Taxation of Firms, Partners' Remuneration and Interest under the Income Tax Act 2025

A partnership firm is taxed as a separate assessee under sections 324 to 330 of the Income-tax Act, 2025. To be assessed as a firm, the partnership must be evidenced by an instrument (the partnership deed) that specifies each partner's share. The firm can then deduct salary, bonus, commission and remuneration to partners, and interest to partners, only within the limits of section 35(e): remuneration to working partners capped by a book-profit formula, and interest capped at 12% simple interest per annum.

This guide covers who is assessed as a firm, how much partner remuneration and interest is deductible, how the partner is taxed on it, TDS on the payment, and what happens when a partner leaves or the firm closes. The text is the Act as amended by the Finance Act, 2026, with the section number next to each point. The examples use tax year 2026-27. The rate of tax on a firm's total income is not in the Act itself: section 324 says it is the rate "specified in any Central Act for the relevant tax year", so check the current Finance Act for the rate.

When is a partnership taxed as a firm under the Income-tax Act, 2025?

Under section 325(1), a firm is assessed as a firm if both conditions are met:

• the partnership is evidenced by an instrument (a written partnership deed); and
• the individual shares of the partners are specified in that instrument.

Section 324 then charges tax on the firm's total income at the rate specified in the Central Act for that tax year. A partner's share in the firm's profit, received as per the profit-sharing ratio in the deed, is not taxed again in the partner's hands (Schedule III, Table Sl. No. 2). The partner is taxed on the interest, salary, bonus, commission or remuneration they receive, and only to the extent the firm was allowed to deduct it (section 26(2)(g)).

What must go with the return?

• A certified copy of the partnership instrument must accompany the firm's return for the tax year in which assessment as a firm is first sought (section 325(2)).
• The copy is certified in writing by all partners who are not minors. If the return is filed after dissolution, it is certified by all persons who were partners immediately before dissolution, and by the legal representative of any deceased partner (section 325(3)).
• In later years the firm continues to be assessed as a firm if neither the constitution nor the partners' shares change (section 325(4)).
• If either changes, a certified copy of the revised instrument must accompany that year's return (section 325(5)).

What happens if the firm does not comply with section 325?

Section 326 is blunt. If the firm does not comply with section 325 for a tax year, then:

• no deduction is allowed for interest, salary, bonus, commission or remuneration paid to any partner, in computing the firm's business income; and
• that payment is not taxed in the partner's hands under section 26(2)(g).

Section 325(6) gives the same result where the firm commits a failure mentioned in section 271, such as not filing a return when required, or not complying with the terms of a notice. So the cost of a missing deed or a missed return is that the firm pays tax on profit before partner payments are subtracted.

How much remuneration can a firm pay its partners and claim as a deduction?

Section 35 lists amounts that are not deductible in computing business income. Clause (e) deals with firms assessable as such. Remuneration (salary, bonus, commission or remuneration by whatever name called) is not allowed in these cases:

• it is paid to a partner who is not a working partner (section 35(e)(i));
• it is paid to a working partner but is not authorised by the partnership deed for the period it relates to (section 35(e)(ii)(A));
• it is authorised by the deed but relates to a period before the date of the deed, or was not authorised by the earlier deed (section 35(e)(ii)(B)); or
• the aggregate remuneration to all working partners exceeds the cap in section 35(e)(iii), to the extent of the excess.

A working partner is an individual who is actively engaged in conducting the affairs of the business or profession of the firm (section 35(e)(v)(B)).

What is the cap on working partners' remuneration?

Book profit	Maximum aggregate remuneration to all working partners
On the first Rs 6,00,000	Rs 3,00,000 (this is the figure used in the case of a loss) or 90% of the book profit, whichever is higher
On the balance above Rs 6,00,000	60%

Book profit is the net profit shown in the profit and loss account for the tax year, computed as per Chapter IV-D, increased by the total remuneration to all partners if that amount was deducted in arriving at the net profit (section 35(e)(v)(A)). Interest is not added back in this definition.

Worked example 1: remuneration within the limit

Assumptions: a firm with two working partners, tax year 2026-27. The partnership deed dated 1 April 2025 authorises remuneration. Net profit as per the profit and loss account (Chapter IV-D basis) after deducting partner remuneration is Rs 9,00,000. Remuneration paid to the two working partners together is Rs 11,00,000.

