Guarding SMSF wealth – part two

GRANT ABBOTT is director of I Love SMSF.

In the second part of this two-part series, Grant Abbott discusses why SMSFs remain a good estate planning vehicle and an optimum solution for wealth protection.

In the first part of this series we looked at how the courts attacked the SMSF of a defendant in a New South Wales family provisions claim – Kelly v Deluchi [2012] NSWSC 841. In that case, Justice Philip Hallen looked at whether the payment of a death benefit from an SMSF to the deceased’s spouse was a relevant property transaction under the notional estate provisions in Part 3.3 of the NSW Succession Act 2006. Hallen stated: “I am satisfied that the basis of a relevant property transaction for the purposes of section 75 has been established and that it is taken to have been entered into immediately before, and to take eff ect on, the occurrence of the resolution of the trustee, in February 2010, that is to say, aft er the deceased’s death … In all the circumstances of this case, I propose to make an order designating part of the property held by the trustee as notional estate.”

This case is mandatory reading for all SMSF practitioners and any estate planning lawyer. Coupled with the decision by the Victorian Court of Appeal in Wareham v Marsella [2020] VSCA 92, where the judge removed the surviving SMSF trustee for paying the deceased member’s death benefits to herself and not the estate, well, all is not well in SMSF estate planning. Perhaps that is why so many lawyers pronounce that binding death benefit nominations (BDBN) are totally ineff ective and subject to challenge.

So do we simply wind up our SMSFs when our clients get older and put everything into a discretionary or family protection trust to shield the benefits from family provisions claims?

Absolutely for some cases, but for 80 per cent of SMSFs, if you know what you are doing and know how to structure a client’s SMSF correctly for succession and estate planning protection, the SMSF as a trust is like the king of the castle. Why?

SMSFs are great estate planning vehicles

SMSFs have the tax benefits of a superannuation fund as well as the fl exibility of the family and testamentary trust (subject to income stream limitations). Each SMSF is diff erent, as they are tailored to the specif c and changing needs of the family through the use of a strong and fl exible set of governing rules, particularly when it comes to estate planning. The limitations of income stream estate planning for adult children is best handled by an SMSF death benefits trust rather than a testamentary trust, which is subject to state-based family provisions claims, although in NSW we must be mindful of the Kelly case.

An SMSF death benefits trust is, simply put, a testamentary trust created by the trustee of an SMSF that garners the taxation benefits for minors under section 102AG of the Income Tax Assessment Act 1936. Importantly, it is not impacted by the recent anti-avoidance provisions instituted for testamentary trusts fl owing from a deceased member’s estate and does not need a tax ruling if super is paid into the testamentary trust.

Estate planning advantages of SMSFs

• SMSFs are family funds built for lifetimes and thus can provide long-term estate planning solutions, including laying down income streams for future generations in the hands of the right adviser or destroyed by poor legal advice in forcing superannuation benefi ts into a deceased member’s estate.

• If an SMSF will is used, specificactions and requests by a member of a fund may be put in place in respect of their superannuation benefits in the event of their death. An SMSF can have six specific directions to the trustee, one of which is the payment of superannuation benefits as desired. It is a formal contract between the member and trustees and even includes the appointment of an accountant, planner or lawyer to administer the estate. As a Superannuation Industry (Supervision) (SIS) Act 1993 contract, it is legally protected under section 54C of that act.

• The element of control is present. Like the family trust, the trustees of the SMSF have control of the fund. Under the SIS Act, there is a requirement that all members of the fund, generally the family, must also be trustees of the fund or directors of the fund’s corporate trustee. This means shared control among fund members. On the other hand, the leading member SMSF (discussed later) puts in place a predefined succession plan to guarantee control between generations.

• SMSFs provide a wide range of investment choices. Where the member is using an SMSF will, they may designate specific assets to pass to SIS dependants and non-dependants via the estate upon their death. If an income stream option is used, then the trustee will invest the assets of the fund for the benefit of the dependant income stream recipient. An SMSF will may mandate a specific investment strategy for the pension.

• Assets remaining in the fund are protected from creditors as per the Bankruptcy Act 1966.

• SMSFs have a significant advantage over entities in terms of taxation with an SMSF death benefits trust, which protects the SMSF estate from a family provision claim, providing adult marginal tax rates on distributions to minors.

• SMSFs are favourably treated under the social security laws. Until age pension age, they are treated as exempt from the assets test.

• SMSFs are not complex in terms of administration, with a professional administrator recording all transactions the trustee has made, although compliance with the SIS Act does add to the cost of delivering a fund that complies with all the laws.

• Income streams in an SMSF can be paid to dependants as allowed under the SIS Act. If the dependant is a child of the deceased, they must be less than 18 years of age unless financially dependent upon the member, where a child pension can be commenced but no later than age 25. In addition, the pension must cease by age 25 unless the child is disabled. If the dependant is a grandchild or other person who is financially dependent upon the member, the commutation by age 25 requirement does not apply.

Estate planning disadvantages of SMSFs

• If an SMSF will or valid BDBN is not used, the passing of superannuation benefits of the deceased member is at the mercy of the remaining trustee of the fund. The most notorious example of this happening was seen in Katz v Grossman [2005] NSWSC 934, although this case appears to confl ict with the Marsella case and shows how diff erent jurisdictions apply the laws separately.

