Remuneration to partners often becomes a costly compliance nightmare for firms that overlook critical regulatory details. Unfortunately, many businesses continue to follow outdated practices, risking significant penalties and disallowances during tax assessments.
Proper Partners Remuneration structures remain a challenging aspect of Accounting for Firms, particularly when preparing Financial Statements for Non Corporate Entities. In fact, recent regulatory changes have made compliance even more complex, with new TDS rules and interpretation shifts that demand immediate attention.
This comprehensive guide examines the hidden rules governing partner remuneration payments in 2025, highlighting common misconceptions and providing actionable solutions to protect your firm from costly mistakes. Whether you’re managing an established partnership or forming a new one, understanding these often-overlooked compliance requirements could save you substantial time, money, and stress.
Common Misconceptions About Partner Remuneration
Many partnerships fall into costly tax traps due to fundamental misunderstandings about how partner payments should be structured. These misconceptions often lead to disallowed deductions and unexpected tax liabilities that could have been easily avoided with proper knowledge.
1. Salary vs Remuneration: Why the confusion matters
The terms “salary” and “remuneration” are frequently used interchangeably, creating significant confusion among firm owners. Remuneration is actually the broader term that encompasses salary, commission, compensation, and wages. This distinction isn’t merely semantic—it has real tax implications.
Unlike regular employee salaries, partner payments have specific tax treatment under Section 40(b) of the Income Tax Act. Moreover, remuneration can only be paid to working partners who actively participate in managing the firm’s affairs. Many firms mistakenly believe that all partners qualify for remuneration, but non-working or “sleeping” partners cannot receive such payments as deductible expenses.
Another common error is assuming that non-individual partners (such as companies) can receive remuneration. According to tax regulations, only individual partners who actively engage in the firm’s operations qualify as working partners. This misconception often leads to disallowed deductions during assessments.
2. Misunderstanding the role of the partnership deed
Perhaps the most costly misconception involves the partnership deed’s role in partner remuneration. Many firms operate with vague clauses stating remuneration will be paid “as per Income Tax provisions” or omit specific details altogether.
For tax compliance, the partnership deed must explicitly detail:
- The exact amount of remuneration or a clear formula for calculation
- Which partners qualify as working partners
- When and how remuneration will be paid
Without these specific provisions, deductions may be disallowed under Section 40(b)(v) of the Income Tax Act, as emphasized in Circular No. 739 dated March 25, 1996. Additionally, firms often make the mistake of attempting to backdate remuneration provisions. Important to realize, remuneration is only deductible from the date the partnership deed includes such provisions, not from any period prior.
3. Ignoring the impact of book profit calculation
The calculation of “book profit” forms the foundation for determining allowable partner remuneration, yet this area is rife with misconceptions. Many firms incorrectly believe that book profit includes only business income rather than the total net profit shown in the profit and loss account.
In essence, book profit means the net profit as shown in the profit and loss account for the relevant previous year, computed according to Chapter IV-D, increased by the aggregate amount of remuneration paid to partners (if deducted while computing the net profit). Contrary to popular belief, this includes income from all sources appearing in the profit and loss account—not just business income.
The formula for calculating book profit is:
- Net profit as per profit and loss account
- Add: Remuneration to partners (if already debited in P&L)
- Add: Interest paid to partners (if debited in P&L)
- Less: Interest as allowed under Section 40(b)Â
Firms frequently make the error of excluding non-business income from book profit calculations. Consequently, they either undercalculate the allowable remuneration or risk disallowances during assessment. As per tax experts, “even if income from other sources is included in the profit and loss accounts to ascertain the net profit for book-profit computation of partner remuneration, the same cannot be discarded”.
Understanding these nuances is critical since they directly impact the maximum allowable deduction for partner payments and, ultimately, the firm’s tax liability.
Hidden Compliance Traps Firms Often Miss
Beyond misconceptions lie active compliance traps that can ensnare even well-meaning firms. These hidden pitfalls often remain undetected until a tax assessment or dispute arises, by which time significant damage may have already occurred.
1. Outdated partnership deeds
Partnership deeds require regular updates, yet most firms neglect this critical document until problems emerge. An outdated deed can lead to serious consequences beyond mere administrative inconvenience.
Deed invalidation occurs automatically when a new partner joins the firm. This often happens without partners realizing their agreement has become legally void. Once invalidated, your firm operates as a “partnership at will” – putting your service contracts and entire practice at immediate risk.
Furthermore, partnership deeds lacking updates to reflect modern business realities create dangerous ambiguities around:
- New income streams and profit distribution methods
- Risk sharing arrangements (especially regulatory compliance risks)
- Non-property asset valuations (like shares in other entities)
- Surgery occupancy rights and property-related costs
Ideally, firms should review their partnership deeds annually. Any changes to the partnership structure, such as alterations in firm name, business location, or partner details, must be reported to the Registrar of Firms within 90 days.
