Inquisitive about how to save tax through family trusts? Let us guide you through the tax benefits of family trust in India.
We break down family trusts, their tax implications, and strategies you can adopt to improve tax efficiency by using this structure.
Family Trusts & Their Tax Implications in India: An Overview
A family trust (or private trust) is a legal structure in India where a person (settlor) transfers assets to trustees to manage for the benefit of family members (beneficiaries).
Governed by the Indian Trusts Act of 1882, they provide a way to transfer wealth across generations and ensure assets are managed according to the settlor’s wishes.
The trust deed outlines the terms of asset management, including the roles of trustees and beneficiaries.
Tax Implications
The tax treatment of family trusts in India varies based on their structure:
- Revocable Trusts: This type of trust can be altered or dissolved by the settlor. Income generated by the trust is taxed in the hands of the settlor.
- Irrevocable Trusts: It cannot be easily modified once created. Income is taxed either in the hands of the beneficiaries or the trustees, depending on whether the trust is specific (for specific beneficiaries) or discretionary (where the trustee decides distribution).
- Specific/ Non Discretionary Trust: Here the beneficiaries and their shares are specified, Beneficiaries are taxed on the income they receive.
- Discretionary Trust: Here the beneficiaries are not mentioned. Trustees are taxed on the trust’s income at the maximum marginal rate.
- Capital Gains: If the trust transfers assets, capital gains tax applies.
- Gift Tax: Assets transferred to the trust may attract gift tax, but gifts to close relatives are exempt.
Tax Benefits of Family Trusts in India
Setting up a family trust can offer several benefits. Some of the key advantages include:
- Flexibility in Income Distribution: Discretionary trusts allow trustees to optimize income distributions based on beneficiaries’ needs and tax situations, enhancing overall tax efficiency.
- Estate Planning: They facilitate the seamless transfer of assets across generations, ensuring that family wealth is preserved and managed according to the settlor’s wishes.
- Asset Protection: Assets held in irrevocable trusts are generally protected from personal liabilities, safeguarding family wealth from creditors and legal claims.
- Deductions for Charitable Trusts: Trusts established for charitable purposes can offer significant tax deductions under Sections 11 and 12 of the Income Tax Act, promoting structured and tax-efficient philanthropy.
- Management of Investments: Family trusts can hold and manage various investments in a potentially more tax-efficient manner than individuals, allowing for better financial planning.
- Accumulating Income for Future Needs: Family trusts can be used to accumulate income for minors, providing a structured approach to saving for their future needs in a tax-efficient way.
- Tax Planning for High-Income Earners: High-net-worth individuals (HNIs) often use family trusts to split their wealth among family members, optimizing tax outflows by allocating income to lower tax bracket members.
- Long-Term Capital Gains Benefits: If assets like equity shares, mutual funds, or real estate are held by a family trust, they can benefit from long-term capital gains tax exemptions or lower tax rates if applicable after a specified holding period.
- Reduced Disputes: It can help minimize conflicts over asset distribution by providing a clear management framework. They also offer tax benefits, allowing income to be taxed at lower rates, preserving wealth for beneficiaries.
How to Save Tax Through Family Trusts: 11 Top Strategies
Now that we are aware of the benefits of family trusts, let’s quickly take a look at some of the strategies that can help save taxes:
1. Use of Specific Trusts for Beneficiaries in Lower Tax Brackets
Set up a trust where income is allocated to beneficiaries who have little or no income, like minors or non-earning family members.
The income is thus taxed at these lower rates rather than at the higher rates applicable to the trust itself. The overall tax paid by the family is reduced.
2. Master Asset Transfer Timing of Appreciating Assets:
Transfer assets to the trust at a time when the value of those assets is lower (for example, during a market downturn or before the asset appreciates).
When the value of the asset increases in the future, the appreciation happens within the trust.
This helps you avoid paying higher taxes on the increased value of the asset by transferring it early when the value is lower.
However, bear in mind the capital gains tax that may come at the time of transferring the assets to trust.