Step	Working	Amount (Rs)
1. Book profit	9,00,000 + 11,00,000	20,00,000
2. Cap on first Rs 6,00,000	90% of 6,00,000 = 5,40,000 (higher than 3,00,000)	5,40,000
3. Cap on balance	(20,00,000 - 6,00,000) x 60% = 14,00,000 x 60%	8,40,000
4. Maximum allowable	5,40,000 + 8,40,000	13,80,000
5. Paid		11,00,000
6. Disallowed	Paid is below the cap	Nil

Worked example 2: remuneration above the limit

Assumptions: same deed, tax year 2026-27. Net profit after partner remuneration is Rs 50,000. Remuneration paid to working partners is Rs 7,50,000.

Step	Working	Amount (Rs)
1. Book profit	50,000 + 7,50,000	8,00,000
2. Cap on first Rs 6,00,000	90% of 6,00,000	5,40,000
3. Cap on balance	(8,00,000 - 6,00,000) x 60% = 2,00,000 x 60%	1,20,000
4. Maximum allowable	5,40,000 + 1,20,000	6,60,000
5. Disallowed	7,50,000 - 6,60,000	90,000

The Rs 90,000 is added back to the firm's business income. The partners are taxed on Rs 6,60,000 only, because section 26(2)(g) reaches the amount allowed under section 35(e).

What is the limit on interest paid to partners?

Interest to any partner is disallowed in these cases:

• it is not authorised by the partnership deed for the period it relates to, or relates to a period before the deed date (section 35(e)(ii));
• it is above 12% simple interest per annum (section 35(e)(iv)); only the excess is disallowed.

Where an individual is a partner in a representative capacity (on behalf of another person), interest paid to him in that capacity and interest paid to the person represented are both counted for the 12% test. Interest paid to him in his own right is left out. The same exclusion applies if he receives his own interest on behalf of someone else (section 35(e)(iv)(A) and (B)).

Worked example 3: interest above 12%

Assumptions: Meena is a partner with a capital contribution of Rs 10,00,000 for the whole of tax year 2026-27. The deed authorises 15% interest on capital.

Step	Working	Amount (Rs)
1. Interest credited	10,00,000 x 15%	1,50,000
2. Maximum allowable	10,00,000 x 12%	1,20,000
3. Disallowed in the firm's hands	1,50,000 - 1,20,000	30,000
4. Taxed in Meena's hands as business income (s. 26(2)(g))	Allowed portion only	1,20,000

Real-life example: remuneration paid before the deed was signed

Ravi and Meena run a trading firm. They agreed orally in April 2026 that both would draw a monthly salary, but only signed the deed on 1 October 2026, and the deed mentions that remuneration is payable "from 1 April 2026". Under section 35(e)(ii)(B), remuneration that relates to a period before the date of the deed is not allowed. The six months of salary from April to September 2026 is added back to the firm's income, even though the deed refers to April. Had they signed in April, the whole year would have been tested only against the cap.

Real-life example: a retired uncle who is a sleeping partner

Ravi's uncle holds a 10% share but does not take part in the business. The firm pays him Rs 60,000 as "salary". He is not a working partner, so under section 35(e)(i) the Rs 60,000 is not deductible, and it is also not taxed in his hands under section 26(2)(g). His share of profit is not taxed in his hands either. If the firm had paid him interest on capital as authorised by the deed, within 12%, that interest would still be deductible (section 35(e)(ii) and (iv)).

Does an LLP follow the same firm rules?

Yes. Under section 2(45), "firm" has the meaning in section 4 of the Indian Partnership Act, 1932 and includes a limited liability partnership (LLP) as defined in the LLP Act, 2008. Section 2(74) likewise treats a partner of an LLP as a "partner". So the partner remuneration and interest limits, and the TDS on payments to partners, described in this article apply to an LLP and its partners in the same way.

Is TDS deducted on payments to partners?

Yes. Under section 393(3), Table Sl. No. 7, a firm that credits or pays any salary, remuneration, commission, bonus or interest to a partner (including credit to his capital account) deducts tax at 10%. The threshold is Rs 20,000, and tax is deducted on the entire amount once the threshold limit is exceeded (section 393(3)(a)). For a resident deductee the quarterly statement goes in Form 140 (rule 219(1), Table Sl. No. 3), and deposit dates are in rule 218(2): the 7th of the following month, or 30 April for March.

