Meaning of Partnership, Firm and Partners

29/07/2020 2 By indiafreenotes

The Income Tax Act, 1961, in India, the terms “partnership,” “firm,” and “partners” hold specific meanings and implications for tax purposes. Understanding these definitions and the legal framework surrounding them is crucial for compliance and tax planning for entities operating as partnerships.

Definition of Partnership

Under Section 4 of the Indian Partnership Act, 1932, a partnership is defined as “the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all.” This definition underscores the essence of a partnership as a voluntary association of two or more persons who agree to carry on a business and share its profits or losses. The Partnership Act does not limit the maximum number of partners; however, the Companies Act, 2013, imposes a limit of 50 partners for a partnership firm to prevent it from becoming an association or company.

Characteristics of a Partnership:

  • Agreement-Based:

The formation of a partnership is based on a contract, either oral or written (Partnership Deed), among the partners.

  • Profit and Loss Sharing:

Partners agree to share the profits and bear the losses of the business in a predetermined ratio.

  • Mutual Agency:

Every partner acts as both an agent and principal. Each partner is an agent of the firm and other partners, binding the entity in the course of the business.

  • Unlimited Liability:

Partners have unlimited liability, meaning their personal assets can be used to settle the firm’s debts if necessary.

Definition of Firm

In the context of the Income Tax Act, the term “firm” specifically refers to a partnership entity that is engaged in a business or profession. The Act recognizes a firm as a separate taxable entity distinct from its partners. The term is synonymous with a partnership firm and carries the same legal implications as outlined under the Partnership Act, with additional requirements for taxation purposes.

Characteristics of a Firm:

  • Separate Legal Entity for Tax Purposes:

Although not a separate legal entity like a corporation, for tax purposes, a firm is treated distinctly from its partners.

  • Taxation:

A firm is taxable at a rate specified for firms under the Income Tax Act. It enjoys certain benefits and deductions specific to its status.

  • Partnership Deed:

The existence of a partnership deed is crucial for the recognition of a firm for tax purposes. It outlines the rights, duties, profit-sharing ratio among partners, and other terms governing the partnership.

Definition of Partners

Partners are individuals who have entered into a partnership with one another. They contribute capital, share profits and losses, and participate in the firm’s management, unless otherwise agreed. Partners are the driving force behind the partnership, making decisions and undertaking actions for the firm’s benefit.

Taxation of Partnership Firms and Partners

The Income Tax Act lays down specific provisions for the taxation of partnership firms and their partners:

  • Taxation of Firms:

A firm is taxed on its income at the rates applicable to firms. It is required to file an annual income tax return. A partnership firm is also eligible for certain deductions and benefits under the Act.

  • Remuneration and Interest to Partners:

The Act allows firms to deduct interest on capital and remuneration (salary, commission) paid to partners, provided these payments are authorized by the partnership deed and within the limits prescribed under the Act.

  • Taxation of Partners:

Individual partners are taxed on their share of the firm’s profits. The share of profit from a firm is exempt in the hands of the partners to avoid double taxation, as the income is already taxed at the firm level. However, interest and remuneration received by partners from the firm are taxable as income from other sources or profits and gains from business or profession, depending on the nature of the receipt.

Basis of Comparison

Partnership Firm Partners
Definition Agreement Business Entity Individuals
Legal Status Not Separate Separate Individuals
Formation Agreement Registration Joining Agreement
Liability Unlimited Unlimited Unlimited
Management Shared By Partners Personal Involvement
Profit Sharing Agreed Ratio As per Agreement Direct Share
Loss Bearing Shared By Firm Individual Share
Decision Making Collective Partners’ Consent Individual Opinion
Continuity Uncertain Depends on Agreement Affects Continuity
Ownership Shared By Partners Personal Stake

Number of Members

2-20 (Typically) Not Applicable At least 2
Dissolution Easier Legal Process Affects Partnership
Legal Formalities Fewer More Minimal
Capital Contribution Voluntary As per Agreement Personal Contribution

Books of Accounts

Maintained Mandatory

Partner’s Responsibility

Compliance and Documentation

Compliance with tax laws for a partnership firm involves the proper documentation of the partnership deed, accurate bookkeeping, timely filing of income tax returns, and adherence to the provisions related to remuneration and interest payments to partners. The partnership deed, in particular, plays a pivotal role in determining the tax obligations and entitlements of both the firm and its partners.