Self Managed Superannuation Fund (SMSF) – Exit strategies.
It is widely known that self-managed superannuation funds (SMSFs) are the fastest growing sector of the superannuation industry. Over the last few years, an average of 30,000 new funds have been established. Whilst the establishment of SMSFs receives much attention, little attention is paid to the other end of the SMSF life cycle – when the SMSF is no longer appropriate.
Why do clients need an exit strategy?
The importance of an exit strategy is often related to the fund’s investments. Does the fund have illiquid or indivisible assets that may impact on the ability to make benefit payments?
If one or more members dies or is unable to be a trustee, it is important to consider the attitudes and abilities of remaining members. Will the surviving members want to continue the fund? Do they have the necessary skills and interest levels? An SMSF is often a fun and interesting venture when undertaken by a husband and wife but quickly turns to a chore when left to only one.
Exit strategy alternatives:
- There are three primary alternatives as an exit strategy for an SMSF:
- Rollover to a public offer fund.
- Convert to a small APRA fund (SAF).
- Meet a condition of release.
Each alternative has its place, depending upon what the trigger event for the exit strategy is, what the fund assets are and the attitudes of any remaining members.
Rollover to a public offer fund:
Rolling over to a public offer fund is a capital gains tax (CGT) event whilst in accumulation phase. Any gains will be realised and tax will be payable. If capital losses exist, they will not be able to be carried forward. A CGT event occurs regardless of whether assets are sold down and cash is transferred to the public offer fund or whether assets are transferred in-specie (a common misunderstanding).
The range of investment options that are available in a public offer fund may also be of significance when choosing an exit strategy. It will be important to compare the existing investments in an SMSF with those available in a public offer fund. If the SMSF has assets that are not able to be accepted, how do the members feel about disposing of the assets? This may be an issue if the SMSF has real property, collectables or shares in private companies. If the SMSF has a residential apartment on the Gold Coast, the SMSF members may be perfectly comfortable in selling the property to facilitate a move to a public offer fund. If however, the property is business real property that the SMSF members are running the family business from, the sale of the property may be highly undesirable.
Another barrier to rolling over to a retail fund may be if the SMSF is paying complying pensions. Very few retail funds will currently accept account-based term allocated pensions, let alone complying lifetime or life expectancy pensions.
There may also be social security implications of rolling over pension benefits from an SMSF. For clients who are in receipt of a Centrelink income payment and have an account-based pension prior to 1 January 2015, the new deeming rules will not apply. However, if a member’s SMSF pension account is rolled over to a retail fund, the grandfathering will cease. The balance of the account-based pension will then be treated as a financial asset and deemed for the purpose of assessing Centrelink eligibility, which may result in a reduction in age pension.
Convert to a small APRA fund:
An alternative to a public offer fund is to convert the SMSF to a SAF. A SAF is an SMSF with a professional licensed trustee. The professional trustee company manages the fund for the benefit of the members and is responsible for all compliance, regulatory reporting and administration of the fund.
Nearly all of the legislative concessions that apply to SMSFs are also available in SAFs, including the ability for members to direct trustees in respect of death benefits and investments.
The conversion from an SMSF to a SAF can entirely avoid the imposition of CGT if clients retire as trustees of the fund and appoint the professional licensed trustee. The fund (the tax paying entity) continues uninterrupted and does not dispose of any assets; there is simply a change in trustee. There is no change of tax file number or Australian business number.
In addition to CGT issues, moving to a SAF may help members who wish to retain particular investments such as a unique shareholding, real property or collectables. Different SAF trustees will have their own rules in respect of allowable assets; however a SAF will be far more likely to accept a particular asset than a retail or industry fund. Provided that the investments are relatively diversified, it is common for SAFs to allow holdings of real property, private companies and collectables.
In a SAF, the investment decisions are directed by each member, the trustee does not generally make investment decisions unless the members fall outside of their elected investment strategy. Even then, the trustee will generally require the members to rectify the situation; stepping in will only be a last resort.
A SAF will also be able to continue any complying pension that may exist, both account-based term allocated pensions and complying lifetime or life expectancy pensions.
Converting an SMSF to a SAF will also not have any implications for the grandfathering of Centrelink deeming on account-based pensions.
Meet a condition of release:
If the members have met a condition of release, it is possible to simply pay the member benefits and wind up the SMSF. Sufficient funds will need to be retained for wind-up costs and taxes and a final return will be lodged.
Naturally, comparing the tax-effective environment of superannuation with other forms of investments needs to be considered, as does the client’s ability to return money to superannuation. If clients are ineligible to contribute, then their ability to invest in superannuation is lost. If clients have a higher superannuation balance than they are able to re-contribute then the time taken to return monies to superannuation needs to be considered.
There may also be Centrelink implications of cashing benefits from an SMSF, so care must be taken.
When do clients need an exit strategy?
There are a number of trigger events that may lead to clients needing to exit an SMSF including;
- disqualified persons
- loss of capacity
- lack of interest
- relationship breakdown of fund members
- death of a member
- special estate planning needs.
A disqualified person is an individual who:
- has been convicted of an offence involving dishonesty
- is an undischarged bankrupt
- has been disqualified by a Regulator of a civil penalty.
