Understanding Income from Business and Profession under Income Tax Act, 1961

Income from business and profession is an important head under the Income Tax Act, 1961, covering earnings from trade, commerce, and professional services. It applies to business owners, entrepreneurs, freelancers, and professionals such as doctors, lawyers, and chartered accountants.

Proper computation and correct classification of income and expenses are essential to avoid penalties and ensure compliance. This article explains the method of computation, allowable deductions, presumptive taxation schemes, and relevant case law principles.

1. Understanding Business vs. Profession

The Income Tax Act, 1961, treats income from business and income from profession as two distinct categories. Understanding the difference is important because the tax treatment, eligible deductions, and compliance requirements vary for each category.

Business Income refers to profits derived from activities related to trade, commerce, or the manufacturing of goods and services. This includes both traditional and modern forms of business.

Example: A boutique selling apparel, a software startup offering IT solutions, or an e-commerce business selling handmade products online. .

Professional Income, on the other hand, arises from activities requiring specialized skills, expertise, or knowledge. This typically includes services provided by professionals like lawyers, doctors, chartered accountants, architects, and consultants.

Example: A freelance lawyer earning fees for legal advice, a doctor running a private clinic, or a chartered accountant providing auditing services. Unlike business income, professional income usually involves rendering services rather than selling goods.

Why the Distinction Matters?

Different Tax Provisions: Certain provisions of the Income Tax Act apply specifically to either businesses or professionals. For example, presumptive taxation under Section 44AD is designed for small businesses, while Section 44ADA caters specifically to professionals. Using the wrong scheme can lead to errors in filing or even penalties.

Deductions vary: Deductible expenses for businesses (like raw material costs, inventory purchases, and rent for business premises) may differ from those for professionals (like professional fees, subscriptions to knowledge databases, or clinic office rent). Understanding which category your income falls into ensures that you claim only the correct expenses.

Compliance Requirements: Businesses and professionals may have different requirements regarding bookkeeping, audits, and accounting standards. Misclassification could trigger unnecessary scrutiny or legal issues.

In the landmark case of B.C. Srinivasa Setty (1981), the Supreme Court of India clarified that the term “business” should be interpreted broadly to include any activity undertaken with the intention of earning profit, not just traditional trade or commerce.

2. Computation of Business and Professional Income

Computing income from business or profession is a structured process under the Income Tax Act. It involves identifying all revenues, deducting allowable expenses, considering depreciation, and then applying relevant taxation provisions such as presumptive schemes. Understanding this step-by-step approach helps taxpayers avoid errors, optimize deductions, and remain compliant

Step 1: Gross Receipts or Profit

• The first step is determining the total revenue earned from business operations or professional services. This forms the base for computing taxable income. Example: A boutique selling apparel earns ₹20 lakh during the financial year. This entire amount is considered gross receipts.
• This matters because the accurate calculation of gross receipts is crucial, as all allowable deductions, depreciation, and presumptive taxation calculations are based on this figure. Missing revenue or incorrectly including personal income can lead to misreporting and penalties.

Step 2: Allowable Expenses

Expenses that are wholly and exclusively incurred for business or professional purposes are deductible under Section 37. Common allowable expenses include: Salaries to employees, Rent for office or business premises, Electricity, water, and internet bill, Professional fees (legal, audit, consultancy), Insurance premiums for business assets

In CIT vs. Bhatia Transport Co., the Supreme Court emphasised that only expenses directly related to business are deductible. Personal expenses, or costs indirectly related to business, cannot reduce taxable income.

Step 3: Depreciation

• Depreciation under Section 32 allows taxpayers to reduce taxable income by accounting for the economic wear and tear of assets used in business or profession. Both tangible (computers, furniture, vehicles) and intangible assets (software, patents) are eligible.
• Depreciation ensures taxation reflects the true cost of using assets over time, rather than taxing the full cost in the year of purchase

Step 4: Non-Allowable Expenses

• Certain expenses cannot be deducted, such as: Fines and penalties, Personal expenditures unrelated to business, Expenses for family members with no actual work
• So, one should always separate personal and business expenses, maintain receipts, and avoid claiming non-allowable expenses.

Let’s See How Computation Works in Practice –

A freelance consultant earns ₹15 lakh in a year and incurs certain expenses. Here’s how taxable income is computed under normal provisions vs. Section 44ADA (presumptive taxation):

• Under normal provisions, taxpayers deduct actual business/professional expenses to compute taxable income.
• Under Section 44ADA, 50% of gross receipts are automatically treated as taxable income, making it simpler for small professionals to comply with the law.

3. Presumptive Taxation for Small Taxpayers

The Income Tax Act recognises that maintaining detailed accounts can be cumbersome, especially for small businesses and professionals. To simplify taxation, it introduced presumptive taxation schemes, allowing eligible taxpayers to declare a fixed percentage of their turnover or receipts as taxable income.

