ITR filing alert: How payments to family members can be tax deductible for businesses

In a recent tax assessment, a business proprietor named Rajesh was hit with an additional tax demand of Rs 1.5 lakh after the assessing officer (AO) disallowed the Rs 6 lakh annual salary he had paid to his son. According to a post by tax advisory platform Tax Buddy on X (formerly Twitter), the AO argued that the transaction fell under Section 40A(2)(b) of the Income Tax Act, which governs payments made to “specified persons,” including relatives.

What the law says

Section 40A(2) empowers tax officers to disallow expenses if payments to specified persons appear excessive or unreasonable compared with the fair market value (FMV) of the goods or services, the legitimate needs of the business, or the benefit derived. The section does not automatically ban payments to relatives—it only seeks to prevent misuse through inflated expenses.

“Specified persons” cover a wide range, including relatives and individuals with a substantial interest in a business. Substantial interest generally means owning at least 20% voting power in a company or being entitled to at least 20% of the profits in a firm, association, or proprietorship.

Rajesh’s case

Rajesh’s son was engaged in plant operations and client management, responsibilities that were crucial for the business. In his Income Tax Return (ITR), Rajesh submitted extensive documentation to establish the genuineness of the role: duty rosters, production logs, client communications, meeting records, and proof of qualifications. Monthly reviews were also filed to demonstrate deliverables.

To show that the salary was reasonable, Rajesh benchmarked the compensation. Similar roles in the region offered between ₹55,000 and ₹70,000 per month. Within his own firm, a senior non-relative employee was paid ₹58,000 monthly. The son’s annual package of ₹6 lakh clearly fell within these benchmarks.

On the compliance front, Rajesh had deducted tax at source (TDS), and Form 26AS reflected the payment. His son declared the full salary in his own tax return. Rajesh also highlighted that the same salary had been accepted without objection in the previous year, reinforcing the consistency of the arrangement.

Legal precedent

Tax professionals point out that the courts have repeatedly emphasized the importance of FMV over relationships in such cases. In ACIT v. Amar Plastics (ITAT Mumbai, 2016), the tribunal ruled against disallowance because the AO failed to demonstrate that payments to relatives exceeded FMV. The decision clarified that family ties alone cannot justify a tax adjustment.

Where disallowance is justified

Despite Rajesh’s defence, experts caution that disallowance can legitimately occur when:

No actual services are rendered.

Roles are duplicated or payments are circular.

Compensation is clearly higher than market benchmarks.

No records, evidence, or tax compliance is maintained.

Lessons for taxpayers

The case highlights an important takeaway: paying salaries to relatives is not prohibited, but it must be defensible. Businesses should paper roles carefully, preserve records such as emails and meeting notes, maintain FMV evidence through salary surveys or comparable quotes, and ensure TDS deduction with consistency in returns.

Done correctly, family members on the payroll can stand up to tax scrutiny and qualify as legitimate business expenses.