Home / Money / Personal-finance /  Hindu Undivided Family: easy to make, but difficult to break

It is often said that tax is a fine for doing well. Cliched it may sound, but most taxpayers go to great lengths to save on taxes. This may be through investments made just to save taxes, irrespective of whether the product helps meet goals or not, or putting money in a scheme just because everyone else is. Some choose to create a Hindu Undivided Family (HUF).

In a country like India, where familial bonds are usually strong, this seems like a good idea. But is an HUF really helpful, and does it serve the purpose, especially in the long run? Here’s a look at some rules regarding HUFs, and pros and cons of the arrangement.

What works...

An HUF is a separate entity that can be created by members of a family, wherein the members are lineal ascendants or descendants. Hindus, Buddhists, Jains and Sikhs can open HUFs.

A single person cannot create an HUF. Usually the senior-most member of the family is considered the karta, the person who manages the affairs of the HUF.

Once a person gets married, an HUF is automatically created. But to be recorded by tax authorities, it needs to have an income-generating asset, which can only come as a gift from a relative or through a Will for all members of the HUF. Once it has such an asset, the HUF needs to be registered in a particular name and other formalities such as opening a bank account and acquiring a Permanent Account Number (PAN) have to be done.

“It (HUF) may work for people who have high income or multiple sources of income," says Gautam Nayak, a Mumbai-based chartered accountant. The reason why many families create an HUF is because it gets a separate PAN and is taxed separately. So, even if the members have individual incomes, those are not clubbed with the income of the HUF.

The way individuals get tax deductions under various sections of the Income-tax Act, 1961, HUFs, too, get tax benefits. So, any investment made or insurance paid by the HUF is deducted from its income for taxation purpose. “An HUF is used to build assets as members cannot draw money out of it," said B. Srinivasan, a Bengaluru-based financial planner.

However, funding an HUF is tricky. Capital can be brought in only through gift or inheritance subject to gift tax laws, which say that any amount above 50,000 from non-family members is subject to tax. But there are instances where it works, for example, an ancestral property that yields rental income. Under normal circumstances, the rent will be attached to a person’s income and will be taxed according to that individual’s tax slab. However, if it is transferred to an HUF, the income will be that of the HUF’s and will be taxed separately. Let’s take an example. Say, person A earns 9 lakh per year and has an ancestral property, which yields 3 lakh as annual rent. If A got the property from his father, while calculating his tax liability, both incomes will be clubbed and taxed in his hands. Assuming that A has no investments and not considering education cess and surcharge, he will be subject to a tax of 1.85 lakh (30% slab for assessment year 2015-16). If the property is transferred to an HUF of which A is, say, the karta, then under the same assumptions, A will pay 1.05 lakh as individual tax and the HUF will pay 5,000 as tax. So, in all there will be a tax saving of 75,000. The rent becomes tax-free in the hands of the karta, which is A here, and for the other members as well.

“There are ways in which it (HUF) can be used properly for tax planning," said Nayak.

Apart from this, returns on investments made using the HUF’s income will be considered that of the HUF and will be taxed accordingly after considering tax-saving investments. An HUF can also provide loans to members and coparceners of the HUF for various purposes. It also comes in handy if a person decides to start a business in the name of an HUF, which has his children as members, then everyone has an equal claim on the business. “Salaries can be paid to members if they are managing the business and effectively contributing to the functioning of the business," said Srinivasan.

These are some of the benefits that make HUF attractive.

...what doesn’t

Though creating and registering an HUF is fairly easy, complications may arise later. “You open a Pandora’s box when you create an HUF," said Surya Bhatia, managing partner, Asset Managers. The first problem is that once a property is assigned to an HUF, all coparceners have equal right to it. So, it cannot be transferred or sold without the consent of all coparceners, and even the karta cannot transfer it to anyone without everyone’s consent. “Partition of real estate belonging to an HUF can be a nightmare, and more often than not, it leads to disputes and court cases," said Bhatia.

Also, an HUF cannot be broken into parts; all members have to agree to dissolve an HUF.

If an HUF has only a few members, things may run smoothly. Problems mostly appear when the number of coparceners increases. Since all lineal descendants are part of an HUF, every child, whether boy or girl, who gets added to the family, becomes a part of the HUF. “One cannot stop the ownership. It is assigned by birth," said Bhatia.

Apart from HUFs becoming too large, the goal for which it was created has to be clear. “If the purpose is only tax saving, it may work only for the initial years," said Srinivasan. As income and number of members grow, complications, too, increase. If the income tax authorities feel that the HUF has been created to launder money, it may choose to take suitable action against it.

At the root of many problems is poor understanding of the laws that govern HUFs. These laws are not codified and are read along with the Hindu Succession Act and the Income-tax Act. “Most of the younger generation does not understand these laws, especially because laws around HUFs are getting complicated," said Nayak adding that while advising clients, he points out the disadvantages and makes them understand that their children may not understand the arrangement. There are ambiguities even at the concept level, said Bhatia.

HUFs are an Indian phenomenon; some family members move abroad either to study or work and the computation of income may be difficult as many countries do not recognize HUF. “The computation of income in such cases is still a grey area," said Nayak.

Taxation of assets can also be an issue as personal funds put into an HUF will actually be clubbed with the coparcener’s individual income, which may not work if the original purpose of starting the HUF was tax-saving.

Mint Money take

In the past, India has had harsh income tax rates. In 1973-74, the highest tax rate was 97.75%. It was only in 1997-98 that the tax slabs were brought down to the current levels, but that too gradually. Back when taxes could take away a large chunk of the money over a certain threshold, forming HUFs made sense as doing so helped saving more on taxes.

Also, while joint families were more prevalent then, one sees more nuclear families now. Divorce rate, too, has increased. This adds to complications as once someone becomes a coparcener in an HUF, the person cannot be moved out.

Though some chartered accountants and financial planners believe that if used properly, HUFs can still be a useful tool, but it seems that the cons outweigh the pros.

“There are small benefits, but in the long run, one has to take a judicious call," said Nayak. And if simple tax planning is the goal, you may be better off without an HUF.

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