Optimising tax outcomes in death

A legislative amendment made in 2013 has allowed for more effective tax outcomes for death benefit beneficiaries, but there is one critical contingent factor, SMSF technical support executive manager at SuperConcepts Nicholas Ali writes.

While we often (rightly) focus on control of an SMSF when a member dies, it is often not relevant as many funds have relatively straightforward requirements from an estate planning perspective. Perhaps more important real-world issues revolve around strategies to maximise the super benefits paid to beneficiaries.

One area in which trustees (and some practitioners) lack knowledge is superannuation interests. Many people think a member has one superannuation interest, which is the case if the member balance is in accumulation mode. What is not fully understood is each pension is considered a separate superannuation interest. As such, each pension can have its own proportion of tax-free and taxable components even within the one SMSF. This can provide some strategic planning opportunities regarding death benefits.

But first, let’s wind the clock back a little to see how we have got to this point.

The ATO first raised the issue on 20 August 2004 with the release of Interpretative Decision (ID) 2004/688, which stated “once a fund no longer has any current pensions in payment and there is no provision for a contingent pension to commence, the fund no longer requires current pension assets”.

In other words, where there was no reversion in place for a superannuation income stream, any monies used to fund the income stream, then paid out of the fund as a lump sum or cashed within the fund would come under accumulation mode and be taxed accordingly and therefore potentially be subject to capital gains tax (CGT).

Any non-reversionary income stream would automatically become an accumulation benefit of the deceased even if it subsequently became a death benefit pension for a spouse. The introduction of Simpler Super on 1 July 2007 created further issues, with earnings on an accumulation account being considered a taxable component. Moreover, it also meant the separate superannuation interest calculated and crystallised at the commencement of the pension ceased and the pension components were then amalgamated with any other accumulation benefits of the deceased in the fund.

Taxation Ruling 2013/5 reconfirmed this long-held view and stated: “The commissioner considers that a superannuation income stream ceases when there is no longer a member who is entitled, or a dependant beneficiary of a member who is automatically entitled, to be paid a superannuation income stream benefit from a superannuation interest that supports a superannuation income stream.”

Below is an example of how CGT on death used to be treated under ATO ID 2004/688.

Example – CGT on death

Barry is a widower and sole member of his SMSF. He has an account-based pension with a capital value of $1.85 million. This income stream has been running for several years. The assets of the fund include a property valued at $750,000 with a cost base of $500,000. Barry has one child, Dwayne, who is an independent adult. Barry passes away on 1 July and leaves his superannuation entitlement to his son.

Dwayne sells the property on 1 September for $750,000 to fund the lump sum death benefit paid on 1 December.

Sale price $750,000

Less: cost base ($500,000)

Net capital gain $250,000

Less: CGT discount ($82,500)

Assessable capital gain $167,500

CGT payable by SMSF ($25,125)

Net amount $724,875

Even though the property was used to fund a pension just prior to Barry’s death, because there was no member who is entitled, or a dependant beneficiary of a member who is automatically entitled to be paid a superannuation income stream benefit, the income stream ceased on Barry’s death and his benefit reverted back to accumulation mode.

Changes made in Mid-Year Economic Fiscal Outlook

In response to criticisms the commissioner’s preliminary view in the Draft Ruling was inequitable, the government announced in the Mid-Year Economic Fiscal Outlook released on 22 October 2012 there would be amendments to the legislation to allow the tax exemption for earnings on assets supporting superannuation pensions to continue following the death of a fund member in the pension phase until the deceased member’s benefits have been paid out of the fund.

The amendments introduced in the Income Tax Assessment Amendment (Superannuation Measures No 1) Regulation 2013 clarified how the exempt current pension income (ECPI) and tax-free and taxable components are calculated regarding a death benefit arising from a non-reversionary pension:

• ECPI continues after death, if the benefit is dealt with ‘as soon as practicable’, and

• the benefit can be paid as a lump sum, new superannuation income stream or a combination of the two. Therefore, in the previous example, if Dwayne pays Barry’s benefit as a lump sum ‘as soon as practicable’, the ECPI status of Barry’s pension assets continues and the SMSF will not incur the $25,125 CGT. This increases the lump sum benefit payable to Dwayne. Earnings from the date of the primary pensioner passing to the time the benefit is dealt with will also be considered amounts used to fund a super income stream and therefore will be exempt from tax.

Bear in mind the regulatory amendments do not remove an obligation to pay lump sum tax where the benefit is received by non-tax dependants. The regulation also creates an alternative method for calculating the tax-free and taxable components of certain superannuation benefits paid after the death of a person who was receiving a super income stream immediately before their death:

• tax-free and taxable components retain their proportions,

• this includes earnings on the assets supporting the pension but does not include additions arising from insurance proceeds or allocations to the deceased’s account via an anti-detriment payment.

Example – earnings on superannuation interest

Betty was in receipt of a non-reversionary pension at the time of her death on 1 July 2021. Betty’s spouse, Simon, wants to take Betty’s benefit as a death benefit pension. Betty’s benefit in the fund was $650,000 at the time of her death, consisting of 50 per cent tax-free and 50 per cent taxable components. By the time Simon received grant of probate on 1 November 2021, Betty’s benefit in the fund was $700,000 (that is, it had earned $50,000). Simon commenced a new death benefit pension on 1 November 2021, which was the earliest Betty’s benefit could be dealt with.

