Taxation of Partners

Introduction:-

In India, partnership firm is a very popular method for doing business. The income tax Act has recognised the firm as a type of assessee and has incorporated many provisions with regard to taxation of firm and its partners.

Taxation on partner at the time of admission:-

The partner at the time of joining the firm may contribute in cash or give some assets in kind or both. The amount is given out of his taxed money; there is no tax again when it is contributed to the firm.

The income tax will be applicable when the partner brings the assets to the firm as his contribution. Now the question is whether it is a transfer? As per income tax, when the asset is transferred or relinquished by one assessee to another assessee, it is regarded as transfer under section 45. Now the next question is the consideration received for the asset or assets which was transferred to firm. The capital account of the partner is credited and concerned asset will be debited in the books of the firm. Here, both firm and partner are related parties hence the consideration is to be determined on fare basis. The Act has inserted sub section 3 to section 45, which states that the value recorded in the books of the firm is deemed to be the consideration paid to the partner for the assets received by the firm. The Act has beautifully designed this section, because, for example if the market value of the asset is Rs. 5 Lakh, but it is recorded in the books for Rs.3Lakhs. The partner has to consider Rs.3Lakhs as his consideration and out of which he/she can claim cost of acquisition of assets along with indexed cost if applicable and liable to pay income tax. On the other hand, the firm, when it sells the asset/s, the cost of the asset becomes Rs.3Lakhs only and now the firm has to pay tax on such difference.

Section 45(3) is a specific section given by the Act, to compute the capital gain on transfer of assets to firm or AOP or BOI. This section is different from the general sections which are dealing with the computation of capital gain. 

Applicability of section 50C:-

Now the next question is whether 50C applicable in the hands of the partner? In this regard honorable Mumbai ITAT in the case of Amartara Plastics (P) Ltd V/s ACIT, [TS-5030-ITAT-2011(Mumbai)-O] ruled that, both 50C and 45(3) are deeming provisions hence, two deeming provision cannot be applied for a single transaction, hence 50C is not applicable on the partner.

Applicability of section 56(2)(x):-

In my view, The same analogy is applicable in the case of 56(2)(x) also. Here, again this section is deeming section. Moreover, section 45(3) will override the other provisions since it is a specific provision to contribute the assets to the firm.

Taxation when the partner is continuing in the firm:-

The partners generally receive, interest on capital, remuneration and share of profit. As per section 28(v) which states that any interest, salary, bonus, commission or remuneration by whatever name called due to or received by a partner of the firm.

The remuneration, even though it can be called as salary, it is to be taxed under income from business since the partners themselves are the employers. The interest, commission etc cannot be taxed under “Income from Other Sources” but under “Income from Business or Profession”.

It is worth to note that, the amount of salary or bonus, commission etc disallowed in section 40(b) cannot be added to the income of the partner again. The income of the partner should be adjusted accordingly.

Applicability of Tax Audit

The tax audit under section 44AB is applicable if the turnover exceeds rupees one crore. The salary, commission or bonuses which are taxable under the head “Income from business or profession” exceeding the limit, the tax audit is applicable and audit report is to be filed. However, the share of profit or loss is not liable to be clubbed for the purpose of turnover since the profit is exempted under subsection 2A of section 10.

Taxation on cash settlement at the time of Retirement:-

The partner can retire from firm at any time after complying with their partnership deed. The partner may agree to settle his accounts by cash or by taking some of the assets.

The cash received by the partner in his capital account will not be again subject to tax even though if he receives in excess of the capital or current account balance. In the case of Ajay Kumar Doshi v/s ACIT [TS-6396-ITAT-2015(Kolkata)-O], the Honorable ITAT Kolkata held that, the amount received by the partner is capital receipt and not liable for tax.

The firm is used as a media to transfer the asset

The firm is having immovable property in its name and all old partners wants retire from the firm. New partners will be joined to continue the business of the firm. The Honorable Karnataka High Court in the case of CIT V/s Gurunath Talkies 328 ITR 59 (2010) has held that, the firm is liable to be assessed to capital gain tax since it is colorable devise to evade the tax.

Assets taken by the partners:

The outgoing partner account is settled by giving some of the assets or all the assets, and then section 45(4) will come into play. The section states that, the firm is liable to tax by considering the fair market value of the assets given up to the partners. CIT VS A.N. NAIK ASSOCIATES 265 ITR 0346 (2004) (Bom), it was held that, after amendment of Finance act in 1988, subsection (ii) of section 47 was removed. Hence the exemption given earlier for transfer of assets at the time of dissolution or otherwise was no more applicable. Hence the asset given by the firm to its partner at the time of dissolution or otherwise will be chargeable to tax in the hands of the firm.

In the same example of paragraph 3, the assets brought by the partner recorded for 3 Lakhs in the books of the firm is taken back by the partner on his retirement. The Fair market value is 5 Lakhs; the firm has to pay capital gain tax on Rs. 2 Lakhs.

The above capital gain is to be paid by the firm and not by the partner.

Dissolution of Partnership Firm:-

At the time of dissolution, the account of the firm is to be prepared till the date of dissolution. The profit or loss after making provision to income tax is to be distributed. The assets and liabilities may be shared in their profit sharing ratio or it can be taken by any partner/s.

The subsection 4 of section 45 is applicable for the transfer of capital assets by the firm to the partner and the firm is liable to pay tax by considering fair market value as its consideration after deducting cost as discussed in the above paragraphs.

Slump sale and Dissolution:-

There may be possibility of slump sale by the firm. Slump sale means transferring assets and liabilities as a going concern basis. If any asset or liability is not transferred under slump sale, it will be taken by any partner. The firm has to pay tax under section 50B which states that, the profit on slump sale is taxable in the hands of the firm after deducting net worth. Net worth means total assets minus total liability of the firm.

Once the slump sale is done, the firm may have only cash and bank balances. The partners will share this in their sharing ratio. As explained above, it is capital receipt in the hands of the partner and is not taxable again.

Conclusion:-

Forming, altering and dissolving of partnership are very easy comparing to company. The only disadvantage is liabilities of the partners are unlimited. For the purpose of income tax even LLP is also equal to firm and all provision related to firm is equally applicable.