Businesses can deduct payments to family members as a business expense if they meet the criteria of Section 40A(2) of the Income Tax Act. To avoid disallowance during tax assessment, these payments must be legitimate, properly documented, and at fair market value (FMV).
Key Requirements for Tax Deductibility ⚖️
To prove that a payment to a relative is a legitimate business expense, a taxpayer must demonstrate three things:
- Genuine Service: The family member must perform a real and necessary role for the business. Taxpayers should maintain detailed records like job descriptions, duty rosters, production logs, and evidence of work performed, such as emails or meeting notes.
- Fair Market Value: The compensation must be reasonable and comparable to what would be paid to an unrelated employee for a similar job. The business can use salary surveys or compare the payment to what other non-relative employees in the company are paid to justify the amount.
- Proper Compliance: The business must adhere to all tax regulations. This includes deducting Tax Deducted at Source (TDS) and ensuring the payment is correctly reported in both the business’s and the relative’s tax returns.
Rajesh’s Case: A Practical Example
Rajesh, a business proprietor, successfully defended the ₹6 lakh annual salary he paid to his son by providing extensive documentation to the tax officer. He showed that his son’s role in plant operations and client management was crucial to the business. To prove the salary was reasonable, he benchmarked it against salaries for similar roles in the region and within his own firm, demonstrating that it was at FMV. Rajesh also maintained proper tax compliance, as he had deducted TDS and his son had declared the income.
When Disallowance Can Occur
Disallowance is likely if the tax officer finds that the payment is an attempt to evade taxes. This happens when:
- The relative provides no actual service.
- The compensation is clearly higher than market benchmarks.
- The business has no records or evidence to support the payment.
- The roles are duplicated or payments are circular.
Legal precedents, such as the ACIT v. Amar Plastics (2016) case, have established that a family relationship alone is not a valid reason for disallowing a business expense. The focus is on whether the payment is excessive or unreasonable based on business needs and FMV.