Business Expenses Paid to Relatives May be Disallowed

As a freelancer, when you take the first few steps towards financial independence and setting up your own work – it is common for the family to help you get started. This help may be in the form of giving you a place on rent, providing a service and charging less or more or not at all or any other form of assistance. Let’s find out how these expenses are treated for Income Tax. The Income Tax Department allows you to deduct reasonable and justifiable expenses paid from your Income.

However, when the payment for some expenses is made to relatives or persons who have a substantial interest in your business or profession, such expenses may not be allowed to be deducted if they seem excessive or unreasonable.

Section 40A(2) of the Income-Tax Act

As per this Section if you have incurred any expenditure where payment has been or is to be made to any specified persons, and the tax officer is of the opinion that such expenditure is excessive or unreasonable in comparison to the goods, services, facilities received or exceeds the prudential business requirements, the amount of expenditure considered to be excessive or unreasonable shall not be allowed as a deduction.

So, if you have made payment of Rs. 1 lakh to a specified person for the expenses incurred/service received and the tax officer basis the evidence thinks that payment to the said person is unreasonable to the extent of Rs. 30,000, then in that case only Rs. 70,000 will be allowed as a deduction out of Rs. 1 lakh payments made to the specified person. 

Which Specified Persons are Covered under Section 40A(2)?

A relative has been defined in section 2(41) of the Income Tax Act – A relative can be spouse, brother or sister or any lineal ascendant or descendant.

A person with a substantial interest means a person who has at least 20% of the equity or in case of other than corporate such person is entitled to 20% profits. 

Any unreasonable/excessive payments made by taxpayer to specified person as mentioned above shall be disallowed while computing the taxable income.

Illustration

Suppose Rohit, a freelance designer takes premises which are owned by his married sister for carrying on freelancing work.

Rent is an expense which is allowed to be deducted from the freelancing income of Rohit. Since the premises are owned by Rohit’s sister he decides to divert some of his income to his sister by paying her higher than the reasonable market rent for such premises. Rohit wants to claim the rent payment as a business expense and reduce his overall income –the recipient, his sister, who has no other income, ends up paying only a 10% tax on the rental income. The Assessing Officer may not allow a rent payment which is not in line with the fair market value of the premises and where the recipient is a relative. Therefore, expenses for which payment has been made to a relative or a person with substantial interest shall be disallowed when –

• These expenses are incurred for goods, services or facilities.
• Payment has been made to a relative or a person with substantial interest as defined above.
• Such expenses are excessive or unreasonable. They are not in line with fair market value. Or they may not be a legitimate need of your business & profession. Or when you have incurred these expenses and they result in a benefit to you. Do note that an Assessing Officer can disallow expenses when they are not in sync with the needs of your business, even though these may have been paid as per the market value.

Here are some examples of transactions which may be under a scanner from the Income Tax:–

All of the above expenses can be disallowed if they appear excessive/unreasonable to the tax officer.

Do note that the tax officer may disallow the entire expense or a portion which is considered excessive may be disallowed. Be careful while setting up your freelancing work and arranging for facilities and goods so that these expenses are allowed to be deducted from your freelancing income and they help you save tax. REACH OUT TO US  if you have any questions!  

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