How does a partnership firm pay tax in India?

In simplified terms, the partnership firm comes into existence when two or more individuals join hands to start a business. The Indian Partnership Act, 1932, regulates these firms. The legal definition of partnership as given under section 4 of the Indian Partnership Act, 1932 is;

“Partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all.’’

Unlimited liability is an essential feature of a partnership firm. It means that in case of heavy losses, the partners will have to sell their assets to repay the liability if the firm cannot discharge its liabilities by selling or disposing of its assets.

Another key element of the partnership firm is a Partnership Deed. A written agreement or contract is made between the partners, including the firm and partners' necessary details. Furthermore, it also defines other significant points, like goodwill valuation method, profit sharing ratio, payment of interest on capital, charging interest on drawings, Partner's salary, etc. In case of disputes, partners can simply refer to the partnership deed to settle these disputes.

How is the tax levied on a Partnership firm?

1. Tax Rate

The tax slab rate for partnership firms in India is 30%. That means partnership firms have to pay 30% of the total income, as income tax amount. The surcharge of 12% is also charged, in case the annual income exceeds one crore. The firm is also liable to pay 4% Education Cess (of which 1% is the Higher Education Cess)

Which incomes form a part of Total income?

The following incomes are to be considered while computing partnership firm’s taxable income-

• Income from House Property:
  Total revenue includes the rental income generated from the property.
• Income from Business & Profession:
  To compute the business income, impossible one should follow section 28 to 44D of the Income Tax Act, which deals with Income from Business & Profession.    
• Income from capital gains:
  If the partnership sells its capital assets (land, cars, stocks, and all other investment properties), the profit made on that sale is the capital gain. There are two types of gains under capital gains, i.e. Long term capital gains and Short term capital gains. The tax rate in the former's case is 20%, and for the latter, it is 15%.
• Income from other sources:
  Income, other than those mentioned above, or incomes that do not fall under any particular heads comes under Income from other sources. These incomes are also considered while estimating the total revenue. The tax rate on additional income is 30%.

2. Deductions

Deductions are more like expenses, which reduce tax liability as they are deducted from the gross income to calculate the tax payable. The deductions allowed and disallowed are briefly outlined below-

• Salary paid to non-working or sleeping partners: salary paid to any such partner is not allowable as an expenditure to the partnership firm. However, this is not the case with a working or active partner, if mentioned in the partnership deed.
• Interest to the partners: A partnership deed should authorise the payment of interest to the partners. Thus, if it exists in the act, it becomes eligible for a deduction. But, if the interest clause doesn't exist in the partnership deed, it won't be allowable as an expense, thus.
• Rate of Interest: In the existence of a clause regarding payment of interest in the partnership agreement, the interest that is allowed to the partners is @12% per annum (simple interest). But, if the interest rate is higher than 12% or is charged as compound interest, in that case, the interest becomes disallowable. Other deductions include retrospective or pre-dated Interest or salary payments.
• Limit to salary: The loss-making partnership firms can only pay INR 1.5 lakh or 90% of the book profit (net profit calculated after accounting for provisions of section 28 -44D). Whichever is higher, as a remuneration to the partners (This is the total remuneration amount, after adding all the partners). Hence, any excess salary paid to the partners is excluded.
• Interest on drawings: If the partner draws, say, INR 10,000 from the partnership firm, and the firm charges interest on those drawings @10% per annum. In that case, INR 1000 is taxable in the hands of the firm.      

Please note -

When the firm charges interest on drawings and pays interest to the partner, the partnership firm cannot claim the balance amount as an expense, and thus, it becomes invalid. Suppose you earn INR 100 on your capital, and you are also charged 10% on the drawings, then, in this case, the firm cannot claim INR 90 as an expense. There is no netting off of interest.

Apart from that, Partner's share in the total income is deductible in the partners' hands as it has already been taxed @30% under the partnership firm.

3. Filing Tax return

• Partnership firms use ITR Form -5 to file income tax returns. Please note that the individuals (or partners), HUF's, and Companies are not eligible to file ITR-5. These parties use ITR-3 to file tax returns.
• ITR-5  Form is available on the income tax department's online portal, i.e. https://incometaxindiaefiling.gov.in/ to file the income tax returns. The online mode of filing of ITR -5 is also available. It's done by furnishing a copy of the challan at the bank.
• Under the online system, the filing of returns is done in a computerised format using a digital signature or by automated transferring of returns and subsequently, submitting the verification of the recovery in the Form ITR-5.
• While filing the ITR-5, you will come across various tabs requiring information related to, Personal details (this section includes, Name, PAN details, Address, Firms incorporation date, email address, etc.)Filing Status ( provide details regarding residential status, DPIIT, certification number), Audit details (information about section 44AD,44ADA,44BB, 44BB, 44AE, and turnover), Balance sheet, Manufacturing account, Trading account, Profit and loss account, Other details (question regarding accounting technique used, debit and credit of items, valuation method)
• There are 31 schedules in the ITR-5 Form related to, tax credit computation, deductions, donations, unabsorbed depreciation, GST, tax reliefs, income from abroad, exempt incomes, etc.
• At last, you'll have to fill a verification form, where the details, such as name, father name, PAN number, their designation in the firm (such as managing partner, Trustee, Partner, Member, Liquidator, Executor, Designated Partner, Authorised Signatory, and Representative Assessee) of the chosen partner. Make sure to sign the verification document before furnishing the return duly.
• The assessee would require two copies of the ITR form,
• He should post one copy to the Electronic City Office, Bengaluru, Karnataka, and keep the other proof or reference.            

Please note-

If auditing of your partnership firm's accounts is necessary under section 44AB, in that case, filing return via online mode becomes mandatory.

When to fill the ITR-5?

Generally, the due date for filing an income tax return is July 31st. But, in the firm's books of accounts’ mandatory auditing, the last date for filing a tax return is 30th September. Further, as per section 92E, the partnership firm needs to provide a report in Form No. 3CEB, in that case, the due date for filing the tax return would be 30th November.

As per the Indian Partnership Act, 1932, it is not mandatory for a firm to have a partnership deed. However, after reading this article, you could've figured out how partnership deeds are indispensable for running the business smoothly. It helps in avoiding confusion while computing taxable income. Not having a written agreement can create chaos in the future, because it's not possible for every partner to retain verbal agreement. Hence, leading to unnecessary complications at the time of computing income tax.

Also read:

1) What Happens to Indian's Tax Money after Payment?
2) Top-10 Highest Tax Paying States in India
3) Why Do We Pay Income Tax in India? Importance, Applicability & more
4) Types of Direct & Indirect Taxes in India