Determination of the net income or loss of a partnership and partnership 'salaries'

Is a partnership 'salary' paid to a person, as a partner carrying on business in partnership, an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the purposes of determining the net income or partnership loss of the partnership under section 90 of the Income Tax Assessment Act 1936 (ITAA 1936)?

No. A partnership 'salary' is not an allowable deduction to the partnership under section 8-1 of the ITAA 1997 for the purposes of determining the net income or partnership loss of a partnership under section 90 of the ITAA 1936. The payment of a partnership 'salary' cannot result in or increase a partnership loss.

Two partners are carrying on a business in partnership for income tax purposes.

There is a partnership agreement in place. The partnership agreement allows the partners to draw a salary.

Prior to the end of the income year the partners orally agreed that one of the partners be paid a salary for performing various duties in relation to the partnership business. The partner drew the 'salary' against the partnership business in accordance with the oral agreement.

Division 5 of Part III of the ITAA 1936 contains the assessing provisions in respect of partnership income. The general structure is that the net income or partnership loss of the partnership is determined by calculating the assessable income less all allowable deductions of the partnership as if it were a taxpayer who was a resident (section 90 of the ITAA 1936).

After the partnership net income or partnership loss has been determined for the particular income year, each of the partners returns their share of the net income or partnership loss either as assessable income or an allowable deduction (section 92 of the ITAA 1936).

Therefore, in ascertaining the taxation position of each of the partners in the partnership, the net income or partnership loss of the partnership must first be calculated under section 90 of the ITAA 1936. This includes determining the allowable deductions of the partnership under section 8-1 of the ITAA 1997.

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of producing assessable income. However, losses and outgoings are not allowable deductions under subsection 8-1(2) of the ITAA 1997 to the extent to which they are of a capital, private or domestic nature, or relate to the production of exempt income.

A partnership 'salary' occurs where the partners agree that 'salaries' may be drawn by the partners against the partnership business. A partnership 'salary' is not truly a salary as ordinarily understood. This is because a partnership is not a legal entity with its own personality and existence separate and distinct from the partners ( Rose v. Federal Commissioner of Taxation (1951) 84 CLR 118; (1951) 5 AITR 197; (1951) 9 ATD 334). Consequently, a partner cannot be an employee and a partner at the same time ( Stubbs v. Lakos (1994) 56 IR 110 per Linkenbagh J).

Therefore, the courts characterise partnership 'salary' agreements as not creating the relation of employer and employee, but rather, as an agreement to vary the sharing of partnership profits between the partners (Ellis v. Joseph Ellis & Co. [1905] 1 KB 324 at 328 and 329 ( Ellis' Case )).

The effect of an agreement to pay a partnership 'salary' is that the partner receives an additional part of the profits of the partnership before they fall to be divided between the partners in the appropriate proportions. However, the 'salary' is still regarded as constituting part of the profits of the partnership ( Watson v. Haggitt [1928] AC 127; MacKinlay v. Arthur Young & Co [1990] 2 AC 239).

In other words, the 'salary' payments received by the partner during the year, before partnership accounts are taken and the partnership profit (or loss) ascertained, are merely advances or drawings.

Therefore, as the 'salary' payment is an advance or drawing it cannot be characterised as a cost of the business ( Case S75 85 ATC 544; (1985) 28 CTBR(NS) Case 81 and Scott v. Federal Commissioner of Taxation [2002] AATA 778; 2002 ATC 2158; (2002) 50 ATR 1235). Therefore the 'salary' payment does not constitute an allowable deduction to the partnership under section 8-1 of the ITAA 1997 that is taken into account in calculating the net income or partnership loss of the partnership under section 90 of the ITAA 1936.