9 minute read
A big yawn or brave new world?
Peter Townsend, principal of Townsend Business and Corporate Lawyers, lays out the opportunities and problems of running an SMSF using the proposed new six member limit.
One of the many changes wrought by the COVID-19 pandemic has been the delay in the introduction of the six-member SMSF. The question is: does anybody care? For such a seemingly radical change the reform has provoked little interest. It was a surprise when it was first mooted by the federal government and remains somewhat of a curiosity. It may come into law in the next session of parliament, but don’t expect to see any placard wavers out front on the day.
When she announced the reform in April 2018, then-revenue and financial services minister Kelly O’Dwyer said the change from a maximum four members in an SMSF to a maximum six would allow for greater flexibility. O’Dwyer didn’t mention exactly why that would be so. Similarly, she did not explain why six was the magic number. If six provided so much extra benefit, imagine what 10 might achieve.
The explanatory memorandum for the bill was also suitably enthusiastic: “Increasing the allowable size of these funds increases choice and flexibility for members. SMSFs are often used by families as a vehicle for controlling their own superannuation savings and investment strategies ... This change will help large families to include all their family members in their SMSF.”
Some of these statements are debatable, but even if accepted, don’t point to any significant need for the reform, or even any request or lobbying for it. Just on 93 per cent of SMSFs in Australia have one or two members. The vast majority of users of SMSFs therefore do not want their children in the fund. The average size of the Aussie family is 2.53 people. Not a major market there for funds permitting four kids to join.
Having said that, there are roughly 61,500 members of three-member funds and 82,000 members of four-member funds: material numbers if only relatively small at 7 per cent of the total.
Although several early surveys indicated planners thought half their clients might consider adding more members to their fund, that was based on concerns about Labor’s proposed changes to the handling of franking credits, and since that issue has been put to bed the interest in changing might be much less.
Jumbo funds are coming nonetheless and so we need to consider some of the important issues a jumbo fund gives rise to, including a usefulness away from just very large families.
Pros and cons
Benefits of a six-member fund would include economies of scale through sharing compliance and administration costs, higher contribution inflows from five or six members as opposed to a lesser number and potentially sheltering small super guarantee contributions for the kids from high public offer account fees. Conversely, the challenges a jumbo fund would create might include the complexity of more member trustees, kids knowing more about their parents’ financial affairs and vice versa, different investment strategies for different age groups and possibly higher establishment costs to ensure the parents’ control issues are covered, as discussed later.
Trustees
The maximum number of trustees a trust can have is regulated by state law. Some states have no limit, while others hover around the four to six mark. If the fund’s home state’s trustee legislation has a limit of less than six, then a jumbo fund in that state will need a corporate trustee.
Control
Three or four kids outvoting their parents at a meeting of individual trustees is not an ideal situation, though not all that likely either. The deed should permit weighted voting by the member’s account balance rather than by simply a raised hand at the meeting.
The same would need to apply to both meetings of shareholders and directors of the corporate trustee. For shareholders’ voting requirements it may be that classes of shares should be used to ensure greater control. Directors’ voting could be weighted in the same way as the voting of members of the fund. Changes like these may require careful scrutiny of an amendment to the standard trustee company constitution.
Estate planning
A deceased member can’t simply leave his death benefit in the fund to be added to the accounts of the surviving members. The benefit must be paid out (even if only virtually) and any addition to the surviving members’ account is then characterised as a contribution, needing to fall within the members’ allowable limits. But a jumbo fund might permit the surviving members to enjoy the benefits of certain assets in the fund if other assets/liquidity are/is available to pay the death benefit. That particularly valuable real estate can then be available to other family members without the need for transfer or transfer duty.
Diverse investment strategy
Creating an investment strategy that will suit at least two very diverse age groups while maintaining the benefits of the single fund with its pooled additional resources should prove challenging. Wondering if this will lead to an increase in investments with a wide range of underlying opportunities, such as exchange-traded funds and listed investment companies, is a valid query.
Increased contributions from the extra members could permit the fund to buy assets otherwise unavailable to it, or at least to borrow less to do so. The challenge might be to not get carried away with that additional buying power. This could be particularly so in the area of real estate where the current low interest rates and increased buying power could lead to the purchase of a property much larger than was previously possible. Serviceability of such a loan would be a paramount consideration, particularly if an older member were to die.