3. Minimize Tax on Accumulated Income With Discretionary Trusts
Trusts can accumulate income without immediate taxation, but if income is distributed, it becomes taxable to the beneficiaries.
In discretionary trusts, trustees can hold back (accumulate) income rather than distributing it immediately.
This allows income to be taxed in the future when beneficiaries find it more favorable, thereby reducing the overall tax burden.
4. Utilize Specific Trusts for Capital Gains Efficiency
Specific trusts can be structured to manage capital gains effectively.
By allocating capital gains to beneficiaries in lower tax brackets or utilizing exemptions available under the Income Tax Act, families can reduce the tax burden associated with capital gains.
5. Use Charitable Trust Tax Exemptions
Charitable trusts in India enjoy significant tax exemptions if registered under section 12AA. This trust. However, it is not utilized for private family objectives and should have only religious or charitable obligations
By establishing a charitable trust and ensuring that at least 85% of its income is applied towards charitable purposes, families can benefit from exemptions on the remaining income.
This strategy not only helps in tax savings but also contributes to social causes.
Also, any income or donations made to charitable purposes may qualify for tax exemptions under the Income Tax Act.
6. Utilize Trusts to Avoid Gift Tax
Transfer assets to the trust as a gift. If the beneficiaries are close relatives (like children or spouse), the transfer is exempt from gift tax under Indian tax laws.
This allows tax-free transfer of wealth to family members through the trust. Make sure you check with the local tax laws when using this strategy.
7. Get Professional Help
Consult with tax professionals or legal experts from trusted firms like PKC Management Consulting to structure your trust in the most tax-efficient way.
At PKC, we offer brief tax planning by incorporating trust and we will also take care of other miscellaneous tasks relating to deed prep and filing.
8. Avoid Clubbing Provisions With Irrevocable Trusts
In India, clubbing provisions may apply where the income of a minor or spouse is clubbed with that of the parent or spouse.
By using irrevocable trusts, families can avoid these provisions and keep the trust’s income separate from personal incomes.
9. Structure Investments to Maximize Tax Efficiency
In case of discretionary trusts, several investment options are available. The trustees should utilize the funds in a way to maximize tax efficiency.
For this, the trust deed needs to be prepared in such a way that it should allow such investment.
This includes considering investment types that may offer favorable tax treatment or exemptions under Indian law.
10. Use Family Trust for Succession Planning
A family trust can smoothly transfer wealth to the next generation without going through inheritance or probate processes, which can be time-consuming and costly.
This ensures that family assets are preserved for future generations while minimizing tax implication
11. Regular Review and Adaptation
Apart from the mandatory requirement of trust deed modification, make sure to review your trust’s structure regularly with experts.
Experts can help you adapt to any changes in tax laws and family needs.
This keeps your trust up-to-date and ensures you’re taking full advantage of any new tax-saving opportunities.
Frequently Asked Questions
- What is a family trust?
A family trust is a legal arrangement where assets are held by a trustee for the benefit of family members. It can help manage wealth and minimize tax liabilities
- Are family trusts tax free in India ?
Family trusts are not tax-free in India; they are subject to taxation based on the income generated, typically at the maximum marginal rate unless specific exemptions apply for certain types of income or beneficiaries
- Is ITR filing mandatory for family and private trusts in India?
Filing an Income Tax Return (ITR) is mandatory for family and private trusts in India, as they must report their income and pay taxes accordingly, with the trustee acting as a representative assessee.
- What are specific trusts for beneficiaries?
Specific trusts allocate income and assets to designated beneficiaries, often those in lower tax brackets, which helps reduce overall tax liability.
- How can family trusts save on taxes?
Family trusts can distribute income to beneficiaries in lower tax brackets, allowing the income to be taxed at lower rates compared to the higher rates applicable to the trust itself.
- Are charitable trusts beneficial for tax savings?
Yes, charitable trusts enjoy significant tax exemptions in India. Contributions made to these trusts can reduce taxable income while supporting social causes.
