If you’ve ever sat across a table with your business partner(s), calculator in hand and some confusion on your face, you’re not alone. In India, whether in a long-established family business or a new-age partnership, one recurring question is: How much can the working partners pay themselves without running afoul of the tax authorities?

Let’s bring this issue to life with an example:

A Real Dilemma for Partners

Meet Arjun and Sneha, co-founders of a modest accounting firm in Bhopal. They put in late nights, build a clientele, and handle virtually all the operations. The business is growing, and naturally they want to reward themselves fairly for their efforts. When they finally visit their tax consultant, the consultant says: “You cannot just pay yourselves however you like. Section 40(b) says so.” Suddenly, their plans seem a lot more complicated.

What the consultant meant was: if the firm simply pays large salaries/commissions to partners (especially “working” partners) without observing the conditions and limits under Section 40(b), the firm risks disallowed deductions—and that means higher tax for the firm, and potentially unpleasant consequences for the partners.

The spirit behind Section 40(b)

Why does Section 40(b) exist in the first place? On a high level: to prevent abuse of the partnership structure in order to reduce taxable profits of the firm by paying overly high remuneration to partners (who may also be its owners), thereby shifting profits out of the firm (taxable at the firm rate) into partners’ hands (taxable differently).

In simpler words: the law wants to ensure that profits of a firm aren’t drained out as partner salaries/commissions purely for tax-avoidance. So Section 40(b) sets specific caps on what counts as a deductible expense for “partner remuneration” and “interest on partner capital.”

It is not meant to punish, but merely to act as a guardrail: if the deduction is excessive or the terms not proper, the deduction is disallowed.

What’s really allowed under Section 40(b)

Here are the key features of Section 40(b) (as relevant for remuneration and interest paid to partners by a partnership firm):

Who qualifies?

• Only working partners can receive remuneration (salary, bonus, commission) that is deductible. A “working partner” is one who is actively engaged in conducting the affairs of the business or profession of the firm.
• The partner must be authorized by the partnership deed: the deed should specify the amount of salary/remuneration, or at least a method for computing it. If the partnership deed does not authorise either the amount or the method, the deduction may be disallowed.
• The remuneration must relate to a period following the date of the partnership deed (or its renewal) which contains the remuneration clause. Retroactive payments for a period prior to the deed’s effective date may be disallowed.
• If the firm is paying tax under the presumptive scheme (such as under Section 44AD or Section 44ADA), then the benefit of Section 40(b) deduction (for partner remuneration) may not be available.

What kinds of payments?

• Remuneration to working partners includes salary, bonus, commission, and other payments for services rendered as a partner.
• Interest on capital contributed by partners: this is allowed (for working or non‐working partners) subject to conditions. The rate of interest must not exceed 12% simple interest per annum.
• Share of profits distributed to partners is a different matter—it is not treated as “remuneration” under Section 40(b); profit share is generally exempt in the partner’s hands under Section 10(2A) (if applicable) and does not form part of “remuneration” for deductibility purposes.

How is “Book Profit” defined for this purpose?

The term “book profit” in the context of Section 40(b) refers to: the net profit of the firm as per the profit & loss account for the relevant previous year, computed in accordance with Chapter IV-D of the Income Tax Act, increased by the aggregate amount of remuneration paid or payable to all the partners of the firm (if such amount has been debited in the profit & loss account) and less the interest allowed under Section 40(b).

The pay-limits (caps) under Section 40(b)

Here’s where the real numbers matter. Section 40(b) sets a ceiling on how much remuneration (to all working partners taken together) the firm can deduct. Any amount paid beyond that ceiling will be disallowed as a deduction for the firm (though the firm could still pay it out—it just won’t reduce its taxable profit).

Historical limits (pre-amendment)

Prior to the change brought in by the budget (we’ll detail that shortly), the limits were:

• On the first ₹3,00,000 of the book profit (or in case of a loss): higher of ₹1,50,000 or 90% of the book profit.
• On the balance of the book profit (i.e., book profit beyond ₹3,00,000): 60% of the balance.

Example (older rule): If the firm’s book profit is ₹10 lakh, then:

• On first ₹3,00,000: 90% → ₹2,70,000 (or ₹1,50,000 whichever is higher; 90% of 3,00,000 = 2,70,000, so this is higher)
• On remaining ₹7,00,000: 60% → ₹4,20,000
• Total allowed remuneration = ₹2,70,000 + ₹4,20,000 = ₹6,90,000
  If they paid ₹7,50,000, then ₹60,000 (i.e. ₹7,50,000–₹6,90,000) becomes non-deductible.

