A worked example
An individual has been a partner in a firm since 2005. In FY 2025-26 he exits, agreeing on a total consideration of ₹10,00,000 for his interest. Of this, ₹7,00,000 is paid to him by the firm — against a credit balance of ₹4,00,000 standing in his capital account — and the remaining ₹3,00,000 is paid to him directly by the incoming partner who takes his place. Two payments, one exit — and two completely different tax treatments.
Leg 1: Money received from the firm — the firm pays the tax
A partner's exit is a ‘reconstitution of the specified entity’ under the 2021 scheme. Where, in connection with a reconstitution, a partner receives money from the firm, Section 45(4) applies — and its most striking feature is that the resulting capital gain is charged to the firm, not the retiring partner. The provision works on a simple formula: the taxable gain is the money received from the firm minus the balance in the partner's capital account (computed without considering any revaluation of assets or self-generated goodwill).
In our example: ₹7,00,000 received minus ₹4,00,000 capital balance = ₹3,00,000, taxable as capital gains in the hands of the firm for FY 2025-26. In the retiring partner's hands, this leg is not taxable at all — the ₹4,00,000 is a return of his own capital, and the ₹3,00,000 excess stands statutorily charged to the firm.
Three compliance points make or break this leg in practice. First, the capital balance must be scrubbed: any portion arising from revaluation of assets or recognition of self-generated goodwill is excluded, which increases the firm's taxable gain. Second, the character of the firm's gain — short-term or long-term — follows Rule 8AA(5), depending on the assets to which the gain is attributable. Third, and most frequently missed: Rule 8AB allows the firm to attribute the taxed amount to its remaining capital assets and claim a corresponding deduction when those assets are eventually sold — but only if the firm files Form 5C. Firms that skip this filing effectively pay tax twice on the same economic gain.
Leg 2: Money received directly from the incoming partner — the retiring partner pays
The ₹3,00,000 paid by the incoming partner never touches the firm, and Section 45(4) does not reach it — the provision covers only what the partner receives from the firm. What has happened in substance is different in law: the outgoing partner has assigned his interest in the firm to the incoming partner for a price. A partner's interest in a firm is a capital asset, and its assignment for consideration is a transfer. The Supreme Court's classic line of decisions has long distinguished this situation — assignment for direct consideration — from a pure retirement settled through the firm's accounts.
The result: the ₹3,00,000 is taxable in the retiring partner's own hands under Section 45(1) as capital gains. Since the interest was held from 2005, the gain is long-term, taxed at 12.5% without indexation under the current Section 112 regime. The cost of acquisition needs careful handling: where the entire capital balance has already been returned by the firm and absorbed in the firm's Section 45(4) computation, claiming it again against the direct receipt invites a double-deduction objection — the defensible position is often a nil or nominal cost, supported by a clean capital-account working since inception.
Why the routing decision is really a tax-allocation decision
Look at what the split achieved. Had the entire ₹10,00,000 been routed through the firm, the whole ₹6,00,000 excess over capital would have been taxed in the firm's hands — economically borne by the continuing partners — with nothing taxable for the retiring partner. Routing ₹3,00,000 through the incoming partner instead shifted exactly that much of the burden onto the retiring partner at 12.5%. Neither route is ‘wrong’; but the choice allocates real money between the exiting partner and those who remain, and it should be a conscious commercial decision recorded in the retirement deed — not an accident of how the cheques happened to be drawn. Artificial splits invite scrutiny, so the deed should state the commercial rationale for any direct payment.
The checklist before any partner exit
Scrub the capital account for revaluation and self-generated goodwill credits; decide the payment routing consciously and record the rationale in the deed; ensure the firm computes its Section 45(4) gain correctly, characterises it under Rule 8AA(5) and files Form 5C to preserve the Rule 8AB deduction; and compute the retiring partner's own capital gains on any direct consideration, with a defensible cost position. Done in the right order — deed first, cheques after — the exit is clean; done in reverse, it is a dispute waiting for a notice.
How DSRV & Co. LLP can help: our direct tax team structures partner retirements and firm reconstitutions end-to-end — routing analysis, Section 9B/45(4) computations, Rule 8AB and Form 5C compliance, retirement deed drafting and representation in any subsequent assessment. If a partner exit or admission is on your horizon, speak to us before the deed is signed: the tax outcome is decided at the drafting table, not at the filing deadline.