2. Paying sleeping partners by mistake
Sleeping partners (also called silent partners) provide capital but don’t actively participate in business management. Nevertheless, firms frequently make costly mistakes regarding their payment arrangements.
The first major trap involves remuneration deductibility. Section 40(b) specifically prohibits deduction of remuneration paid to non-working partners, including sleeping partners. Despite this clear restriction, many firms continue providing salary-like payments to silent partners, creating significant tax exposure.
Indeed, while sleeping partners are entitled to their share of profits proportionate to their investment, they cannot receive remuneration payments that qualify as deductible expenses for the firm. This distinction remains foggy for many accounting professionals.
Additionally, sleeping partners create hidden compliance risks regarding liability. Although generally considered to have limited liability extending only to their capital contribution, sleeping partners may still face exposure for acts done by other partners. This creates a complex web of potential liabilities that firms must navigate carefully.
3. Exceeding Section 40(b) limits unknowingly
The Income Tax Act establishes strict limits on partner remuneration deductibility through Section 40(b), yet firms frequently exceed these thresholds unwittingly.
Prior to Budget 2024, deduction limits were set at Rs. 1,50,000 or 90% of book profit (whichever is higher) for the first Rs. 3,00,000, and 60% of remaining book profit. These limits have now increased to Rs. 3,00,000 or 90% of book profit (whichever is higher) for the first Rs. 6,00,000, with 60% applicable to remaining book profit.
However, firms continue making several critical errors:
First, many fail to recognize that remuneration is allowable only for working partners explicitly authorized by the partnership deed. Payments must also relate to periods after such authorization was documented—retroactive authorization remains invalid.
Second, firms misunderstand what constitutes “book profit,” often calculating it incorrectly. Book profit means net profit shown in the profit and loss account, increased by any remuneration already paid to partners.
Finally, partnerships sometimes pay partners through alternative means to circumvent Section 40(b) limits, not realizing these arrangements may still trigger tax consequences under different provisions. This includes categorizing payments as something other than remuneration to avoid TDS requirements.
TDS on Partner Payments: New Rules You Can’t Ignore
A significant tax reform looms on the horizon for partnerships and LLPs. Starting April 1, 2025, firms must navigate a complex new landscape of Tax Deducted at Source (TDS) requirements on remuneration to partners.
1. Overview of Section 194T
Section 194T represents a fundamental shift in how partner payments are taxed. Effectively from April 1, 2025, this provision mandates that firms deduct TDS at 10% on payments such as salary, remuneration, commission, bonus, and interest made to partners. Before this change, no TDS was applicable on such payments.
The scope of this new rule is comprehensive:
- Applies to all partnership firms and LLPs
- Covers both resident and non-resident partners
- Encompasses various payment types including salary, bonus, commission, and interest on capital/loan
Notably, TDS under Section 194T is not applicable on drawings or capital repayment to partners. This creates an important distinction between income-related payments and capital transactions.
🔗 Know More on Section 194T
2. When and how TDS must be deducted
For TDS obligations to trigger, the total payments to a partner must exceed ₹20,000 in a financial year. In essence, once this threshold is crossed, TDS applies to the entire amount, not just the portion exceeding the limit.
As an illustration, if a firm pays a partner ₹3,00,000 as remuneration in a financial year, a 10% TDS (₹30,000) must be deducted on the whole amount.
Regarding timing, TDS must be deducted at the earliest of:
- When the amount is credited to the partner’s account (including capital account) in the firm’s books
- When the actual payment is made to the partner
Unlike certain other TDS provisions, partners cannot claim exemptions or submit Form 15G/15H to avoid these deductions. Additionally, Section 197 provides no option for lower TDS rates in this case.
3. Common TDS mistakes and penalties
Firms often make costly errors when implementing TDS requirements. Among the most frequent mistakes are:
First, incorrect PAN information can lead to higher TDS rates of 20% and creates complications for partners claiming tax credits. Another common error is late or non-deposit of deducted TDS amounts, which triggers interest penalties of 1-1.5% per month.
The failure to deduct TDS can result in penalties equal to the amount that should have been deducted. Furthermore, improper TDS return filing or furnishing incorrect information can incur penalties ranging from ₹10,000 to ₹1,00,000.
Many firms also struggle with determining when to deduct TDS on partner remuneration, particularly when payments depend on year-end profitability calculations. For this reason, partnership firms need to close their books promptly before financial year-end to ensure timely and accurate TDS compliance.
To avoid these pitfalls, firms should immediately review their accounting systems, obtain a Tax Deduction and Collection Account Number (TAN) if they don’t already have one, and establish proper documentation processes for all partner payments.
Real-World Examples of Costly Mistakes
The theoretical risks of non-compliance become painfully real when examining recent tax cases where firms faced substantial financial consequences.
1. Case study: Disallowed remuneration due to missing deed clause
In the landmark case of Mayur Wines Vs NFAC, a partnership firm had its entire partner remuneration of Rs.35,76,830 disallowed. Initially, the Centralized Processing Center (CPC) rejected the deduction claiming the partnership deed wasn’t included with the tax return. Fortunately, the ITAT Pune eventually ruled in the firm’s favor, noting no statutory requirement existed for including the deed with returns.
