calculate Book Profit
- Net Profit as per P&L Account: ₹1,00,000
- Add: Remuneration to partners already debited: ₹6,00,000
- Book Profit = ₹7,00,000
Step 2: Calculate Maximum Allowable Salary
- On the first ₹3,00,000 of Book Profit:
  - 90% of ₹3,00,000 = ₹2,70,000
  - The higher of ₹1,50,000 or ₹2,70,000 is ₹2,70,000.
- On the balance of the Book Profit (₹7,00,000 – ₹3,00,000 = ₹4,00,000):
  - 60% of ₹4,00,000 = ₹2,40,000.
- Total Allowable Salary = ₹2,70,000 + ₹2,40,000 = ₹5,10,000.
Conclusion of Example:
- The firm actually paid ₹6,00,000 in salary.
- The maximum allowable deduction as per Section 40(b) is ₹5,10,000.
- Therefore, the excess payment of ₹90,000 (₹6,00,000 – ₹5,10,000) will be disallowed. This disallowed amount will be added back to the firm’s income, and the firm will have to pay tax on it.

Interest Allowed in Partnership Firms India: The 12% Rule

Similar to salary, the interest paid to partners on their capital contributions is also governed by specific rules. Understanding partner interest in firms is crucial for ensuring compliance.

The Maximum Permissible Interest Rate

The rule for interest is much simpler than that for remuneration. The maximum rate of simple interest that is allowed as a deduction for the firm is 12% per annum.

It’s important to note the specifics here:

Maximum Rate: 12% is the ceiling. If your partnership deed allows for a 15% interest rate, the firm can pay that amount to the partner, but it can only claim a deduction for 12%. The extra 3% will be disallowed as an expense.
Lower Rate: If your deed specifies a lower rate, say 10%, then the deduction will be limited to that 10%. The firm cannot claim 12% just because it is the statutory limit. The deduction is the lower of the rate specified in the deed or 12%.
Simple Interest: The Act specifies “simple interest.” Any component of compound interest will be disallowed.

The Partnership Deed is Non-Negotiable

Reiterating this crucial point is necessary. Even if the firm pays interest at a rate well below 12% (e.g., 8%), the entire amount will be disallowed if the payment of interest is not explicitly authorized by a valid partnership deed. This underscores the absolute importance of having a well-drafted deed that covers all aspects of partnership firm salary regulations India.

Taxation of Partner Salary in India: The Partner’s Perspective

Once the firm has paid the salary and interest, how is this income treated in the hands of the individual partner? This is where many individuals make a common mistake.

Is it “Salary Income”? A Common Misconception

Although the payment is called “salary” or “remuneration,” it is not taxed under the head “Income from Salaries” in the partner’s personal income tax return. Because a partner is an owner and not an employee of the firm, any salary, bonus, commission, or interest received from the firm is taxed under the head “Profits and Gains from Business or Profession” (PGBP).

Section 40(b) Implications for Partners

This classification has significant Section 40(b) implications for partners:

No Standard Deduction: Salaried employees are eligible for a standard deduction of ₹50,000 from their salary income. Partners receiving remuneration do not get this benefit.
No Salaried Employee Benefits: Tax benefits like House Rent Allowance (HRA) exemption and Leave Travel Allowance (LTA) cannot be claimed against this income.
Claiming Business Expenses: On the upside, since the income is treated as business income, a partner can claim a deduction for any expenses incurred wholly and exclusively for the purpose of earning this remuneration (e.g., professional fees, travel expenses related to the firm’s work).

The amount of remuneration and interest that is allowed as a deduction in the hands of the firm under Section 40(b) is the exact amount that is taxable as PGBP income in the hands of the partner. Any portion disallowed in the firm’s assessment (e.g., salary above the limits) is treated as an appropriation of profit and is not taxed again in the partner’s hands, as the firm has already paid tax on it.

Conclusion: Key Takeaways for Your Business

Navigating the rules of partner remuneration is a critical aspect of managing a partnership firm’s finances and tax obligations. A clear understanding ensures you remain compliant, avoid penalties, and structure payments in the most tax-efficient manner possible.

Here are the most important takeaways:

The Partnership Deed is the supreme and non-negotiable document. Without its authorization, no deduction for salary or interest is possible.
Salary is deductible only when paid to working partners and is subject to specific monetary limits calculated based on the firm’s Book Profit.
Interest paid on a partner’s capital is capped at a maximum simple interest rate of 12% per annum, or a lower rate if specified in the deed.
Understanding the rules for partner salary interest allowed is crucial not just for the firm’s tax liability, but also for the partners’ individual tax assessments. For a detailed guide on the firm’s obligations, see our article on Income Tax Return Filing for Partnership Firm – ITR Form, Due Date & Checklist.

Navigating tax laws like Section 40(b) can be tricky. A small mistake in your partnership deed or a miscalculation of book profit can lead to significant tax implications. Ensure your partnership is structured for maximum tax efficiency and compliance. Contact the experts at TaxRobo Online CA Consultation Service today for a consultation on drafting a compliant partnership deed and managing your firm’s taxation.

FAQs on Partner Salary and Interest

Q1. What happens if our firm pays a salary higher than the limit specified in Section 40(b)?
A: The amount paid in excess of the calculated limit will be disallowed as an expense for the partnership firm. This means the firm’s taxable profit will increase by that excess amount, leading to a higher tax liability for the firm itself. The partners will still receive the full salary, but the firm loses the tax benefit on the excess portion.

Q2. Can a non-working or ‘sleeping’ partner receive a deductible salary?
A: No. Section 40(b) explicitly states that remuneration (salary, bonus, commission) is only deductible if paid to a “working partner,” who is actively and regularly involved in conducting the business operations. Any salary paid to a sleeping partner will be completely disallowed as a business expense for the firm.

Q3. Do the rules of Section 40(b) also apply to a Limited Liability Partnership (LLP)?
A: Yes, absolutely. The Income Tax Act clarifies that for the purposes of partner remuneration and interest, the term “partnership firm” includes an LLP. Therefore, all the provisions of Section 40(b) regarding the calculation and deductibility of these payments are equally applicable to LLPs. You can learn more by Comparing Business Structures: Private Limited, LLP, OPC & More.

Q4. Is GST applicable on the salary paid to a partner?
A: No. According to a ruling by the Authority for Advance Rulings (AAR) and clarifications under GST law, remuneration paid to partners is not considered a “supply” of services and therefore does not attract Goods and Services Tax (GST). It is treated as an appropriation of profit, falling outside the ambit of GST.

Q5. Can the partnership deed be amended to include a salary clause later?
A: Yes, a partnership deed can be amended at any time with the mutual consent of all partners. However, the remuneration clause will only apply prospectively from the date of the amendment (the date the new deed is executed). You cannot claim deductions for salaries paid for a period before the deed authorizing it was in existence. For professional help in drafting or amending your deed, you can explore TaxRobo Company Registration Service.

For further official reference, please visit the Income Tax India Website.