Assessment of Firm with Computation of Tax Liability

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1. Assessment of Firm

Legally, a partnership firm does not have a separate entity from that of the partners constituting the firm as the partners are the owners of the firm. However, a firm is treated as a separate tax-entity under the Income-tax Act. Though the limited liability partnership is a separate entity but for income tax purposes, it will be assessable in the same manner as partnership firm is assessed as firm includes limited liability partnership.

Assessment of Firm
Assessment of Firm

(A) Salient Features of Assessment of Firm

Salient features of the assessment of a firm are as under:

(1)          A firm (including LLP) is treated as a separate tax entity and its total income should be computed under four heads of income.

(2)          While computing the income of the firm under the head ‘Profits and gains of business or profession’, besides the deductions which are allowed under sections 30 to 37, special deduction is allowed to the firm (including LLP) on account of remuneration to working partners and interest paid to the partners. However, it is subject to certain limits laid down under section 40(b). (Remuneration to working partners or interest paid to the partners is not allowed if the firm opts for presumptive income under section 44AD or 44ADA).

(3)          The firm will be taxed at special rates and at a flat rate of 30% plus education cess @ 2% plus SHEC @ 1% after allowing deduction for interest on capital and loan of the partners and remuneration to working partners. The amount of income tax shall be increased by a surcharge @ 12% of such income tax if the firm has total income exceeding Rs.1 crore. In this case education and cess shall be added @ 3% of the tax and surcharge so added.

(4)          The firm will be assessed as a firm provided conditions mentioned under section 184 are satisfied. In case these conditions are not satisfied in a particular assessment year, although the firm will be assessed as firm, but no deduction by way of payment of interest, salary, bonus, commission or remuneration, by whatever name called, made to the partner, shall be allowed in computing the income chargeable under the head “profits and gains of business or profession” and such interest, salary, bonus, commission or remuneration shall not be chargeable to income-tax in the hands of the partner. Section 184, other than section 184(5), should not be relevant for LLP.

(5)          Share of profit which a partner receives from the firm (after deduction of remuneration and interest allowable) shall be fully exempt in the hands of the partner. However, only that part of the interest and remuneration which was allowed as a deduction to the firm shall be taxable in the hands of the partners in their individual assessment under the head ‘profits and gains of business or profession’.

2.  Essential Conditions to be satisfied by a Firm to be Assessed as Firm and to be eligible for Deduction of Interest, Salary, etc. to the Partners [Section 184]

(A) In the First Assessment Year:

The following conditions must be satisfied by the firm in the first assessment year to be assessed as a firm:

(1)          Partnership is evidenced by an instrument i.e. there is a written document giving the terms of partnership.

(2)          The individual share of the partners is specified in that instrument

(3)          Certified copy of partnership deed must be filed: A certified copy of the said instrument of partnership shall accompany the return of income in respect of the assessment year for which the assessment as a firm is first sought.

(B) In the subsequent assessment years:

Once the firm is assessed as a firm for any assessment year, it shall be assessed in the same capacity for every subsequent year if there is no change in the constitution of the firm or the share of the partners.

Where any such change had taken place in the previous year, the firm shall furnish a certified copy of the revised instrument of partnership along with the return of income for the assessment year relevant to such previous year.

3. Circumstance where the Firm will be Assessed as a Firm but shall not be eligible for Deduction on account of Interest, Salary, Bonus, etc.:

In the following two cases, the firm shall be assessed as a firm but shall not eligible for any deduction on account of interest to a partner and remuneration to a working partner although the same are mentioned in the partnership deed:

(a)           where there is, on the part of the firm, any such failure as is mentioned in section 144 (relating to the best judgment assessment). [Section 184(5)]

(b)          where the firm does not comply with the three conditions mentioned under section 184 discussed above. [Section 185]

However, in both the above two cases, such amount of interest, salary, bonus, etc. shall not be charged to tax in the hands of the partner

4.  Deduction Allowable on account of Remuneration and Interest to the Partners of the Firm (including Limited Liability Partnership)

As discussed above, the total income of the firm (including LLP) will be determined as a separate entity and it will be computed under various heads of income. However, while computing taxable profits under the head ‘profits and gains of business or profession’, a deduction is allowable to the firm on account of interest and remuneration payable to the partners. Deduction of interest to a partner is allowable under section 36 and remuneration to a working partner will be allowed under section 37.

Section 40(b) deals with the amounts which are not deductible in case of a firm assessable as such. Therefore, deductions on account of interest and remuneration to the partners can be claimed under sections 36 or 37, as the case may be, but it will be subject to the conditions prescribed by section 40(b), which are as under:

(1)          Payment of salary, bonus, commission or remuneration by whatever name called, to a nonworking partner shall not be allowed as deduction. In other words, such remuneration is allowed as deduction only when it is paid to the working partner.

(2)          Payment of remuneration to working partners and interest to any partner will be allowed as deduction only when it is authorised by and is in accordance with partnership deed.

