The blended family challenge

The increasing number of blended families makes estate planning more of a challenge for SMSFs. Cooper Partners director and head of SMSF succession Jemma Sanderson details some options available that can enable a satisfactory outcome.

With divorce being a constant statistic in Australia, including ‘grey’ divorces, those involving people over age 55, blended families will also continue to increase. As the population ages, the number of second and third marriages is likely to rise whether due to the death of a spouse or divorce.

When there are blended families in the mix, it can create some substantial challenges from an estate planning perspective where often it is the intention of the party with more wealth to want to look after their new spouse, but ensure assets are ultimately passed on for the benefit of their children. Further, it is also often the intention that the tax effectiveness of superannuation is also maintained to its utmost and that intention can taint the other priorities, which may be for certain beneficiaries to receive benefits.

Fundamentally it is of utmost importance to ascertain the estate planning intentions and who the client wants to benefit. That may end up not achieving the most tax-effective outcome, but the beneficiaries will be pleased they received 85 per cent of something rather than 100 per cent of zero.

Blended finances

When second, third and sometimes more marriages arise, it is often tempting for finances, and in particular superannuation, to be consolidated in an effort to:

• manage the costs,

• have a consistent investment approach, or even just an investment approach that isn’t the default option,

• have one party remain in control of assets where they may employ a withdrawal and recontribution strategy to maximise the tax effectiveness, and

• try and equalise for tax purposes resulting in two transfer balance caps and two bites at the Division 296 tax threshold.

It is quite straightforward, SuperStream notwithstanding, to consolidate benefits into an SMSF, however, it is a lot more challenging and painful to extricate one member from a fund on death, divorce or dispute. It is also a substantial consideration to have the survivor potentially in control of a fund on death. If death benefit nominations are not valid and binding, then the outcome upon death could be akin to the Ioppolo v Conti case or Munro v Munro, where the surviving spouse had full control of the fund and was able to designate the superannuation benefits to themselves and where the children of the deceased received nothing.

Further, it is the author’s view segregated investment accounts in modern software programs are not efficient to run, and therefore where that is intended, it is often the same cost or cheaper to have a separate SMSF.

The challenging times with these sorts of arrangements and consolidated superannuation come when there is a life event where the relevant person’s children may get involved, such as:

• death,

• imminent death,

• disability/incapacity,

• divorce, and

• other disputes (including the pending divorce of a child).

Further, where there is a disparity between the wealth of the couple, it can lead to estate intentions that are challenging to implement without further complexity or to mitigate against an estate challenge.

Estate intentions

Where the parents in a blended family die, it is not uncommon for the person with the higher level of wealth to express their intentions to look after their spouse with a regular income stream, while expressing:

• they do not want the capital to pass to the spouse,

• they may not believe the spouse can manage the money, as they may not be financially savvy,

• they want the capital to ultimately pass to their children, and

• they don’t want the capital to pass to the survivor’s children.

Achieving the above is a challenge in an SMSF context because a regular income stream left behind for the survivor will have a capital sum underpinning it, raising issues such as to whom the capital sum belongs and whether the amount would form part of the survivor’s capital.

Further, it must be determined to whom the survivor can leave their superannuation benefits. Can previous stepchildren be eligible as Superannuation Industry (Supervision) Act dependants? ATO Interpretative Decision 2011/77 says they cannot.

Also, should the benefits be directed to the estate and in turn the survivor’s will, it must be assessed whether the instructions provide certainty for the family given the survivor could update their binding death benefit nomination to pay out their benefits to their own children. The will could also be contested by the survivor’s own children and in many states the previous stepchildren have a very limited ability to do so.

So, it may be tax-effective for the survivor to have in place an income stream within the fund, however, from an estate planning perspective this may result in substantial complexity, inflexibility and conflict.

Alternative strategies to consider

In these scenarios, we can have blind spots when it comes to superannuation, as it is the most tax-effective vehicle in the country to provide a regular income. However, it may be that an alternative structure is more appropriate to consider to achieve the intentions, albeit not as tax effectively. However, using a structure like this could also compromise other intentions.