Liquidity
A one or two-member fund would generally find it easier to handle the issue of liquidity that arises when a member must be paid their annual pension amount, becomes mentally incapable and needs to source their member’s benefit or dies. In a sixmember fund that liquidity could be more of an issue. Assets bought with a view to a long-term hold, in theory benefiting all the diverse age groups, may need to be liquidated to free up much-needed cash. Not only does the younger generation lose the long-term benefit of the asset, but there is a capital gains tax issue following the sale.
One of the stated benefits of a jumbo fund is the ability to acquire assets otherwise not in reach. If those assets are not going to survive the exigencies and problems associated with the older members of the fund, then is there any point in acquiring them in the first place? Putting aside some additional administration costs, the family may as well have their own separate funds.
The most obvious strategy to handle liquidity issues is life insurance for the older members, but the very fact they are the older members may make life insurance unviable as an option.
Looking beyond the family
An SMSF is not an investment, but rather a structure to hold investments. As a structure it can be used in many of the same contexts as a company, discretionary trust or unit trust. The advent of the six-member fund may see more people view the SMSF as an appropriate structure for a wide range of investments, particularly those involving a group of people hoping to pool their resources.
The SMSF may be the structure business buddies use to purchase an asset rather than being restricted to being a structure only for jumbo families. The SMSF has much to offer.
Tax
The SMSF has immense advantages over other commercial structures when it comes to tax both in terms of the applicable rate of tax and the use of franking credits. The lower tax rate potentially accentuates the compounding effect of earnings reinvestment in the fund.
Choice of investments
SMSFs can choose to invest in any investments authorised by law and the trust deed, subject to the investment strategy. This could include listed investments, unlisted investments unavailable through public offer funds, or projects that require a reasonable amount of capital to be worthwhile, such as start-ups, venture capital, innovative investments or real estate.
Borrowing
The limited ability to resource the SMSF due to contribution limits can be overcome by borrowing. The SMSF may enhance its capital base through a limited recourse borrowing arrangement (LRBA), subject to appropriateness, the investment strategy and the LRBA rules. This can provide the SMSF with greater flexibility to invest in more substantial projects or further diversify investments. Loan interest and borrowing expenses are generally tax deductible to the SMSF.
Participants’ interests
SMSF members can contribute in equal amounts, but unequal balances can easily be accommodated. In the SMSF, each member maintains their own member balance or account to which investment earnings and expenses can be allocated on a fair and reasonable basis, subject to the governing rules.
Where the members are business partners or friends who have combined capital to invest for retirement, they can also have a second SMSF for family members or superannuation balances with public offer funds, for example, for their concessional contributions, including mandatory contributions.
Preservation and access restrictions
Superannuation benefits are preserved. Generally, the benefits can only be withdrawn on the member meeting an unrestricted condition of release, such as retirement.
However, payment of benefits from superannuation is not mandatory even after a member has met an unrestricted release condition. Cashing of benefits is only compulsory after a member has died. While the member is alive, there is the option to retain benefits in the fund in accumulation phase, with tax on earnings at a maximum 15 per cent rate. In addition, pensions that have commenced can be stopped and rolled back to an accumulation account. Members can also make withdrawals and at the same time contribute to super in the same financial year, as long as they meet eligibility requirements.
In some circumstances, especially where members have substantial assets and income outside super, it may be advantageous to retain their money in an SMSF, enjoying a lower tax rate for future withdrawal and upon death to devolve the benefits to dependants free of probate and, possibly, access by creditors (for lump sum benefits) or to the legal personal representative, including holdings in a super proceeds trust.
Asset protection
A member’s interest in a regulated super fund is generally protected from the trustee in bankruptcy. Any lump sum paid to the bankrupt person on or after the bankruptcy date is also protected. Super pensions do not receive the same level of protection.
The exception is where the contribution of money or assets to super is made with the intention to defeat creditors. These actions will not be protected and may be clawed back by the trustee in bankruptcy.
In closing
Although jumbo funds are unlikely to see an immediate uplift in the average number of members in funds across the country, they may open the opportunity for SMSFs to be seen more as an asset holding structure than simply a tool for families like the Brady Bunch.