(3)          Payment of remuneration/interest, although authorised by the partnership deed but which relates to a period prior to the date of such partnership deed, shall not be allowed. In other words, salary cannot be claimed as deduction with retrospective date even if the partnership deed provides that it shall be given with retrospective effect.

(4)          Interest payable to a partner, although authorised by the partnership deed shall be allowable as a deduction subject to a maximum of 12% simple interest per annum. If the partnership deed provides for interest at less than 12% p.a., the deduction of interest shall be allowed to the extent provided by the partnership deed.

(5)          The payment of remuneration to working partner, although relates to a period after the date of the partnership deed and authorised by the partnership deed, shall be allowed as a deduction to the extent provided in the partnership deed but subject to maximum of the following limits:

Limit prescribed for Firm including L.L.P. whether Carrying on Business or Profession towards Remuneration paid to Partners.

(a) on the first Rs.3,00,000 of the book profit or in case of a lossRs.1,50,000 or at the rate of 90% of the book profit whichever is more
(b) on the balance of the book profitat the rate of 60%

5. Treatment of Share of Profit, Interest and Remuneration received by a Partner from a Firm (including Limited Liability Partnership)

1.            Share of profit in the hands of the partner shall be fully exempt under section 10(2A).

 2.           Interest received/receivable by a partner shall be included in the Total Income of the partner under the head ‘Profits and gains of business or profession’ to the extent deduction of interest was allowed to the firm as per section 40(b), which cannot exceed 12% p.a.

3.            Remuneration to a working partner shall also be included in the Total Income of the partner under the head ‘profits and gains of business or profession’ to the extent deduction of remuneration was allowed to the firm as per section 40(b).

Example:

If the partner was paid a remuneration of Rs.2,40,000 by the firm, but as per section 40(b) deduction was allowed to the firm on account of such remuneration to the extent of Rs.1,80,000, Rs.1,80,000 only will be included in the Total Income of the partner. Balance Rs.60,000 may be treated as share of profit which is exempt.

6.  Provisions regarding Set Off and Carry Forward of Losses of Firms

There are no special provisions for set off and carry forward of losses of firms. These are the same as applicable in case of other assessees and these have already been discussed under chapter on ‘Set Off and Carry Forward of Losses’. The losses and unabsorbed depreciation of the firm can be carried forward by the firm only.

(A) Carry forward and Set off of losses under any head in case of change in constitution of firm [Section 78]:

(1)          Where a change has occurred in the constitution of a firm, due to retirement of a partner or death of a partner, the firm shall not be entitled to carry forward and set off so much of the loss proportionate to the share of a retired or deceased partner as exceeds his share of profits, if any, in the firm in respect of the previous year. [Section 78(1)]

The loss for the purpose of section 78(1) and (2) above does not only mean loss under the head profit or gains from business or profession, it means loss under any head of income.

(2)          Where any person carrying on any business or profession has been succeeded in such capacity by another person otherwise than by inheritance, no person other than the person incurring the loss shall be entitled to have it carried forward and set off against his income. [Section 78(2)]

In other words, treatment in case of change in constitution of firm will be as follows:

Step 1: Calculate the share of profit of the retiring/deceased partner in the year in which there is a change in the constitution due to such retirement/death.

Step 2: Compute the share of loss of the retiring/deceased partner in the brought forward loss of the firm.

Step 3: Set off the share in the brought forward losses of the retiring/deceased partner from his share of the profit of the current year.

This set off of share of brought forward loss will be allowed to the extent of share of profit of such partner.

The balance loss, if any, will not be allowed to be carried forward either to such partner or to the firm.

On the other hand, if in the current year also the share of the partner is a loss, then share of the brought forward loss along with the share of loss of current year will not be allowed to be set off and carried forward.

7. Computation of Total Income of Firm (including Limited Liability Partnership)

Step 1: Compute the income of the firm under different heads of income viz., ‘Income from house property’; ‘Profits and gains of business or profession’; ‘Capital gains’ and ‘Income from other sources. However, while computing Business Income, remuneration and interest paid to the partners will be allowed subject to section 40(b) already discussed.

Step 2: Apply section 60 and 61 relating to clubbing of income, if applicable.

Step 3: Make adjustment on account of brought forward loss, unabsorbed depreciation, etc. if any. Income computed under Step 1 and 2 minus losses mentioned under Step 3 is known as Gross Total Income.

Step 4: From Gross Total Income, allow the  deductions allowable to a firm under Chapter VIA.

Step 5: Gross Total Income as calculated under step 3 minus deductions under Step 4 shall be the Total Income of the Firm.

8. Income Tax Slab Rate for ‘Partnership Firm’ for Financial Year 2020-2021 (AY: 2021-22)

A partnership firm (including LLP) is taxable at 30%.

Plus:

Surcharge: – 12% of tax where total income exceeds Rs. 1 crore.


Health and Education cess: 4% of income tax plus surcharge.

However, the total amount payable as income-tax and surcharge on total income exceeding Rs. 1 Crore shall not exceed the total amount payable as income-tax on a total income of Rs. 1 Crore by more than the amount of income that exceeds Rs. 1 Crore.

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