Option one – leave some capital

In this scenario, a level of capital would be left behind for the survivor designed to fund regular cash flow for them over the remainder of their life. It is their capital, they have control of it and therefore it would pass to their beneficiaries, and they would manage the money. The initial level of capital has some science behind the value in terms of a regular income stream for life expectancy, and then if the survivor dies early, the capital is available for their children. Conversely, if they live a long life, the amount may run out although it is up to them to manage the investments for that longer term.

The benefit of this scenario is that the children of the deceased are not waiting for the step-parent to die and can receive their inheritance at the time their parent dies, allowing them to move on with their lives. There could still be some assets that are intertwined, such as a life tenancy in the family home, however, by and large when we are looking at these matters, there is usually a reasonable pool of money that people are considering. Accordingly, leaving an amount of capital behind is palatable.

Further, it could be left in superannuation for the survivor, whether in a separate fund where the succession passes easily to the survivor or in the same fund where the amount is retained in the fund and the balance is paid out, leaving the survivor behind.

The author’s preference is the first option whereby a separate fund is set up for this purpose, with the succession of the fund having no involvement from the children. The new fund will be established with assets that are due to pass to the children, limiting the likelihood of conflict.

The clear downside here is having capital left behind for the survivor and if they do not live for a long time, then their beneficiaries will receive these monies. However, given there is the intention of providing an income stream for the survivor for their life, then there is generally an acceptance of this circumstance. Again, some science can be put behind how much to designate into this second fund and it can be adjusted each year with rollovers while everyone is still alive. It needs to be undertaken with the expectation the survivor will live into their dotage, and thus any calculation can factor in the exhaustion of the capital at life expectancy plus five years to be cautious.

Option two – discretionary trust where the kids inherit

An alternative is to look at the regular income stream for the spouse provided in a structure external to superannuation, with capital left over then passing to the control of the children. The most efficient means to achieve this is through a discretionary inter-vivos trust where the structure is run for the benefit of the spouse over their lifetime. Under the arrangement they would receive a designated annual income amount, which would be taxable to them, with the capital remaining within the trust. The children could be receiving the balance of any income above the designated income stream amount.

Upon the survivor’s death, the capital doesn’t have to be paid out, unless they are owed money by the trust, which isn’t likely given it could be managed via actual distributions matching the taxable distribution, and the children are the controllers and can fully benefit.

The benefit is if the survivor doesn’t live much longer than their partner, then a level of capital won’t pass to their beneficiaries. However, there are other items to consider.

Firstly, succession and control are important to designate correctly, including instructions for the deceased children with respect to how the trust is to operate. If there is likely to be conflict and those instructions will not be followed, perhaps an independent person will be required to be involved in the trust until the survivor dies.

Secondly, ongoing interaction between the survivor and the deceased’s children may not be ideal, particularly if there is conflict regarding how the assets are to be invested.

Further, the strategy is not as tax-effective as superannuation for the survivor as income would be taxable.

And finally the family trust election provisions need to be reviewed in detail to ensure there is no risk of family trust distribution tax if the incorrect test individual is nominated. In this regard it may be appropriate for the trust to be set up and assets gifted prior to the passing of the first.

Option three – faith

In this scenario, the wealthier member of the couple would leave their superannuation to their spouse, given it would be more tax-effective to do so, and then have faith they would disburse it appropriately.

The author would counsel against this course of action as it is very risky and it wouldn’t take much conflict or a disagreement for the whole scenario to be derailed just to save a bit of tax.

Summary

The above is but a few scenarios to consider when having the conversations with clients in these situations. Blended families introduce a lot of additional considerations, however, it is the estate planning objective/ intention that is the most important consideration. If structuring can be undertaken that achieves the objective first and foremost and also has a taxeffective outcome, it would be worthwhile. However, if tax savings are the primary concern, conflict could occur at a later date. Who will have control is also paramount.