Key Sections

• Section 44AD: Designed for small businesses with turnover up to ₹2.5 crore. Taxable income is 8% of turnover. If digital payments are received, this rate is reduced to 6%, encouraging digital transactions.
• Section 44ADA: Intended for professionals like lawyers, doctors, architects, and consultants. Those with gross receipts up to ₹50 lakh can declare 50% of total receipts as taxable income. This simplifies compliance and reduces the need to maintain exhaustive accounts.

• Under normal computation, all actual business expenses are deducted to calculate taxable income.
• Under Section 44AD, a fixed percentage of turnover (8% or 6% for digital payments) is treated as taxable income, reducing accounting complexit

4. Allowable Deductions

While presumptive taxation simplifies the process, taxpayers who do not opt for it or whose turnover exceeds the eligibility limit must compute income under the normal provisions and claim allowable deductions. The Act provides specific deductions to ensure that only legitimate business or professional expenses reduce taxable income.

Key Sections for Deductions

• Sections 30–37: Cover expenses such as rent, salaries, professional fees, office repairs, insurance premiums, and other costs wholly and exclusively incurred for business or profession.
• Section 32: Allows depreciation on tangible and intangible business assets like machinery, computers, furniture, and software.
• Section 35: Provides deductions for research and development (R&D) expenditures, which encourages innovation and business growth.

5. Common Pitfalls and Compliance Tips

While computing income from business and profession, many taxpayers make avoidable mistakes. Being aware of these can save time, reduce disputes, and optimize tax compliance.

Common Mistakes

1. Misclassifying Personal Expenses as Business Deductions: Taxpayers sometimes attempt to deduct personal or household expenses under business heads. For example, claiming personal mobile bills or home electricity as business expenses. This not only increases scrutiny from tax authorities but can also lead to penalties.

2. Ignoring Eligibility for Presumptive Taxation: Small businesses or professionals who are eligible for Sections 44AD or 44ADA may still compute income under normal provisions, incurring unnecessary accounting work. Choosing the presumptive scheme simplifies compliance and reduces errors.

3. Not Maintaining Books under Section 44AA: Certain professionals and businesses are required to maintain books of accounts. Failure to do so can lead to disallowance of expenses and higher taxable income.

Tips for Practitioners

1. Maintain Accurate Invoices and Receipts: Keep all supporting documents for income and expenses. These are crucial for justifying deductions and supporting claims during audits.

2. Keep Books of Accounts if Required: Even if using presumptive taxation, professionals should maintain basic records of receipts and expenditures. For larger businesses, detailed accounting is mandatory.

3. Classify Expenses Correctly: Distinguish clearly between allowable and non-allowable expenses. For example, office repairs are deductible, personal home repairs are not. Proper classification prevents disputes.

6. Recent Updates and Amendments

Tax laws evolve, and staying updated ensures accurate filing and compliance. Some recent changes relevant to business and professional income are:

• Presumptive taxation limit (Section 44AD): The turnover limit under Section 44AD has been increased to ₹2.5 crore, provided cash receipts do not exceed 5% of total turnover. Otherwise, the limit remains ₹2 crore.
• Digital transaction benefit: If turnover is received digitally (online payments, UPI, card), only 6% of turnover is considered taxable under 44AD, promoting digital payments.
• Professional compliance (Section 44ADA): Remains capped at ₹50 lakh gross receipts, meaning only professionals below this threshold can opt for presumptive taxation.

Conclusion

Income from business and profession is a key head under the Income Tax Act, 1961, affecting small businesses, freelancers, and professionals. Accurate computation, correct classification of expenses, and awareness of allowable deductions are essential for compliance and tax optimisation.

Presumptive taxation under Sections 44AD and 44ADA simplifies reporting for eligible taxpayers, reducing accounting burdens while ensuring legal correctness. Maintaining records, following judicial guidance, and staying updated with recent amendments help taxpayers avoid disputes, plan efficiently, and focus on growing their business or professional practice.

References

1. C. Srinivasa Setty v. Commissioner of Income Tax, (1981) 128 ITR 294 (SC).

2. CIT v. Bhatia Transport Co., (1982) 140 ITR 559 (SC).

3. Government of India, Income Tax Act, 1961 (Ministry of Finance, Department of Revenue, 1961).

4. Government of India, Finance Act 2023 (Ministry of Finance, Department of Revenue, 2023).

5. Income Tax Department, Guidelines for Business and Professional Income (2023) https://www.incometaxindia.gov.in/.

6. Sharma & P. Verma, Taxation of Business and Professional Income in India (New Delhi: Taxmann Publications, 2022).

7. Economic Times, ‘Updates on Presumptive Taxation and Digital Transactions’ (2023) https://economictimes.indiatimes.com/.