The new limits (after amendment)

The important change: The Finance Act, 2024 (and Budget 2024) has revised the limits with effect from 1st April 2025 (i.e., for Assessment Year 2025-26 and onwards).

The revised limits are:

• On the first ₹6,00,000 of the book profit (or in case of a loss): higher of ₹3,00,000 or 90% of the book profit.
• On the remaining balance of the book profit (i.e., book profit beyond ₹6,00,000): 60% of that balance.

To illustrate: Suppose the firm’s book profit is ₹10 lakh under new rule:

• First ₹6 lakh: 90% → ₹5.40 lakh (but also check the “whichever is higher of ₹3 lakh or 90%” — here 90% of 6 lakh = 5.4 lakh, which is higher than 3 lakh, so use 5.4 lakh)
• Balance ₹4 lakh: 60% → ₹2.40 lakh
• Total allowed remuneration = ₹5.40 lakh + ₹2.40 lakh = ₹7.80 lakh

Thus the cap for deductible remuneration has significantly improved (higher) under the new rule—giving firms more head-room.

Interest on partner’s capital

Separately: interest payable to partners on their capital is allowed only if:

• the partnership deed authorises the interest;
• the period is valid (i.e., authorised period);
• the rate of interest does not exceed 12% simple interest per annum.
  Any interest above 12% is disallowed under Section 40(b).

The “Gotchas” and Common Mistakes

Even with clear rules, many firms trip up. Here are common pitfalls for you (and for Arjun & Sneha in the earlier example) to watch out for:

• The partnership deed must clearly authorise the remuneration (or interest). If it is vague (“to be decided later” or “on such terms as may be approved”) it may not satisfy the requirement.
• Changing the deed retroactively or authorising remuneration for a period prior to the deed’s effective date won’t help. Remuneration for periods when the clause wasn’t in force may be disallowed.
• Paying remuneration to non-working (sleeping) partners but claiming deduction as if they’re working partners is not allowed—deduction allowed only for working partners.
• Firms sometimes mis‐calculate “book profit” (especially forgetting to add back remuneration already debited, or interest allowed) – leading to incorrect cap.
• If the firm pays remuneration beyond the capped limit, the excess amount will be disallowed as a deduction. While the firm can still pay the partner that amount, the tax deduction benefit is lost (i.e., it increases the firm’s taxable profit).
• Even though the firm may pay the remuneration, the partner must treat the amount allowed as deduction in the firm’s hands as “income from business/profession” in their hands (not salary). And if the firm’s deduction is disallowed, there are implications for how the partner accounts for it.

Why Accurate Reporting Saves Headaches

Returning to Arjun & Sneha: if they keep proper books, ensure their partnership deed clearly defines working partners and remuneration formula, and pay remuneration only up to the cap—and document everything—they’re in the clear. This helps in smooth statutory audits (if applicable), and reduces the risk of assessment adjustments by the tax department.

If something is amiss—say, the deed doesn’t authorise partner salaries, or they pay more than the allowed cap—the deduction can be denied. That means the firm’s taxable profit rises, and partners may face unforeseen tax liability or loss of planning benefit. Worse, if disallowed deductions are large, the assessment could become more intensive.

For the partner, remuneration paid (within cap) is taxable under “Profits and Gains of Business or Profession” (PGBP) and must be disclosed correctly (for example, in ITR-3 or ITR-4, as applicable). If the deduction gets disallowed at the firm’s end, the partner might face difficulties with their return.

Dual Impact: Firm and Partner Side

It’s worth summarising how this plays out on both sides:

• For the firm: remuneration paid to working partners (and interest paid to partners) within the Section 40(b) limits is treated as a deductible expense from the firm’s profits. This lowers the firm’s taxable profit (subject to other conditions).
• For the partner: the amount of remuneration paid by the firm (and allowed as deduction for the firm) is taxable in the partner’s hands under the head “Profits and Gains from Business or Profession.” It is not treated as “salary” (so e.g., TDS under Section 192 may not apply—though see below on new TDS rule).

Therefore, paying the working partner more (within legal limits) may reduce firm tax and give partner income in hands of partner (taxable at partner’s slab). But paying too much means no deduction for the firm, which may raise its tax liability, and complicate things.

Tools & Technology as Compliance Aids

In today’s digital world, many partnership firms use accounting software, GST‐billing packages, payroll tools etc. For compliance with Section 40(b):

• Use your accounting software to compute “book profit” properly by adding back remuneration/interest etc as required.
• Maintain a separate ledger for partner remuneration and interest, properly authorised by the deed, and document the working partner status.
• Use reminders for amending or updating the partnership deed if remuneration structure changes.
• Use audit trails and digital records for verification.
  These practices improve transparency and reduce risk of mistakes.