The $50,000 earnings will be considered earnings on assets relating to an income stream superannuation interest, not on an accumulation super interest. Therefore, the earnings will be in the ratio of tax-free/taxable as follows: Tax-free $350,000 (50%) Taxable $350,000 (50%) Total $700,000 (100%)

But this will only occur if the death benefit lump sum and pension are paid ‘as soon as practicable’. Otherwise all the earnings will be a taxable component: Tax-free $325,000 (46%) Taxable $375,000 (54%) Total $700,000 (100%)

Example – Separate superannuation interest

Bill, 61, was in receipt of two non reversionary pensions – one consisting entirely of a tax-free component and one consisting entirely of a taxable component as follows:

Tax-free pension $500,000 (50%)

Taxable pension $500,000 (50%)

The fund assets are worth $1 million, with a cost base of $500,000.

Bill passed away on 1 July 2021 without any death benefit nomination in place. Bill’s wife, Wendy, his executor, decides to pay the 100 per cent tax-free pension as a cash lump sum to their adult child, Mark, on 1 September 2021. Wendy decides to take Bill’s 100 per cent taxable pension as a death benefit pension on 1 September 2021. Assets are sold within the fund to allow for the cash lump sum to Mark. The fund earns 10 per cent from the date of death until the benefits are paid (1 September 2021), so at that date it was worth $1.1 million.

As per the 2013 regulation amendments, the superannuation interests remain separate super interests after Bill’s death and can be dealt with separately, but only if done so as soon as practicable.

The assets sold to facilitate the tax-free cash lump sum to Mark will be included as ECPI and not subject to tax on earnings or CGT. Selling $550,000 of assets to pay a cash lump sum to Mark would incur nil CGT.

If not paid as soon as practicable, however, CGT would be payable on the sale of assets as follows:

CGT on sale of assets:

Sale price $550,000

Less: cost base ($250,000)

Net capital gain $300,000

Less: CGT discount ($100,000)*

Asset capital gain $200,000

CGT payable by SMSF ($30,000)

Net amount $520,000

Inside super the CGT discount rate is onethird if the asset is held for greater than 12 months.

Given the assets were sold to pay the cash lump sum to Mark, the fund being subject to CGT to pay the lump sum cash benefit dramatically reduces the amount he receives.

The 2013 bill also makes it clear earnings on the assets will be in the same proportions as the superannuation interests, that is, either tax-free or taxable. The $100,000 capital growth will therefore have an equal 50 per cent tax-free component and 50 per cent taxable component:

Tax-free pension $550,000 (50%)

Taxable pension $550,000 (50%)

Again, if not paid as soon as practicable, the $100,000 earnings would be on an accumulation benefit and therefore a taxable component:

Tax-free component $500,000 (45.45%)

Taxable component $600,000 (54.55%)

However, perhaps of more significance is if the benefits are not used to commence a death benefit pension or pay out the death benefit lump sum in a timely manner, the two super interests would cease and revert to one accumulation interest within the fund. This means the lump sum benefit paid to Mark will not consist solely of a tax-free component as the one accumulation interest will mean both pension interests are mixed. The lump sum death benefit to Mark would then consist of the following components:

Tax-free component $243,158 (45.45%)

Taxable component $291,842 (54.55%)

Total $535,000 (100%)*

Mark’s benefit is only $535,000 because $15,000 CGT is deducted first (the CGT is levied equally between Wendy and Mark, so any benefit paid to Wendy will also be reduced by $15,000 CGT).

Now that part of Mark’s cash lump sum consists of a taxable component, lump sum tax would be payable as follows: $291,842 x 17% = $49,613 lump sum tax payable (including Medicare levy)

This outcome impacts the death benefit in three ways:

1. ECPI will not continue and the fund will be subject to CGT (based on the original cost base of the asset/s transferred in specie and/or sold).

2. Earnings from the date of death until the benefit is dealt with will be a taxable component.

3. The pensions will cease to be separate superannuation interests and will become one accumulation superannuation interest.

What does ‘as soon as practicable’ mean?

Unfortunately, there is no hard and fast rule, but the ATO’s general rule of thumb is the death benefit must be paid within six months from the date of death (often called the death benefits period). However, death benefits can take longer in some circumstances, in which case the ATO may accept a longer death benefits period. The ATO considers the following events acceptable reasons for paying death benefits outside of the accepted six-month period:

• taking time to seek specialist advice,

• delays in determining the validity of a binding death benefit nomination, and

• trying to locate beneficiaries.

Conversely, the regulator will not accept the following as reasons explaining why the death benefits took longer than six months to pay:

• waiting for the ‘right time’ to sell an asset,

• the fund having insufficient cash to pay the benefit, and

• the trustees having personal issues and not being able to administer the fund. It is of great significance for trustees and their advisers/accountants to understand the importance of maintaining separate superannuation interests. Unreasonable delays to the payment of death benefits can undermine sound estate planning strategies and cause undue stress at a time it is least needed.