Taxation of Partnership Firm In India

Which business structure is more tax-efficient in India, a partnership firm or a proprietorship? Many entrepreneurs struggle with this choice because while both models are simple to start and operate, the way they are taxed is very different. A partnership firm is treated as a separate entity with its own PAN and tax rules, whereas a proprietorship is taxed as part of the individual owner’s income. This difference impacts tax slabs, deductions, compliance, and even how profits are distributed. At the end, this blog will give you a clear answer to this question so you can make the right decision for your business.

How a Partnership Firm Is Taxed

A partnership firm is treated as a distinct taxable entity and must file an Income Tax Return (ITR-5) and pay advance tax when applicable — see partnership firm registration process. Profits of the firm are taxed in the firm’s hands, but a partner’s share of those profits is exempt under Section 10(2A) of the Income Tax Act.

Payments such as partner remuneration or interest on capital are deductible only if they are authorised by the partnership deed and comply with Section 40(b). For partners, these amounts are taxable as business income under Section 28(v).

Section 40(b) - Allowability Checklist

Section 40(b) of the Income Tax Act is one of the most litigated areas in partnership taxation. It lays down strict conditions for when a firm can claim deductions for partner remuneration and interest on capital. Missing even one condition can lead to disallowance, tax demand, and penalties. Use this zero-error checklist before finalising your return:

1. Authorisation in Deed
   The partnership deed must expressly permit remuneration and/or interest to partners. If it is not written, it will not be allowed, no matter what was actually paid.
2. Method & Limits in Deed
   The deed should clearly mention either the actual amount or a computable formula (like a percentage of book profits). Vague or open-ended wording is a red flag for disallowance.
3. Working Partner Test (for remuneration)
   Only working partners, who are actively engaged in the firm’s business, can receive taxable remuneration. Their status must be defined in the deed. Sleeping partners are not eligible.
4. Book Profit Basis
   The computation of permissible remuneration must be based on book profit as per Income-tax Rules, not on cash flow or management estimates. Correctly arriving at book profit is critical.
5. Updated Remuneration Limits (from April 1, 2025)
   The permissible limits for remuneration to working partners have been doubled:

• On the first ₹6,00,000 of book profit (or in case of loss): ₹3,00,000 or 90% of book profit, whichever is higher.
• On the balance of book profit: 60% of book profit.

6. Interest Cap & Nature
   Interest paid on capital cannot exceed 12% per annum, and it must be simple interest. Ensure partners’ capital accounts are properly documented in the books.
7. Actual Payment/Accrual
   Entries for salary or interest must be passed in the accounts and supported by ledger and, where relevant, bank records. Deductions cannot be claimed on hypothetical or unpaid amounts.
8. Consistency
   The deed’s effective date matters. Any revision or increase in pay/interest cannot be applied retrospectively unless the law expressly permits. Be cautious with mid-year amendments.
9. Disclosure
   All claims must appear under the right head in the Profit & Loss account, with supporting schedules ready for audit or assessment. Full transparency reduces the risk of disputes.

Bonus Mini-Module: “Deed Surgery”

The way you draft clauses in the deed makes a big difference.

• Conservative wording: “Remuneration shall be paid to working partners as mutually decided, subject to limits under Section 40(b).” (Safe, but rigid.)
• Flexible legal-style wording: “Remuneration to working partners shall be computed as per the limits prescribed under Section 40(b) of the Income Tax Act, based on book profits, and distributed as agreed from time to time.” (More adaptable, legally computable, and less likely to attract disallowance.)

By running through this checklist every year, firms can claim deductions confidently and avoid unnecessary litigation with the tax department.

Firm vs Partner - Who Pays What

Taxation in a partnership structure works at two levels: the firm and the partner. Both are treated separately under the Income Tax Act, which helps avoid double taxation.

At the Firm Level
The firm is recognized as a distinct taxable unit. It can claim deductions for business expenses, depreciation on assets, and eligible partner payments such as salary or interest provided they satisfy Section 40(b). Business losses can be set off and carried forward, but Section 78 imposes restrictions if there is a change in partners. Unlike companies, firms do not fall under the scope of Minimum Alternate Tax. The return of income has to be filed using Form ITR-5, supported by audit reports wherever necessary.

At the Partner Level
Partners are taxed on what they individually receive from the firm. Remuneration and interest credited to a partner are treated as business or professional income under Section 28(v). The partner’s share of profit from the firm, however, enjoys complete exemption under Section 10(2A). Partners are also expected to pay advance tax on their total income if it crosses the prescribed threshold, which includes their earnings from the firm along with any other personal income.

In essence, the firm bears the primary tax on profits, while partners are taxed only on the additional flows such as salary or interest. The same profit is never taxed twice, which keeps the system equitable.