The End Game — Clarity, Honesty & Growth

Section 40(b) may seem like one more tax hurdle, but for everyday business owners and their bookkeepers it can be seen as an opportunity: to establish transparent reward systems, lay down clear roles (working vs non-working partners), build documentation, keep things clean.

Rather than seeing restrictions as shackles, see them as the skeleton key to good governance and long-term stability.

If Arjun and Sneha do this right, their next audit is much smoother, and the tax officer has fewer reasons for concern. They pay themselves fairly, document things, and keep the business growing.

So when you’re sitting down at your next partner meeting, ask yourselves: Is our reward system built for clarity, fairness, and future growth?

Summary Table: Key Provisions & Recent Changes

Practical Example (with the new limit)

Let’s take a simplified example to illustrate the new rule under the post-amendment regime:

Suppose a partnership firm’s book profit for FY 2025-26 is ₹8,00,000.
Step 1: On first ₹6,00,000: 90% → ₹5,40,000 (since 90% of 6,00,000 is 5,40,000, which is higher than ₹3,00,000)
Step 2: On remaining ₹2,00,000: 60% → ₹1,20,000
Step 3: Total maximum deductible remuneration = ₹5,40,000 + ₹1,20,000 = ₹6,60,000
If the firm pays, say, ₹7,00,000 to the working partners in aggregate, then the amount exceeding the allowed deduction i.e. ₹7,00,000 – ₹6,60,000 = ₹40,000 will be disallowed as deduction. The firm’s taxable profit will increase by ₹40,000.

Also: if the firm pays to a partner more than ₹20,000 in a year as remuneration/commission/interest etc, then the firm must deduct TDS at 10% under Section 194T at the time of payment or credit whichever is earlier.

Action-Points for Firms & Partners

Here’s a checklist for firms (and partners) to ensure compliance:

1. Review the partnership deed: ensure it clearly defines who are “working partners”, specifies remuneration (or the method of computing it) and interest on capital (if any) with clarity.
2. Update the deed if necessary, especially given the changed limits from April 2025.
3. At the start of the financial year, estimate likely book profit, expected partner remuneration and align payments so as not to exceed the cap under Section 40(b).
4. Maintain proper accounting records: compute book profit as per rules (add back remuneration/interest etc), ensure correct deduction.
5. At the time of payment of remuneration/interest to partners, check if TDS under Section 194T is required (i.e., if sum > ₹20,000) and deduct 10% TDS (resident partner) at payment/credit.
6. In partner’s hands: ensure the remuneration allowed is included under “Profits and Gains of Business or Profession” in the partner’s tax return; ensure TDS credit (Form 26AS) is properly reflected.
7. If the firm claims remuneration but actual payment or authorisation is defective (e.g., deed missing, or payment to non-working partner) then the deduction may be denied—anticipate this and avoid surprise tax cost.
8. For non‐working (sleeping) partners: do not treat payments to them as deductible remuneration; they can get share of profit, possibly interest on capital (subject to conditions), but not “salary/commission” as though they were working partners.
9. For interest on capital: ensure that interest is authorised by deed, not more than 12% p.a. on capital contributed, ensure correct period.
10. If the firm is under presumptive taxation (44AD/44ADA) then the deduction under Section 40(b) for remuneration may not be available—seek advice in those cases.

Why the Change Now?

The recent amendment (increase in the remuneration cap) was introduced because the previous limit (₹1.5 lakh on first ₹3 lakh of book profit) had remained unchanged for many years (since 2010) and did not keep pace with increasing business profits, inflation, and complexities of partnerships.

By increasing the limit (to ₹3 lakh on first ₹6 lakh of profit, and maintaining 60% beyond that), the law acknowledges that partnership firms need more flexibility to reward working partners. Simultaneously introducing TDS under Section 194T improves transparency and ensures the tax revenue catch and tracking of partner remuneration.

Conclusion

For partnership firms and their working partners, Section 40(b) isn’t just another tax-clause to worry about—it is a framework that determines how you can reward partners legitimately, how much of that reward is tax-deductible for the firm, and how tax will flow for the partners. The recent change (effective 1 April 2025) enlarges the headroom, which is good news, but also brings in new compliance dimensions (via Section 194T).

If you’re a partner (or you advise partnerships), here are the three key takeaways:

• Ensure your partnership deed is fit-for-purpose (clear, up to date).
• When paying partner remuneration and interest: pay only to working partners (for remuneration), and within authorised limits; track the cap carefully.
• From FY 2025-26 onwards: ensure you consider the new higher ceiling (first ₹6 lakh at 90%/₹3 lakh whichever higher + 60% beyond) and ensure TDS compliance under Section 194T.