For families with ancestral property, investments or a family business, a Hindu Undivided Family (HUF) can offer a separate pool of income and a separate tax return, making it useful for tax planning. But for salaried taxpayers looking to move a part of their salary into an HUF to reduce tax outgo, the structure has limits.
An HUF is treated as a separate taxable person under the Income Tax Act. It has its own PAN, bank account, books of accounts and income-tax return. Income that genuinely belongs to the HUF such as rent from HUF-owned property, business income, interest or investment income is taxed in the HUF’s hands rather than in the hands of its individual members.
Since the HUF is taxed separately, it can be a tax-saving tool as the income is split and may be taxed at lower slab rates for the assets that actually belong to the HUF, said Aarjav Jain, executive director of Dinesh Aarjav & Associates, a chartered accountancy firm.
“One important planning advantage is that distributing genuine income between the individual and the HUF may help keep each taxpayer's total income below the surcharge thresholds. Say an individual’s income is ₹95 lakh and the HUF’s is ₹25 lakh. Instead of one person being taxed on ₹1.2 crore, which will attract a higher surcharge, the income is divided between two separate taxable persons. This may reduce the family's overall tax liability where the arrangement reflects genuine ownership and income,” Jain said.
However, this does not mean that individual members of the family can make investments through the HUF to lower tax on the corresponding income. The most important factor that determines that taxability remains in the HUF’s hands is how it is funded.
Right way to fund HUF
An HUF should be funded with money or assets that legitimately belong to the HUF. Ancestral property is one such source. If a property that earns rent is being passed down, it can be transferred to the HUF so that the rental income is taxed in the HUF’s hands. The same applies if the HUF sells the property and earns capital gains.
Inheritance can also be used to start an HUF. Vijaykumar Puri, partner at VPRP & Co LLP, a CA firm in Mumbai, said inherited money or assets can be put into an HUF and invested for the family’s long-term wealth.
“If you are getting an inheritance of, say, ₹10 lakh or ₹20 lakh, it can be put into the HUF and start investing from there,” he said.
But once the money goes into the HUF, it becomes family money. It cannot be treated as the individual’s personal money later, Puri said. This is an important point to keep in mind before putting a large amount into an HUF.
Clubbing provisions apply if an individual family member gifts or transfers property or funds to their HUF for little or no financial return. Any income such as rent or interest generated from such assets is added to and taxed as the individual's personal income.
A gift from someone who is not a member of the HUF is another way to fund it, said CA Sambhav Daga.
“Gifts from members would be clubbed in the karta's hands and taxed as per his slab rates, whereas gifts from non-members belong to the HUF and any income arising from them would be taxed with the HUF,” he explained. A karta is the manager of an HUF.
It should be noted that gifts of over ₹50,000 in a year from non-relatives are taxed at slab rates.
“For the first few years, if the HUF takes ₹4 lakh in the form of gifts from non-relatives, it will be taxable but will have no tax outgo as it’s below the exemption limit,” Daga said.
Another option is lending money to the HUF. A member, and even a non-member, can give a loan to the HUF. However, experts pointed out that it should be a genuine loan and the HUF must repay it. Daga said clubbing provisions do not apply when a member has lent money to the HUF.
The loan should be properly documented with a loan agreement, and the lender must charge interest, Puri said.
“The interest should be recorded in the books of both the individual and the HUF,” he said.
Once it has funds, the HUF can invest in assets such as shares, mutual funds or property and even run a business under its name.
Problems in direct funding
Experts say for many taxpayers, the attraction to register an HUF is so that they can transfer part of their salary or business income to an HUF, invest that money and pay tax on the income in the HUF's hands.
However, this arrangement attracts clubbing provisions, and such income must be declared in the tax returns of the HUF member who transfers the funds.
The same applies to investments. If a person transfers their shares or other investments to an HUF without adequate consideration, the income from those assets can continue to be taxed in the person’s hands under the clubbing provisions, said Jain.
Puri said many taxpayers treat the HUF as another personal bank account where they transfer the money freely.
“Once money is put into HUF, it’s not your money anymore,” he said.
The money belongs to the HUF and its members and coparceners—those who have a right to ancestral property by birth—have rights to it. Moving money in and out of the HUF as if it were a personal account can create problems later.
In practice, however, Puri said many taxpayers transfer money to an HUF and do not report the income arising from those funds in their tax returns despite the clubbing provisions. This may not immediately invite action because smaller cases often escape scrutiny.
"The detection risk is low, so people continue doing it," he said.
The problem surfaces when the HUF gets dissolved, usually when the karta dies or the family grows and the coparceners ask for partition to manage their wealth separately. Puri said before issuing a no-objection certificate for the partition, the tax department examines the HUF's tax returns.
If income that should have been clubbed with an individual member's income was instead reported in the HUF's return, it can come under scrutiny at that stage.
Tax experts also caution against viewing an HUF as a simple tax-saving hack because transferring assets to it changes their ownership. Every coparcener, which includes daughters, has an equal legal interest in HUF assets.
Any future decision to sell, partition or otherwise deal with HUF assets must involve every coparcener’s legal consent. Hence, a karta or member cannot treat a property or investment contributed to the HUF as their personal asset.
For this reason, an HUF works best where there is genuine family wealth to manage over generations, such as ancestral property, inherited assets or a family business. In such cases, it can serve as a succession planning tool while also being taxed as a separate entity.
For the same reason, tax experts say an HUF is of limited use for most salaried taxpayers as without large inheritance or a family business, there are few legitimate ways to build an HUF corpus and the change in the ownership of assets can make succession and partition complex.