For example, if Ravi's firm credits Rs 30,000 of interest to his capital account in a tax year, tax of 10%, which is Rs 3,000, is deducted on the whole Rs 30,000. If the total credited is Rs 18,000, no deduction is required under this entry. This article does not cover the higher rate for a missing PAN or a lower-deduction certificate.

What happens when the constitution of a firm changes?

Section 327 deals with changes at the time of an assessment under section 270 or 271. The assessment is made on the firm as constituted at the time of making the assessment. There is a change in constitution if:

• one or more partners cease to be partners, or new partners are admitted, as long as at least one person who was a partner before the change continues after it (section 327(2)(a)); or
• all partners continue but their shares change, or some partners' shares change (section 327(2)(b)).

The partner-leaves-or-joins rule does not apply where the firm is dissolved on the death of a partner (section 327(3)).

If one firm is succeeded by another, except in a case covered by section 327, section 328 applies instead: separate assessments are made on the predecessor and the successor firm as per section 313 (predecessor assessed up to the date of succession, successor after it).

Are partners personally liable for the firm's tax?

Yes. Under section 329, every person who was a partner during the tax year, and the legal representative of a deceased partner, is jointly and severally liable with the firm for tax, penalty or other sum payable by the firm for that tax year. The department can recover the whole amount from any one of them.

What if the firm is dissolved or stops the business?

Section 330 says the Assessing Officer assesses the firm's total income as if no dissolution or discontinuance had taken place, with all provisions, including penalties, applying. Points to note:

• Penalty can be imposed or directed if the firm was guilty of any act specified in Chapter XXI (section 330(2)).
• Every person who was a partner at the time of dissolution, and the legal representative of a deceased partner, is jointly and severally liable (section 330(3)).
• If proceedings had begun before dissolution, they can continue against those persons from the stage they had reached (section 330(4)).
• Section 302(4), which limits the liability of a legal representative, is not affected (section 330(5)).

Quick reference

Item	Rule	Where
Assessed as a firm	Written instrument with partners' shares; certified copy with return	Section 325(1) to (3)
Revised deed	Certified copy with return of the year of change	Section 325(5)
Non-compliance	No deduction for partner payments; not taxed in partner's hands	Sections 325(6), 326
Remuneration	Working partners only; authorised by deed; book-profit cap	Section 35(e)(i) to (iii)
Interest	Authorised by deed; up to 12% simple per annum	Section 35(e)(iv)
Partner's taxability	Only the amount allowed to the firm	Section 26(2)(g)
TDS on payments to partners	10%, threshold Rs 20,000, firm as payer	Section 393(3), Sl. No. 7
Partner liability	Joint and several	Sections 329, 330(3)

What are the common mistakes with firm taxation?

• Paying remuneration to a non-working partner. It is not deductible under section 35(e)(i), however the deed words it.
• Not specifying the partners' shares in the deed. Without it the firm risks losing the status of a firm under section 325(1)(b).
• Backdating remuneration. A deed cannot authorise a deduction for periods before its own date (section 35(e)(ii)(B)).
• Forgetting the revised deed. A change in shares or partners needs a fresh certified copy with that year's return (section 325(5)).
• Computing book profit from the wrong profit. Start with the Chapter IV-D net profit and add back the total partner remuneration deducted.
• Missing TDS on capital account credits. Section 393(3), Sl. No. 7 covers amounts credited to the partner's account, not only cash payments.

Where is this in the Act?

• Section 324: charge of tax on a firm
• Section 325: assessment as a firm, deed and certified copy
• Section 326: result of non-compliance with section 325
• Section 327: change in constitution of a firm
• Section 328: succession of one firm by another
• Section 329: joint and several liability of partners
• Section 330: firm dissolved or business discontinued
• Section 35(e): limits on partner remuneration and interest; section 26(2)(g): partner's taxability
• Section 393(3), Table Sl. No. 7; rules 218 and 219: TDS, deposit and statement

How do CA firms keep track of partnership clients?

A CA handling several partnership clients has to watch deed dates, changes in shares, TDS on partner payments and return dates for each one. Finexo's practice management software tracks these deadlines and tasks across your client book. It does not compute tax or file returns for you. For the mechanics of TDS deposits, see our post on TDS on rent under the Income-tax Act, 2025.

This article explains the Income-tax Act, 2025 (as amended by the Finance Act, 2026) and the Income-tax Rules, 2026. It is general information, not tax advice. Confirm the position for a specific firm with a qualified chartered accountant.