Running a Family Business with Loans or Gifts? Know the Tax Rules

The concept of Hindu Undivided Families (HUFs) has been around for centuries, providing a viable option for families to manage their business and financial affairs. However, when it comes to funding a HUF business, one must be aware of the tax implications involved.

Can Money Be Lent to an HUF and the Same Money Can Be Invested?

The answer is yes, but with certain conditions. An HUF can accept loans from members or outsiders, which is considered a genuine transaction as long as it is properly documented. The loan amount, repayment terms, and interest payable must be clearly stated.

However, if the borrowed funds are used to invest in other assets such as shares, mutual funds, or fixed deposits, any income earned from these investments - such as interest, dividends, or capital gains - will be taxable in the hands of the HUF. The original loan continues to be shown as a liability on the HUF's books.

Can an HUF Start a Business Using Gifts or Loans?

Yes, an HUF can start a business using gifts or loans. However, it is essential to understand the tax implications involved. If the business is funded through gifts from members or third parties, the ₹50,000 threshold under Section 56(2)(x) of the Income Tax Act applies.

Since the HUF has no "relatives" under the gift tax definition, even gifts from members may be taxable if the value exceeds ₹50,000 in a year. On the other hand, loans from members or outsiders are permissible and preferable, as long as they are properly documented.

Clubbing Provisions

If a member - including the Karta or any coparcener - contributes personal funds or assets to start or run the HUF business, clubbing provisions under Section 64(2) of the Income Tax Act come into play. This means that any income generated from such funds may be taxed in the hands of the member, not the HUF.

This clubbing continues even if the funds are converted into another form or reinvested. Therefore, it is crucial to use loans instead of gifts to avoid income being clubbed back to the contributor.

Best Practice: Use Loans, Not Gifts

Giving these legal and tax implications in mind, funding a business through properly structured loans is generally more tax-efficient and compliant than using gifts or personal contributions from members. Documentation and intention must be clear to avoid income being clubbed back to the contributor.

According to CA Vijaykumar Puri, partner at VPRP & Co LLP, Chartered Accountants, "If you have any personal finance query, write to us at mintmoney@livemint.com to get it answered by experts."