• The SIS Act weighs heavily on the trustee of the fund and, as a result, the trustee and member must consult a specialist SMSF adviser or lawyer to ensure the fund’s estate plan not only delivers what is required, but also complies with the law. There are significant financial penalties for breaching the law and the commissioner of taxation may replace and disqualify a person as trustee.

• The cost of establishing an SMSF estate plan will depend on the size of an SMSF estate.

• SMSFs cannot be viewed in isolation but are part of an entire estate and succession plan.

• Benefits in a superannuation fund are part of spousal matrimonial property and may be split in the event of divorce. This may be of concern where superannuation benefits are paid as a lump sum to children.

• Income streams can only be paid to dependants as defined under section 302-195 of the Income Tax Assessment Act 1997. As noted above, this means the dependant is a child of the deceased and they must be less than 18 years of age unless financially dependent upon the member, when a child pension can be commenced for a child dependant no later than age 25. In addition, the pension must cease by age 25.

It is important to note there are extensive rules and concessions provided in terms of SMSF estate planning under the SIS Act. So to automatically transfer a deceased’s superannuation benefits from a commonwealth-protected SMSF to the deceased’s estate, to be subject to the vagaries of the family provisions claim, is ill-advised professionally and legally.

Structuring the SMSF for succession protection

Have you ever built a leading member SMSF?

A leading member SMSF shift s the power and control of the fund to the member designated as the leading member. As a trust, an SMSF can put in place an appointor – a leading member who can appoint and remove a trustee of the fund plus any member.

For an example of a leading member SMSF look no further for succession protection than the Windsor royal family where the leading member, Queen Elizabeth II, controls and has ultimate power over it. Of course, the Queen may abdicate or die and in that event succession is built in and leading membership passes to Prince Charles. But what if Prince Charles is not alive at the time of the Queen’s death? Built-in succession planning will see Prince William step in as the leading member, and if he is not alive, then Prince George becomes the leading member and King. It’s safe, certain and secure.

A leading member SMSF starts with builtin succession and proceeds from there The overarching goal of a leading member SMSF is to provide safety, certainty and security for fund members and prevent legal challenges, eff ectively building a moat

i. In-built control

A standard SMSF has little control. I have seen a fund locked up for years in a divorce as lawyers to both parties freeze up the trustee and investments. If there is a property in the fund under a limited recourse borrowing arrangement, and neither party wants to contribute into a squabbling SMSF, disaster awaits. And upon death it is worse if the shares in the corporate trustee are locked into the estate, which is subject to a family provisions challenge. It could result in a two-year and $150,000-plus legal feast.

In contrast, the leading member, under the special purpose leading member SMSF deed and constitution if there is a trustee company, has the power to hire and fire the trustee or trustees as well as appoint and remove the members of the fund. If an adult child of the leading member is appointed as a member of the fund, that appointment is at the discretion of the leading member. If that child gets divorced, then they can be removed from the SMSF and transferred to a public off er fund. In addition, subject to any SIS Act requirements, the leading member has power of veto over trustee decisions. Under this arrangement, all trustees get one vote but the leading member, being the chair and veto vote, means the fund is tightly controlled for safety, certainty and security.

ii. In-built succession

There is no succession in a standard SMSF. With 90 per cent of SMSFs consisting of one or two members, if one of the trustees is incapacitated or dies, there will be uncertainty over what then happens to the fund. If the last remaining member and trustee of the fund dies, what happens? This is a particularly important question when the deed only allows the trustees or members to appoint another trustee. So if the fund has no trustee or power to appoint one, then it is not a regulated super fund under section 19 of the SIS Act. So what is it? For tax purposes it is a non-distributing fixed trust taxed at 45 per cent on income and capital gains and with horrendous estate planning tax consequences.

In setting up a leading member SMSF we need to know the first or main successor, the second successor and if possible the third successor leading member. The fund will last for generations to come with extensions to leading membership to carry on for as long as the fund remains intact, given the rule against perpetuities does not expressly relate to SMSFs. And with the leading member asserting control over the fund, the moat is built.

iii. Protecting the fund from family provisions litigation

The key to the royal family’s success is that everything is kept in the family. In a standard SMSF there is no such choice. With BDBNs easily challenged, reversionary pensions not eff ective in many deeds and the desire by estate planning lawyers to shift superannuation to a deceased member’s legal estate, there is built-in family provisions litigation that may see dissipation outside the deceased’s bloodline, even in cases of the best lawyers who promote bloodline trusts, which can be broken down under estate litigation.

Not so in a leading member SMSF where the members must be the direct lineage of the leading member, unless the leading member uses their discretion to appoint a non-bloodline member. Any benefits on death are to go to the deceased member’s bloodline as protected by the leading member. This sees the benefits held up in the leading member SMSF and, if need be, paid out to a leading member discretionary trust rather than pass through the estate. This provides protection from family provisions claims subject to NSW notional estate claims.

Now I can give you at least another five or more reasons why a leading member SMSF is better than a standard SMSF. However, they are not for everyone. But if your client had a choice on having greater safety, certainty and security, what would they want? What would you want?