How to use HUF to reduce your tax liability
Recently, a young friend Ritu, invited me for her wedding. The conversation got to what tax planning tip could I give to Ritu and her soon to be husband, Hemant Jain, a stock broker. The bridge that unites marriage with tax planning is Hindu Undivided Family, popularly known as HUF. The taxman treats HUF as another entity, entitled to the same exemptions and deductions as any other individual taxpayer. This effectively gives the “karta”, usually the oldest male head of the family, with additional basic tax exemption of Rs. 1.8 lakh per year, an additional deduction from income along with the benefit of lower tax slabs that is 10% tax on income up to Rs. 5 lakh and 20% up to Rs. 8 lakh.
The idea of using HUF as a tool had Ritu interested but she was not sure whether Jains could form an HUF, to which I replied that though HUF sounds as if it’s for Hindus only, Jains, Sikhs and Buddhists are also permitted to form an HUF. A HUF is automatically constituted when a couple exchanges wedding vows. Besides, the other simple formalities to form an HUF may include executing a deed on a stamp paper declaring the formation of HUF when any asset/property is transferred to HUF, getting a permanent account number (PAN) and opening a bank account in the name of the HUF; for example Hemant Jain (HUF). The karta is generally entitled to operate the bank transactions, which here could be Jain. In fact, there can be multiple HUFs in one family itself; all married couples of a family may have separate HUFs with the male member being the karta.
The HUF can be formed with money received as gifts from relatives. However, there can be tax implications in case the gifts are higher than Rs. 50,000 per year. While there is no tax on gifts received from specified relatives, HUF does not enjoy this benefit as HUF is not an individual and therefore has no relatives. Nonetheless, an HUF can safely receive gifts of up to Rs. 3 lakh per year without incurring any tax liability because of the benefit of deduction of Rs. 1.2 lakh (or even higher) and basic exemption of Rs. 1.8 lakh. However, the ideal way to avoid the tax tangle is to form the HUF corpus with assets received, as part of the will or inheritance, since the same enjoys tax exemption.
An HUF can earn income from all sources except salary. It can invest the initial corpus as well as gifts received, subsequently to start a business and earn profits or earn capital gains. Ancestral property held by HUF can be let out to earn rental income. In fact, the HUF arrangement especially suits taxpayers who have income from ancestral property and expect to inherit financial assets. Such taxpayers will be able to divert the inheritance to the HUF, thus preventing taxation on such income in their hands, at their maximum marginal rate.
At that point, I thought it was appropriate to explain the benefits of forming HUF in concrete terms, by giving her an example. Assume Ritu earns a salary of Rs. 8 lakh and Hemant earns Rs. 15 lakh from his stock broking and investment business. Hemant also has an ancestral property and earns taxable income of Rs. 2.5 lakh from letting out the same. In this case, the couple’s total tax would be Rs. 4,12,515.
Now, if both Ritu and Hemant form an HUF and if the ancestral property is diverted to the HUF, rental income from such property would be assessed in the hands of the HUF. Also, if the investment business is operated in the name of the HUF, income from such business (say Rs. 6.5 lakh in our case) would also be assessed in the hands of the HUF. Moreover, the health and life insurance policies for both of them could be taken by the HUF (which may currently be taken by either/both of them in excess of the maximum allowable limit); whereby the additional deduction from income can be claimed. Accordingly, the total tax liability would be Rs. 2,30,720.
Hence, by setting up an HUF, they could save tax up to Rs. 1,81,795. However, a word of caution: HUF transactions should be thought through and planned properly to face the rigour of income-tax scrutiny given that the taxman looks at the HUF tax returns with a degree of scepticism. That said it remains a perfectly acceptable tool for tax planning.
I was happy to have added to Ritu’s list of joys to look forward to in her marriage.