If an SMSF trustee becomes an undischarged bankrupt, they are required to notify the ATO immediately. Alternative arrangements must be made for their SMSF within six months of declaring bankruptcy. If alternative arrangements are not made within this time, the fund will fail the definition of an SMSF and not be eligible for tax concessions.
A disqualified person is unable to be a trustee and is, therefore, unable to be a member of an SMSF. There are, however, no legal issues with disqualified persons being members of a public offer fund or a SAF.
To be eligible for concessional tax treatment, a superannuation fund must meet the definition of an Australian superannuation fund. If a fund fails to meet the test at any time during an income year, it does not meet the definition of an Australian superannuation fund and is not entitled to tax concessions.
A superannuation fund is an Australian superannuation fund if:
- the fund was established in Australia, or any asset of the fund is situated in Australia, and
- the central management and control of the fund is ordinarily in Australia, and
- active members who are Australian residents hold at least 50 per cent of the fund value.
For SMSF trustees, the residency test is crucial. As the trustee is responsible for the central management and control of a fund, their physical location is particularly important. If an SMSF trustee becomes a non-resident, the fund will generally fail to meet the definition as the high level decisions relating to the fund (the central management and control) will be made wherever the trustees reside.
There is a two year grace period where the central management and control test can be deemed to have been met, even though the trustees are temporarily outside Australia for a period of up to two years.
In a public offer fund or a SAF, the trustee will invariably be a body corporate, incorporated in Australia, with the business of the fund being managed from Australia. As a result, the central management and control test is generally easily met.
Active members are members who contribute, or for whom contributions are made, to a fund. For the purpose of the residency test, contributions include rollovers to a fund.
In a SAF, given that membership is limited to a maximum of four members, the active member test can be an issue. A SAF can only meet the active member test if non-resident members don’t contribute (or attempt to rollover a balance into the SAF) or if contributory resident members hold greater than 50 per cent of the fund’s assets.
Loss of capacity:
Potential loss of capacity due to dementia or other illnesses is also a source of concern for SMSF trustees. Dementia is projected to increase over four-fold from 245,400 people in 2009 to around 1.13 million people by 2021 so these concerns will continue to escalate.
If an SMSF trustee loses mental capacity they are unable to continue in the role of trustee and they are, therefore, unable to be a member of an SMSF. There are no legal issues with a person who lacks mental capacity being a member of a public offer fund or a SAF. However, there may be practical impediments to their becoming a member of a public offer fund or a SAF if they do not have an enduring power of attorney. Accordingly, having an enduring power of attorney for SMSF trustees is an essential part of the SMSF establishment process.
In addition to loss of capacity, loss of interest can be a driving force behind the requirement for an SMSF exit strategy. Many SMSF clients/trustees are skilled and committed when they commence their journey but may become less interested and able as they age.
In the event of a relationship breakdown between a couple with an SMSF, it is desirable for each person to make their own future superannuation arrangements. Whilst in some relationship breakdowns the former couple maintain a cordial relationship, this is not always the case. Running an SMSF with trustees who are not on good terms is difficult at best.
In addition, if a family law split is being made, it is possible to take advantage of the CGT exemptions when moving one of the parties to a SAF or a new SMSF. However, this is generally not available if the family law split is paid to a public offer fund.
Death is a significant trigger event for a review of the viability of the SMSF. Practitioners are well aware that SMSF trustees are jointly and severally responsible for the running of the SMSF. However in practice, there may be occasions where we find that some trustees are more responsible than others. In the event that a ‘more responsible’ trustee dies, the remaining trustee may not be willing or able to continue in the role of trustee.
The payment of a death benefit is an important issue if indivisible or illiquid assets are involved, or if there are assets such as business real property that the family unit wishes to retain.
Special estate planning needs:
There are a number of estate planning issues that may result in an SMSF no longer being the best superannuation vehicle to achieve a client’s goals. In an SMSF, the death of a trustee changes the composition of the trustees and may provide potential for disputes if there are family tensions. Family members who have personality disorders or addictions may cause difficulties for the SMSF trustees who are responsible for paying the death benefit. The use of a SAF or a public offer fund for these circumstances hands over the stress of dealing with particular family members to the independent professional trustee. In an SMSF, it is possible to build safeguards into the trust documentation. However, if one of several feuding beneficiaries has the cheque book, it may take the remaining beneficiaries considerable time and expense to track down the person and the money.
SAFs and public offer funds may also provide very tax-effective death benefit pension payments for intellectually disabled adult children. The impediment of the disabled person or their legal personal representative needing to be a trustee of an SMSF is not relevant in a SAF or public offer fund.
The issue of requiring an exit strategy for your SMSF may not be front of mind when you are considering establishing your fund; however, there are a number of instances in which one could be required. Taking steps to identify the potential trigger events and various exit strategies in achieving your retirement goals, even when things don’t go to plan, could potentially safeguard your hard-earnt retirement savings.
If you are not sure if you are potentially at risk or simply wish to discuss this issue with one of our SMSF specialists, please either call on 1300 99 77 34 for a chat or email your questions to firstname.lastname@example.org
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