Principles for Calculating Business and Professional Income

Every rupee of profit a shopkeeper, freelancer, or company earns does not automatically become taxable business income the moment it lands in the bank account. Tax law asks a set of specific questions first: was this activity actually a business, was it carried on during the relevant year, and who really controls it? Once income clears that test, a second, equally strict set of rules decides which expenses and losses can be knocked off before arriving at the final taxable figure. Understanding these general principles is the foundation on which the entire chapter on business and professional income rests, and it is where most exam questions and real-world tax disputes actually begin.

The legal framework you are working with 🔗

Income from business or profession has traditionally been governed by Section 28 of the Income Tax Act, 1961, the charging provision, read together with Section 29, which lays down how that income is to be computed. Worth noting for anyone studying this topic right now: the 1961 Act has been replaced by the Income Tax Act, 2025, which came into force on 1 April 2026. The charging rule for business income now sits in Section 26 of the new law, and the computation mechanism sits in Section 27, which directs that profits be worked out as per a fresh set of sections running from 28 to 60. The substance of these rules has not changed, only the numbering and structure have been tidied up. So while your textbook may still refer to “Section 28” and “Section 29,” treat these as the underlying principles rather than fixed numbers, since the same logic now lives in renumbered sections of the current law.

When does business income become taxable? 🔗

Before any computation begins, a few threshold conditions must be satisfied. These decide whether an item of income falls under this head at all.

The business must have existed at some point during the year 🔗

The law only requires that the business or profession was carried on at any time during the previous year, not that it ran continuously from the first day to the last. If someone starts a consultancy in October and shuts it by January, the income earned in those months is still taxable as business income for that year. Equally, if a business stops mid-year, income already earned up to that point remains chargeable.

Who runs the business matters less than who owns it 🔗

Tax law does not care whether the proprietor personally manages daily operations or delegates everything to a manager, agent, or employee. What matters is who has the right to carry on the business and who is entitled to its profits. Ownership for this purpose is treated as beneficial ownership rather than mere legal title, so income is taxed in the hands of the person who actually benefits from it, even if someone else’s name appears on the paperwork.

Legality of the business is irrelevant 🔗

A business does not need to be lawful for its profits to attract tax. Income from an illegal trade, such as smuggling or an unlicensed operation, is chargeable exactly like income from a legitimate one, because the tax law taxes the economic fact of profit, not the character of the activity that produced it. This is confirmed in standard commerce course material on this head of income, which notes there is no distinction between legal and illegal business for chargeability purposes. What the law does refuse, separately, is a deduction for any fine, penalty, or expense that amounts to an offence, but that is a computation-stage rule, not a chargeability one.

All businesses of one person are pooled together 🔗

If an assessee runs more than one business, say a retail shop and a small manufacturing unit, the profits and losses of both are combined into a single figure for the purpose of computing tax, except for speculative business, which the law keeps ring-fenced and taxed separately from other business activity.

General principles for computing the income 🔗

Once income is confirmed as taxable under this head, the next step is arriving at the net figure by deducting eligible expenses. A handful of principles govern every deduction claimed.

Timing: the expense must belong to the year 🔗

An expense can only be deducted in the previous year in which it was actually incurred, based on the method of accounting the assessee regularly follows, whether cash or mercantile.

Purpose: it must be for the business, and nothing else 🔗

Every deductible expense has to be incurred wholly and exclusively for running the business. Personal expenses routed through the business books, however creatively, do not qualify.

Pre-commencement and discontinued-business expenses are excluded 🔗

Costs incurred before a business is actually set up are not treated as business expenditure for this head, since the business did not exist yet in the eyes of the law. Similarly, once a business has been permanently discontinued, no further expenses in relation to it can be claimed under this head.

Deductions are cumulative, and unnamed items can still qualify 🔗

The specific deductions listed in the Act are not a closed, either-or menu; an assessee can claim every applicable one together. Courts have also allowed items of expenditure that are not expressly named in any specific section, provided they follow ordinary commercial principles and are genuinely incidental to the business. This is what gives the computation head its flexibility, since no list of expenses in a decades-old statute could anticipate every genuine business cost that shows up in practice.

Trading losses: when a loss becomes deductible 🔗

A business loss is not automatically deductible just because money went out of the business. Certain conditions have to be met before a loss earns the same treatment as a regular expense.

Losses commonly recognised as incidental and therefore deductible include stock destroyed by fire or natural calamity, goods lost in transit, forfeiture of a security deposit linked to a business contract, losses from foreign exchange fluctuation on revenue transactions, and non-recovery of advances given for business purposes. Loss due to embezzlement by an employee also falls in this category, and is allowed as a deduction in the year the embezzlement is actually discovered rather than the year it happened, since that is when the loss becomes a known, real event. This principle has been tested repeatedly in Indian courts, including cases involving banks that lost funds to staff fraud, and the courts have consistently treated it as a normal hazard of running that kind of business.

Losses that cannot be deducted 🔗

The flip side of this framework is a set of losses the law refuses to treat as business deductions, no matter how genuinely they hurt the owner’s pocket.

The distinction between an employee’s embezzlement and an owner’s own misappropriation is a good illustration of how narrowly the “incidental to business” test is applied. When an employee siphons off funds, the business itself is the victim of an external risk it had to guard against, which is why the loss is allowed. When the proprietor diverts their own funds, there is no external event at all, just money leaving the business for a purpose that was never a business purpose, so no deduction follows.

Why this distinction actually matters 🔗

These principles are not academic hair-splitting. A retailer who successfully claims a genuine stock-loss from a warehouse fire reduces their taxable profit and their tax bill in one shot. The same retailer trying to claim a loss on the sale of their delivery van, or a projected fall in unsold inventory value, would find both claims rejected under these same rules, one for being a capital loss and the other for being notional. Getting this classification right at the return-filing stage saves disputes with the tax department later, since misclassified losses are exactly the kind of claim that draws scrutiny during assessment.

What do you think? If a shopkeeper discovers a long-standing cash shortfall caused by a trusted employee only years after it began, should the deduction be allowed in the year the theft happened or the year it was finally discovered? And does taxing profits from an admittedly illegal business feel consistent with the law’s own refusal to allow deductions for fines and penalties, or does it expose a contradiction in how the tax system treats lawbreaking?

References

1. https://www.incometaxindia.gov.in/w/section-28-54
2. https://taxguru.in/income-tax/income-business-income-tax-act-2025-sections-itr-forms-compliance-ay-2026-27.html
3. https://www.kanakkupillai.com/learn/profit-and-gains-of-business-or-profession-under-income-tax-act/
4. https://egyankosh.ac.in/bitstream/123456789/66980/3/Unit-9.pdf
5. https://www.taxmann.com/post/blog/guide-to-profits-and-gains-of-business-or-profession-under-income-tax-act/
6. https://www.indiafilings.com/learn/business-loss-setoff
7. https://taxguru.in/income-tax/claim-deduction-loss-due-dacoity-theft-embezzlement-business-loss.html