Tax on payment to retiring partner

This query is : Resolved

GIRISH SHARMA (Querist)
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08 October 2011 Dear Expert,

Pls advise on the below:-
A partner retires from a Firm. As per Books his Capital A/C on that date stands at Rs. 2 Lakhs.

1) Can his account be settled for Rs. 1 Lakh ? Tax implication in the hands of partner and the firm ?

2) Tax implication in the hands of partner and firm if account settled for Rs. 3 Lakhs ?

Kindly advise. Many thanks in advance.

Regards
G Sharma

CA.E.Deepan Chakravarthy

CA.E.Deepan Chakravarthy (Expert)
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08 October 2011 According to me, no capital gain arises. let see what other expert says.

Aashok Kumar Sharma

Aashok Kumar Sharma (Expert)
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26 July 2025 Dear User,

You're asking about the **tax implications of payment to a retiring partner**, where the amount settled is **either more or less than the capital account balance** recorded in the firm's books.

Let's address both scenarios in detail:

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## 📌 Background: Retirement of a Partner

When a partner retires:

* The firm usually **settles his capital account**, which includes capital, accumulated profits, reserves, revaluation gains/losses, etc.
* The amount paid can be **more or less than the book value**, depending on **goodwill, revaluation**, or mutual agreement.

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## ✅ Case 1: Account Settled for **Less** than Book Capital (Rs. 1 Lakh vs. Rs. 2 Lakhs)

### 🧾 In the Hands of the Retiring Partner:

* **Loss of ₹1 lakh** is not eligible for any tax deduction.
* No tax is payable because he **receives less** than his capital balance.
* Not treated as capital gain or income.

### 🧾 In the Hands of the Firm:

* **Benefit of paying less** than capital balance is not taxable income to the firm.
* It is simply a **capital adjustment**.

📌 **Conclusion**: **No tax implication** for either the firm or the partner.

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## ✅ Case 2: Account Settled for **More** than Book Capital (Rs. 3 Lakhs vs. Rs. 2 Lakhs)

Now the firm is paying ₹1 lakh more than the capital account balance.

### 🧾 In the Hands of the Retiring Partner:

* The **excess ₹1 lakh** could be considered:

* A **capital gain**, if it's over and above his capital balance and goodwill/share of assets, or
* A **non-taxable capital receipt**, if it represents **share in goodwill or revaluation** and the firm continues.

⚠️ However, **Supreme Court (Sackett v. CIT)** and other judgments have generally held that:

> Amount received by a partner on retirement, including goodwill and revaluation share, is **not taxable as capital gain**, as it is **a capital receipt** (unless it involves transfer of specific assets).

✅ **So, in most cases**, this **extra payment is not taxed** in the hands of the retiring partner.

### 🧾 In the Hands of the Firm:

* The **excess amount paid** is a capital outflow, **not deductible** as an expense.
* No tax benefit or liability.

📌 **Note**: If specific assets are transferred to the partner on retirement (like land, building, etc.), then **capital gains tax** under **Section 45(4)** may apply (discussed below).

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## 🔍 Special Caution: **Section 45(4)** – Capital Gains on Reconstitution

**Finance Act 2021** introduced **Section 45(4)** and **9B**, applicable when:

* A **partner retires**, and
* Receives **money or capital assets**.

Now, the **firm may be liable to capital gains tax** if the amount paid **exceeds the partner's capital balance** (including share of reserves and revaluation gains).

So if you’re paying ₹3 lakhs for a ₹2 lakh capital account, the **firm may have to pay capital gains tax** under **Section 45(4**, depending on:

* Whether this excess relates to revalued assets or goodwill.
* How the capital account was structured.

👉 This provision is **complex** and may apply if there’s **reconstitution** (change in partners).

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## ✅ Summary Table:

| Case | Retiring Partner | Firm |
| --------------------------------- | ----------------- | ----------------------------------------------- |
| Paid ₹1 lakh (less than ₹2 lakh) | No tax | No tax |
| Paid ₹3 lakhs (more than ₹2 lakh) | Normally no tax\* | May trigger capital gains under Section 45(4)\* |

> \* If specific assets or revaluation/goodwill are involved, consult a tax professional to evaluate 45(4) and 9B implications.

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## ✅ Recommendations:

1. **Document the basis** of payment — goodwill, revaluation, mutual agreement.
2. **Avoid transferring specific capital assets** directly to the retiring partner to escape Section 45(4).
3. Consult a **CA or tax advisor** to calculate **capital gain under Section 45(4)** if applicable.

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Would you like a **sample retirement deed clause** or **capital gains calculation sheet** for such a scenario?

Let me know — I’d be glad to help.

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