If you’ve ever sat across a table from your business partners, calculator in hand and confusion on your face, you’re not alone. Stories like this play out daily in countless Indian offices—whether it’s a family business or a new-age venture started by friends—when it comes time to figure out how much working partners can actually be paid without tripping up the tax department.
Let’s bring this issue to life with an example:
A Real Dilemma for Partners
Meet Arjun and Sneha, co-founders of a modest accounting firm in Bhopal. They spend late nights building their clientele and pouring over ledgers. The business is growing, and naturally, they want to reward themselves fairly for their efforts. When they finally visit their tax consultant, they’re told, “You can’t just pay yourselves however you like. Section 40(b) says so.” Suddenly, their plans seemed a lot more complicated.
The Spirit Behind Section 40(b)
Why does Section 40(b) exist? At its heart, it’s simple: tax law in India wants to ensure that profits of a firm aren’t drained out as partner salaries just to dodge taxes. If there were no restrictions, firms could reduce taxable income to zero by doling out the entire profit as salary, leaving almost nothing for the taxman. So, Section 40(b) sets specific caps on what counts as an allowable expense for partner remuneration and interest.
It’s not meant to be a punishment, but a guardrail—protecting both the system and partnerships from future complications.
What’s Really Allowed Under Section 40(b)
First, only “working partners”—those actively involved in the business—can receive tax-deductible salary, commission, or remuneration. No sneaky handouts to sleeping partners. And, crucially, the partnership deed—the founding agreement for your firm—must spell out who is a working partner, the method of calculating out their remuneration, and how much is payable. Fuzzy language like “to be decided later” won’t cut it if there’s ever a dispute or an audit.
The Pay Limits
Let’s put numbers to these rules for clarity (per recent Budget updates):
- For the first ₹3,00,000 of book profit (or in a loss situation), Arjun and Sneha can claim up to 90% of that amount OR ₹3,00,000—whichever is higher—between them as deductible partner salary.
- For the book profit above ₹3,00,000, the cap falls to 60%.
- Simple interest on partner capital is deductible only up to 12% per annum.
Example: If their firm’s book profit is ₹10 lakh, the break-up would look like this:
- First ₹3,00,000: 90% = ₹2,70,000
- Remaining ₹7,00,000: 60% = ₹4,20,000
- Total that can be shared as deductible partner remuneration: ₹2,70,000 + ₹4,20,000 = ₹6,90,000
Anything given above this isn’t allowed as an expense for tax purposes, though the partners can still draw more if they wish—just know that the taxman will ignore the amount over the cap for deductions.
The “Gotchas” and Common Mistakes
It’s easy to get tripped up if you’re not careful:
- The partnership deed must be clear and precise. Vague authorizations will see your deduction claims rejected by authorities.
- Retroactive changes to the deed (for past payments) aren’t valid. Update it before you start paying out remuneration.
- Paying remuneration to non-working partners? That’s a strict no-no for deductions.
- Exceeding the ratio or paying excessive interest/commission can also backfire—keep everything within laid out limits.
Why Accurate Reporting Saves Headaches
Let’s return to Arjun and Sneha. If they keep proper books, separate remuneration accounts, and stick to what’s authorized in their partnership deed, they’re in the clear. This makes their statutory audits smoother, and in the event of a tax assessment, they have every bit of documentation ready to defend their position. If something is wrong—say, the deed doesn’t authorize partner salaries or specifies an amount beyond the allowed limit—the entire deduction could be denied, raising their tax bill significantly.
Dual Impact: Firm and Partner
Remuneration paid within 40(b) limits can be expensed by the firm (lowering tax there). For the partner, this income isn’t “salary” in the classic sense—it’s taxed as “Profits and Gains of Business or Profession.” The partner needs to disclose it correctly (typically in ITR-3 or ITR-4) and may need to handle advance tax accordingly. If the deduction gets disallowed in the firm’s hands for a technical slip, it could be taxed twice—once as firm income, once as partner income—an avoidable mess.
Tools and Technology as Partners in Compliance
In today’s world, it makes sense to use accounting tools or specialized GST billing software to automate the calculation of allowable remuneration. Keeping a clean, digital trail ensures you never accidentally cross the line and that you can furnish detailed records if questioned by the tax authorities.
The End Game—Clarity, Honesty, and Growth
Section 40(b) can seem like a mountain at first glance, but it’s just a series of careful steps. For everyday business owners and their bookkeepers, the smart approach is to focus on:
- Writing a strong, detailed partnership deed.
- Clear documentation and transparency in accounting.
- Sticking strictly to prescribed caps when calculating payouts.
- Using digital tools or software for error-free compliance and easy reporting.
Arjun and Sneha eventually did all this—they rewrote their deed, set up payment schedules within the allowed limits, and adopted simple software for bookkeeping. Their next audit was a breeze, and there were no awkward questions from tax officers.
If you’re a partner (or you advise partnerships), Section 40(b) isn’t just another rule—it’s an opportunity: to build transparency, protect your business, and reward effort while staying in good standing with the law. Instead of seeing these restrictions as shackles, consider them the skeleton key to good governance and lasting partnerships.
So, with the next partner meeting on the horizon, ask yourself: Is your reward system built for clarity, fairness, and future growth?
Author Bio
