In this blogpost, Kavinesh RM, Student of Lloyd Law College, Greater Noida and the Diploma in Entrepreneurship Administration and Business Laws by NUJS, writes about the basics of income tax, tax liabilities on partnership and LLP, what is the tax implication on conversion of partnership into LLP and the liability of partners at the time of liquidation.
The Limited Liability Partnership is a partnership where some of the partners or each and every partner have limited liabilities according to their agreed contributions in Limited Liability Partnership. Even in a company, a shareholder is liable for the debts of the company only to the extent where the share capital he or she contributed be used to pay credits. So a company and an LLP is similar to each other. But the LLP is a separate legal entity, and it is liable to the full extent of its assets.
Tax laws are subject to frequent modifications introduced through the Finance act or by concerned regulatory bodies such as Central Board of Direct Taxes (CBDT) for Income Tax, Central Board of Excise and Customs (CBEC) for excise, service tax and customs and State Governments in case of VAT.
Basics of Income Tax
“A tax that governments impose on financial income generated by all entities within their jurisdiction. By law, businesses and individuals must file an income tax return every year to determine whether they owe any taxes or are eligible for a tax refund. Income tax is a key source of funds that the government uses to fund its activities and serve the public”.
Income tax is governed by Income tax act, 1961. Income tax is classified as five categories under Income Tax Act; they are as follows
- Income from salaries,
- Income from house property,
- Income from Business or Profession,
- Income from Capital gains,
- Income from other sources.
Tax on Partnership and LLP’s
Partnership and LLP’s are taxed on their income at the rate of 30%. The income of partners is distributed after that is tax-free The Profit of LLP is credited to the accounts of the partners may be exempt to tax under Section 10(2A) in the hands of partners to avoid double taxation. But as per the section 40(b) of Income Tax Act, the only salary paid to a working partner is deductible, if certain conditions are met.
The conditions are ; if authorized by the partnership deed if it relates to a period after the date of the partnership deed. It must be also within the following limits.
On the first Rs.3 lakhs of book-profit or in case of loss
Lower of Rs.1.5 lakhs or at the rate of 90%of the book profit.
On the balance book profit
At the rate of 60%
Taxation of LLP’s is governed by the Income Tax Act, 1961 as amended by the Financial Act, 2009 which introduced provisions for the taxations of LLP ; (effective from assessment year, April 2010 to 31 March 2011). LLP’s shall be taxed in the same manner of partnership’s income of them shall be in the hands of the LLP, and remuneration to partners shall be exempt
The Finance act made the following changes to the Income Tax Act, 1961
- ‘firm’ shall have the meaning assigned to it in the Indian Partnership Act, 1932 (9 of 1932), and shall include a Limited Liability Partnership as defined in the Limited Liability Partnership Act, 2008 (6 of 2009)
- ‘partner’ shall have the meaning assigned to it in the Indian Partnership Act, 1932 and shall include
- any person who, being a minor, has been admitted to the benefits of partnership as defined in the Limited Liability Act, 2008 (6 of 2009)
- a partner of a Limited Liability Partnership as defined in the Limited Liability Partnership Act, 2008 (6 of 2009)
- Partnership shall have the meaning assigned to it in the Indian Partnership Act, 1932 (9 of 1932), and shall include a Limited Liability Partnership as defined in the Limited Liability Partnership Act 2008 (6 of 2009).
Tax implication on converting Partnership into LLP
By considering the definition given by Income Tax Act, 1961 firm includes LLP. So there won’t be any change while converting LLP into firm or firm into LLP according to the income tax laws.
Right and obligation of the partners remains the same after conversion and if there is no transfer of assets or liability after conversion
The explanatory memorandum which is attached to the Finance (NO.2) Bill, 2009 clarifies as follows,
“As an LLP and a general partnership is being treated as equivalent in the act, the conversion from a general partnership firm to an LLP will have no tax implication if the rights and obligations of the partners remain the same after conversion and if there is no transfer of any assets or liability after conversion. If there is a violation of these conditions, the provision of section 45 shall apply.”
Hence, there won’t be any capital gain either in the hands of the partners or in the hands of the firm while conversion takes place. So it does not matter whether they convert into the firm or not, all the provisions of the Income Tax Act, 1961 shall continue to apply on LLP.
Tax Deduction at Source (TDS)
According to Income Tax Act 1961, Tax Deduction Source means to collect the tax indirectly by the Indian authorities which are managed by Central Board of Direct Taxes (CBDT) which comes under Indian Revenue Service (IRS). But normally the receipt of remuneration or interest or remuneration and interest is being taxed as business income in the hands of LLP partner. Hence, the expense incurred by the LLP partner for a business purpose like interest payments and business loss of propriety business, if any, can be set off against receipt of interest and remuneration. No TDS deduction is necessary from the LLP while making LLP payment of interest and remuneration payment to LLP partners.
Section 10(2A) exempts the share income from the LLP in the hands of the partner. The share of a partner in the total income of a LLP separately assessed as such shall, be an amount which bears to the total income of the LLP the same proportion as the amount of his share in the profits of the LLP in accordance with the LLP Agreement bears to such profits.
Disallowance of interest under section 40A(2)
As per Section 40A(2)(b) in The Income- Tax Act, 1995, any expenditure incurred by an assessee in respect of which payment has been made to specified persons (relative, director of company, partner of firm, person having substantial interest in business of assessee etc.), is liable to be disallowed in computing business profit to the extent such expenditure is considered to be excessive or unreasonable, having regard to the fair market value of goods or services or facilities etc.
Thus, even if payment of remuneration or interest is allowable as per section 40(b) of Income Tax Act, it can be disallowed under section 40A (2) of Income Tax Act.
Liability of Partners in Liquidation
A new Section 167C has been inserted by the Finance Act, 2009 so as to provide the provisions regarding the liability of partners to pay tax in the case of liquidation of LLP. It provides that where any tax due and cannot be recovered from- 1. LLP in respect of any income of any previous year, or 2. Any other person in respect of any income of any previous year during which such other person was an LLP. In such case, every person who was a partner of the LLP at any time during the relevant previous year, shall be jointly and severally liable for the payment of such tax unless he proves that the non-recovery cannot be attributed to any gross neglect, misfeasance or breach of duty on his part in relation to the affairs of the LLP. Section 167C supersedes the Limited Liability Partnership Act, 2008.
Although this Section appears to be in conflict with the scheme of the Limited Liability Partnership Act, 2008, which does not make the partners personally liable for the liabilities of the LLP, it seems to be in line with existing provisions of Section 179 of the Income-tax Act, which cast a similar liability on the Directors of a private company in liquidation.
Taxation scheme for LLP has been prescribed also for the partnership firm, all provision of Income Tax Act for the tax implication on conversion of Private company into LLP. By the way, this write up has clearly mentioned that there is no TDS deduction is necessary from the LLP which making LLP payment of interest and remuneration into LLP partners which are considered as one of the important themes of this paper, which gave a clear cut about the taxation of partners of LLP’s
 Section 2(23) Income Tax Act 1961