HUF's Indian Income & IRS
The Hindu Undivided Family (HUF) has its roots in the ancient Hindu law like the Manu Smriti. HUF) is a legal entity embedded in tax, corporate governance and state codification of Hindu personal law in India. This dual characteristic of the HUF shaped its legal status as a unit of business and taxation. A Hindu Undivided Family (“HUF”) is a special feature of Hindu society, which today consists of a common ancestor and all of that common ancestor’s lineal descendants together with their spouses and unmarried children. HUF is purely a creature of law and cannot be created by an act of parties. A HUF is a fluctuating body, its size increases with birth of a member in the family and decreases on death of a member of the family. To form an HUF, all you have to do is get married. The HUF gets created as soon as you complete the seven (or four, whatever) circles round the holy fire and become Man and Wife. There have to be a minimum of two people to constitute a family.
The Karta is the manager of the family. Traditionally, the Karta was usually the most senior male.
HUF & Income Tax in India
Mostly joint family property can form part of a HUF. Joint family property includes: (i) “Ancestral Property” (as defined below):
(i) Property from a partition of a larger HUF,
(ii) Property or funds received as inheritance from Parents and other relatives
(iii) Property or funds received as Gift from Parents and other relatives
(iv) Property that is acquired with HUF assets by reinvesting the surplus.
A member of the HUF throwing his money or property into the common pool or family hotchpotch of HUF is not preferred thanks to clubbing Section 64(2) of the Income Tax Act, 1961, which would tax the income earned by the HUF on that money or the property in the individual member's hands only. Thus HUF would have Corpus (Capital) from ancestral property & funds received as a process of inheritance or gifts.
Residential Status as Resident: A HUF, whose management, superintendence and control are exercised wholly from within India during the financial year, would be a Resident. The mere fact of absence of Karta from India does not make the family (HUF) a non-resident.
Separate 2 Taxing entities: HUF funds and the affairs of the HUF are completely differs from one’s (Karta’s) own affairs. One can do his/her business/job freely while continuing as the member of HUF. In fact, HUF income and individual income are different and to be taxed differently. A HUF is treated as a taxpayer separate from the family or the Karta and is eligible for its own tax exemption, separate from the Karta’s individual income tax exemption for Indian income tax purposes.
Tax Treatment of HUF Income in USA
For determining the U.S. tax consequences of a HUF, one has to understand whether HUF will be treated as a separate entity or whether it would be compared to a grantor trust under which the person who is viewed as grantor of the property or the person who controls the property (here the Karta) would he considered the owner of the property for United States income tax purposes. Considering HUF’s structure the IRS will treat a HUF as a separate entity since the Karta cannot be a donor to a HUF and the role of the Karta bears very strong resemblance to the fiduciary responsibilities of a trustee.
Most of the U.S. tax rules that cause a trust to be disregarded (Sections 673-677 and 679 of the Internal Revenue Code (TRC)) apply to the person who is the source or donor of the property to the trust and, therefore by definition, do not apply to the Karta because the Karta can never be the donor of HUF property for which the Karta is responsible. However, under IRC Section 678, if a beneficiary of a trust has the right to vest in himself or herself principal or income of a trust, he or she would be treated as the "owner" of the property for U.S. income tax purposes. However, because the Karta's decisions to make distributions of income, including to himself, must be made in the best interests of the family, it can be assumed that a substantial argument can he made that the Karta does not fall under Section 678 and therefore that the HUF should be treated as a separate entity.
It should be noted that if an Indian citizen or person of Indian origin who is a United States tax resident establishes a HUF with property that person owns in India and any coparceners are also United States tax residents, assuming the analogy of a trust applies, the donor may he continued to be viewed as owner of the HUF property under Internal Revenue Code Section 679, which makes property contributed to a foreign trust by a U.S. person with any U.S. beneficiaries subject to U.S. income tax on the property as if the donor still held the property in the donor's own name. If none of the members of the HUF are U.S. residents, then the donor may incur capital gains tax on the unrealized appreciation in the Indian property, under Internal Revenue Code Section 684, which subjects to U.S. capital gains tax transfers of appreciated property by (U.S. tax residents to foreign trusts that do not qualify as grantor trusts under Section 679.If the HUF is treated as a separate entity for U.S. income tax purposes (i.e. not a grantor trust or some other disregarded entity), then the HUF should not be liable to pay U.S. income taxes on such property, even if the Karta is a U.S. income tax resident, because the HUF would be viewed as a non-U.S. entity with non-U.S. source income. A U.S. coparcener's share of any accumulated income or gains in the HUF that are distributed upon a termination of a HUF could be subject to U.S. income tax under a complex set of rules under which the U.S. coparcener may have to pay an interest charge on the tax that the U.S. coparcener would have paid if the income or gains had been distributed currently. If the Karta has control of any bank accounts in India in connection with the management of the HUF with an aggregate balance of over $10,000, the Karta will have to file annual "FBAR" disclosure reports. If the HUF is not treated as a separate entity but as property of a U.S. donor or Karta, the Karta must include the income of the HUF in his or her income tax return if he or she is a U.S. tax resident. In this event, the taxes paid to India by the HUF should be viewed as being paid by the U.S. donor or Karta and therefore the donor or Karta should be able to claim a credit against the United States income tax for the income tax paid to India. This situation can be compared to the grantor of a grantor trust receiving a tax credit for non-U.S. taxes paid by the trust. In that case, the grantor still can receive the credit even though, from perspective of the non-U.S. jurisdiction, the trust paid the foreign taxes rather than the grantor.
The fact that the Karta controls the HUF should not cause estate tax inclusion under Section 2041 of the Code (“powers of appointment”) because the Karta does not technically have any individual power over the HUF, but must use the full HUF property in the best interests of the family.