Presumptive Taxation (When It Makes Sense)

Presumptive taxation is a simplified tax scheme introduced under Sections 44AD, 44ADA, and 44AE of the Income Tax Act. It allows eligible small businesses, professionals, and transport operators to declare income at a fixed percentage of turnover or receipts, instead of maintaining detailed books of accounts.

When it makes sense:

• Small Businesses (Sec 44AD): For businesses with turnover up to ₹3 crore, declaring income at 6% (digital) or 8% (cash) of turnover, see MSME registration in India (Udyam).
• Professionals (Sec 44ADA): For doctors, lawyers, architects, etc., with receipts up to ₹75 lakh, declaring 50% of gross receipts as income.
• Transporters (Sec 44AE): For owners of goods vehicles (≤10 vehicles), declaring fixed income per vehicle per month.

It is most useful when:

• You want to reduce compliance burden (no need to maintain detailed books or get a tax audit).
• Your actual profit margin is higher than presumptive rates, so you save effort without paying extra tax.
• You are a small or growing business looking for simple taxation without complex filings.

Note: For detailed official guidelines and illustrations on presumptive taxation, you can refer to the Income Tax Department’s tutorial on presumptive basis of taxation.

GST Basics for Partnership Firms

For partnership firms, compliance under the Goods and Services Tax (GST) regime is just as important as income tax obligations. Registration becomes mandatory once a firm crosses the prescribed turnover threshold, which differs for goods and services and may also vary by state. In addition to turnover-based registration, certain activities such as inter-state supply of goods, operation through e-commerce platforms, or dealing in notified categories can also trigger compulsory registration, even if the turnover is below the general threshold.

Once registered, a firm has to follow routine GST compliance — see business address proof for registration. . This includes issuing e-invoices where turnover thresholds make mandatory, generating e-way bills for the movement of goods beyond specified limits, and filing regular returns such as GSTR-1 (outward supplies) and GSTR-3B (summary return with tax payment). Firms must also maintain strict discipline around input tax credit (ITC) by reconciling vendor invoices, ensuring suppliers file their returns on time, and avoiding blocked credits.

TDS/TCS Responsibilities (What Firms Commonly Face)

In the taxation of Partnership Firms and LLPs, compliance with TDS and TCS provisions is a key responsibility to avoid penalties and ensure smooth operations.

• Deduct TDS on salaries, professional fees, rent, contract payments, etc. — see contract labour registration and licensing.
• Collect TCS on specified goods/services (if applicable).
• Deposit TDS/TCS with the government within the due dates.
• File quarterly TDS/TCS returns (Form 24Q, 26Q, 27EQ).
• Issue TDS certificates (Form 16, 16A, 27D) to payees.
• Maintain accurate books & compliance records.
• Interest & penalty apply for late deduction, payment, or filing.

Tax Audit, Books & Filings (Compliance Snapshot)

A partnership firm is treated as a separate taxable entity, which means compliance obligations extend beyond just paying income tax. If the firm’s turnover crosses the prescribed threshold of one crore rupees (or ten crore rupees if at least 95 per cent of transactions are digital), it must undergo a tax audit under Section 44AB. Professionals working through partnership firms face a lower audit threshold of fifty lakh rupees.

Beyond audits, firms are expected to maintain proper books of account, including cash book, ledgers, sales and purchase registers, and records of partner capital accounts. These not only serve as a legal requirement but also form the foundation for preparing the return of income — see ISO certification in India process.

The firm files its return in Form ITR-5, and if liable to audit, must also furnish the audit report in Form 3CA/3CB along with Form 3CD. Timely filing is essential to preserve the right to carry forward business losses and depreciation. For most firms, the due date is 31st October if the audit is applicable and 31st July if not.

In short, proper accounting and timely filings keep the firm compliant, reduce the risk of penalties, and safeguard tax benefits such as loss carry-forward.

Tax Slab for Partnership Firm vs Proprietorship

One of the major differences between a partnership firm and a proprietorship lies in the way they are taxed.

Conclusion

Partnership firms in India offer a structured yet flexible way to do business, but they come with their own tax treatment and compliance responsibilities. While the firm itself pays a flat tax rate and partners enjoy exemption on profit shares, remuneration and interest are closely regulated under Section 40(b). Compared to proprietorships, firms provide stronger legal recognition and liability sharing, though they may not benefit from individual slab rates at lower income levels. For entrepreneurs, the choice between a proprietorship and a partnership firm ultimately depends on income size, business complexity, and long-term goals. Careful drafting of the partnership deed, disciplined bookkeeping, and timely filings are the keys to staying tax-efficient and dispute-free.