When Shashank and Mitali got married, they did not bother much about their finances. After all, both were well qualified and had well paying jobs. In addition, Shashank also earned rental income from ancestral property. But after seeing the huge amount they paid as taxes (after investing in the usual tax saving instruments), they spoke to Shashank's former classmate, who is a practising chartered accountant. That is when they realised that they could save taxes by setting up a Hindu Undivided Family (HUF).
The HUF concept is not new in India, and is one of the best ways to save tax. Any married man from the Hindu, Jain, Sikh, or Buddhist community can form an HUF, and will act as the "Karta" or the head of this family. According to Indian law, an HUF will be considered as a separate entity from the individual for tax purposes, which benefits married couples from these communities to save a substantial amount on taxes.
HUF is a separate entity in itself and qualifies for all tax benefits under Section 80C (up to Rs 1 lakh), 80D (health insurance premium), 80G (donation), 80L (income from bank account), Section 54 (capital gains) and so on.
Tax slabs applicable to income of an HUF is similar to that of any individual taxpayer, with the basic exemption at Rs 2 lakh. First, any two family members with the karta (male member of the family) can create an HUF. For a married individual, family will mean wife / husband and children, if any.
An HUF can be used for any purpose apart from receiving salaries, which means that one can form an HUF to keep ancestral property, or to run a business. For example, if a married man has a salary of Rs 5 lakh, and gets rent on ancestral property of Rs 3 lakh, as an individual he will be paying taxes of approximately Rs 1 lakh (assuming Rs 1 lakh is invested under section 80C). However, if he shifts the property to an HUF, then he will be paying only Rs 20,000 as taxes as an individual and the HUF will be liable for no taxes (assuming that both the individual and the HUF has invested Rs 1 lakh under section 80C). This results in a tax saving of around Rs 80,000.
Let us look at a more detailed example to see how a HUF can save one's taxes.
Forming of an HUF is relatively simple, with all married men and their wives becoming an HUF automatically. There are, however, a few simple procedures to be followed, such as executing a deed on a stamp paper to transfer assets to the HUF - this can be property, cash, jewellery, etc. One will also have to get a PAN card in the name of the HUF and open a bank account. There can be multiple instances of HUF's in each family, with each married couple being part of their own HUF. There are also cases with women only HUF's, where the Karta has passed away, and left behind only female descendants - in such a case, the daughter assumes the role of the Karta.
Transferring money into an HUF is not as easy as it seems as one cannot just transfer money or assets into the HUF name, as this gets combined into a single entity under the existing law and taxed as such. The ideal way to setup a HUF is to put some of the gifts (cash, jewellery, etc) received at one's wedding into the HUF. The other way is to set up the HUF using ancestral property from a will - though in this case the will should specify that the property will go to the HUF and not the individual.
Another pitfall one should be aware of is that while transferring gifts to the HUF, there is no exemption on receiving gifts from specified relatives like in the case of an individual - the HUF is liable to pay taxes on all gifts. However, since the HUF gets tax benefits like an individual entity, gifts of up to Rs 2 lakh (limit can go up to Rs 3 lakh if the tax benefits under Section 80C are fully used) are exempt from taxation.
Assets and liabilities in the name of the HUF will belong to the HUF and this will be treated as a separate entity. For example, if a business is being run under an HUF all business expenses will be deducted from the HUF income. This includes any salary paid to family members who are part of the HUF.
Additionally, a member of an HUF has to maintain books of accounts and all paperwork for the HUF separately. Transfer of assets to HUF happens only one-way. You can create assets for the HUF, but these can be taken out only by dissolving the entity. However, financial assets, gold and cash, can easily be distributed among members.
But there are some disadvantages also by forming an HUF. For instance, if you are looking to sell a property that is in an HUF's name, it may not find many takers as everybody wants a clear property title. If there is a legal dispute around the property, then selling it can become impossible.
An HUF can be dissolved if all the members agree. A partial dissolution is not possible.