Less fortunate was a chartered accountancy firm facing disallowance of Rs.21,40,000 in partner payments. Their supplementary partnership deed merely stated remuneration would be “as per mutual consent” and “as per provisions of the Income Tax Act.” The tribunal determined this vague language failed to specify either amounts or calculation methods . Without clear quantification terms, the entire remuneration stood disallowed.
Similarly, the Telangana High Court upheld a complete disallowance where a partnership deed contained no specific terms for partner payments. The court reaffirmed that Section 40(b)(v) requires explicit authorization in the deed itself.
2. Case study: TDS non-compliance leading to penalties
Starting April 2025, failure to comply with Section 194T can trigger cascading penalties. One manufacturing firm discovered this after incorrectly applying regular TDS provisions to partner payments rather than the specialized rates.
The firm faced:
- Interest penalties at 1% monthly for non-deduction and 1.5% monthly for non-deposit
- Complete disallowance of expenses under Section 40(a)(ia)Â
- Additional penalties imposed by the Assessing Officer under Section 271CÂ
In another case, a mid-sized consultancy firm neglected to obtain a Tax Deduction Account Number (TAN), mistakenly believing partnerships were exempt from TDS requirements. This oversight resulted in regulatory scrutiny, operational disruptions, and reputational damage among clients questioning the firm’s compliance standards.
How to Audit Your Firm’s Partner Remuneration in 2025
Proactive auditing of your partnership’s remuneration structure prevents costly disallowances and penalties. With new TDS rules and stricter enforcement, 2025 demands a thorough review of your firm’s partner payment systems.
1. Step-by-step compliance checklist
First and foremost, establish a quarterly remuneration audit process:
- Verify working partner status documentation for all receiving remuneration
- Recalculate book profits using the correct formula (net profit + existing remuneration)
- Compare actual payments against Section 40(b) limits
- Match remuneration entries with partnership deed provisions
- Confirm TDS deductions at correct 10% rate on all qualifying payments
- Review partner drawings to ensure proper categorization
Implementing this audit cycle helps identify issues before they become assessment problems. To clarify, the most critical verification occurs before year-end, allowing time for corrections before filing returns.
2. Updating your partnership deed
Partnership deeds require precise language about remuneration. In light of recent tribunal rulings, vague provisions no longer suffice. When updating your deed:
- Specify exact amounts or clear calculation formulas
- Identify all working partners by name
- Include payment frequency and method details
- Address interest on capital provisions separately
- Maintain proper execution with witnesses
Remember that retroactive amendments won’t protect previous payments. Correspondingly, updates should occur before the financial year in which they apply, ideally with professional legal assistance to ensure enforceability.
3. Setting up TDS systems correctly
To meet Section 194T requirements starting April 2025:
- Obtain TAN registration if not already held
- Configure accounting software to flag partner payments
- Implement remuneration approval workflows
- Create partner payment registers with TDS tracking
- Establish quarterly reconciliation processes
Your TDS system must track the ₹20,000 threshold cumulatively across all payment types to the same partner. Afterward, ensure timely deposit of deducted amounts to avoid interest penalties that can significantly impact firm profitability.
Conclusion
Partner remuneration remains a critical aspect of financial compliance that demands immediate attention from firms across India. Throughout this guide, we’ve examined how seemingly minor oversights in remuneration structures can trigger substantial tax liabilities and penalties. Though many partnerships continue operating with outdated practices, the regulatory landscape has evolved significantly, especially with Section 194T implementation approaching in April 2025.
Undoubtedly, the most frequent causes of disallowances stem from inadequate partnership deed provisions, incorrect book profit calculations, and unauthorized payments to non-working partners. Recent tribunal rulings clearly demonstrate that vague remuneration clauses no longer satisfy compliance requirements. Therefore, firms must ensure their partnership deeds explicitly state remuneration amounts, identify working partners, and outline clear calculation methodologies.
Beyond documentation, firms must also prepare for the new TDS obligations on partner payments. This unprecedented change requires implementing robust systems to track cumulative payments, maintain proper records, and ensure timely deposit of deducted amounts. Additionally, understanding the distinction between various types of partner payments has become essential for avoiding unnecessary tax exposure.
The financial stakes have never been higher. As demonstrated by the real-world cases discussed earlier, disallowances can reach into tens of lakhs, significantly impacting firm profitability. Consequently, regular remuneration audits should become standard practice for all partnerships, preferably conducted quarterly rather than hastily before filing deadlines.
While navigating these complex regulations may seem daunting, proper compliance ultimately protects your firm’s financial health and professional reputation. After all, prevention through proper structuring costs far less than remediation after assessment. Armed with this comprehensive understanding of partner remuneration rules, your firm can confidently establish compliant payment structures that withstand regulatory scrutiny while maximizing legitimate tax benefits for all partners involved.
