Divorce, death, debt and default: Six questions SMSF trustees should be asking

Just because the law allows investors to do something doesn’t, of course, mean it is a good idea.

This investment adage comes to mind with the recent final ruling from the tax office – in its role as regulator of self-managed super – relating to the acquisition, maintenance and improvement of geared properties in a self-managed super fund (SMSF).

In short, the ruling – clarifying much of the uncertainty about the commissioner’s interpretation of the SMSF gearing laws – is likely to encourage many more SME owners to at least consider holding their business premises in their family super funds.

Property Observer discussed the ruling in detail on June 5, including in regard to the gearing of business premises built over several titles and the undertaking of improvements to business and other properties.

Particularly given the new ruling, it is crucial for business owners to carefully weigh up the advantages and disadvantages of holding their business premises in their SMSFs – whether or not the properties are geared.

The advantages are clear.

Business real estate, such as the premises of a family SMSE, is among the few types of assets that SMSFs are allowed to acquire from their members and other related parties. And business real estate is one of the few types of assets that funds can lease to related parties – including fund members and their businesses – without a limit on its value.

Your business pays a commercial rent to your SMSF. The rent is tax-deductible to your business and your SMSF pays tax at no more than 15% on the rent.

If your fund has borrowed to buy the business premises, the interest is tax-deductible.

Unrivalled asset protection is another advantage. If you later experience financial difficulties, superannuation assets (including business premises) are generally out of the reach of creditors if individual fund members are declared bankrupt – subject to the claw-back provisions in the Bankruptcy Act.

Further, no capital gains tax (CGT) is payable if your fund eventually sells the property when the fund’s assets are backing the payment of a superannuation pension.Bu

Some business owners, however, would tend to concentrate only on the advantages of acquiring their business premises through their SMSFs without giving sufficient attention to the possible disadvantages.

Here are six tough questions to ask yourself:

1. What happens if my business experiences financial difficulties?

Family SMSFs sometimes face the difficulty of having a financially-troubled family business – owned by the fund’s members – unable to pay the rent for fund-owned business premises.

Under superannuation law, fund trustees (who are the members themselves) must operate their super fund for the sole purpose of providing member retirement benefits. And that means pursuing a tenant for unpaid rent – even if that wayward tenant is the members’ own business.

“It can become very difficult because you are then wearing two hats,” says Martin Murden, a director of Partners Group, a financial services provider to accountants.

“You are the landlord in the superannuation fund and then you are the tenant, being a director of the business which is facing difficulties,” he adds.

“I have seen businesses, which have fallen into financially difficulties, not paying the true amount of rent to the super fund,” says Murden, the author of How to invest in property through your self managed super fund (released by Major Street Publishing).

These super funds had breached superannuation law by providing financial assistance to a related party.

The tax office, as regulator of self-managed super, has the power to strip an SMSF of its complying status.

In turn, the market value of a non-complying fund is taxed at the top marginal rate, less any non-concessional or undeducted contributions. This can remove almost half of a fund’s assets in tax, depending upon the circumstances.

And if your business cannot pay proper rent on a fund-owned business premises, your SMSF may have trouble meeting loan repayments if the property is geared. (See question four.)

2. What happens if I divorce?

Husband-and-wife business partners often arrange for their SMSF to acquire their business premises. The sad reality is that a marriage break-up will typically destroy the business partnership – in addition to the closure of the couple’s SMSF when their personal financial links are severed.

Frequently in such instances, the business premises are sold – perhaps in an unfavourable market – in order to split the super savings.

Of course, some husband-and-wife SMSFs would have sufficient other assets to enable one spouse to keep the property in his or her super fund and for other fund-held assets to go into the super account of the other spouse.

Couples who are considering acquiring the premises for their family businesses through their self-managed funds should keep in mind that the possibility that their relationship may fail is far from remote. Figures from the Australian Bureau of Statistics (ABS) suggest that 40% of marriages will end in divorce – a statistic that doesn’t include de facto relationships.

“Trying to disentangle superannuation assets [in a property settlement] can become very difficult,” says Murden.

He points out the need to split an SMSF’s assets such as business premises following a marriage breakdown do not solely involve husband-and-wife funds.

For instance, business partners may have set up an SMSF together to acquire their business premises. And the failure of the marriage or de facto relationship of one of the partners may trigger the splitting of superannuation assets.

In other words, the super savings of both business partners may be affected even though both may have been married to spouses with no involvement in the business.

3. What if a member of my SMSF unexpectedly dies?

Depending upon the circumstances, the death of a fund member may force the sale of fund-owned business premises.

Under superannuation law, a fund must payout the superannuation death benefits of a deceased member to his or her beneficiaries. And funds often have to sell assets such as property to pay the death benefits.

The forced sale of business premises may, in turn, damage the commercial prospects of the family business.

Of course, the beneficiary of a deceased member’s super is often a surviving spouse who is also a member of the same SMSF. In such cases, there is perhaps no need to sell the business premises to pay death benefits.

Murden says some SMSFs deal with risk of having to pay death benefits by taking insurance policies on the life of each member.

A fund’s trustees would arrange for their SMSF to setup a special reserve account to pay the premiums on the life insurance policies. And the beneficiary of any payout upon death or permanent disability would be the SMSF through its special reserve account.

Under superannuation law, fund trustees must have an investment strategy that has regard to such matters as the risk of making an investment, the risks of inadequate diversification, and the liquidity of investments. Liquidity is a key issue when it is time to pay death benefits.

4. What if my SMSF defaults on a loan to buy my business premises?

The lender could sell the property in attempt to recover its debt (including any outstanding interest) along with the costs of selling the property and discharging the mortgage. Whatever is left is repaid to the fund.

Particularly if the property has fallen in value, the fund could lose capital and interest paid to the date of the default.

Sydney tax and superannuation lawyer Robert Richards suspects that some SMSFs will have difficulty making loan repayments after the halving from the concessional contributions cap for members over 50 to $25,000 a year from July. (Concessional contributions comprise salary-sacrificed and compulsory contributions as well as personally-deductible contributions by the self-employed and eligible investors.)

Craig Morgan, a director of mortgage broker SMSF Loans, points out that SMSFs tend to keep their loan-to-valuation ratio for commercial property to a maximum of 55%. With most of the loans Morgan arranges, the rent at least covers the interest payments.

5. What are my possible CGT obligations when selling or contributing my business premises to my SMSF?

The increased value of the business premises during your personal ownership may be subject to capital gains tax (CGT) upon the transfer of its ownership – whether by sale or contribution – to your self-managed fund.

However, the small business CGT concessions on the sale of active assets of a business (such as its business premises) together with the standard CGT discount for assets owned for at least 12 months may eliminate any CGT – depending upon the circumstances. Get specialist tax advice on this point.

You should also be aware that some states apply stamp duty when a property owned by a member is contributed to a super fund.

“You may be eligible for the small business CGT concessions,” says Murden, “but speak to your tax adviser before doing a single thing. Get it wrong and you are going to pay a lot of tax.”

6. Are my retirement investments adequately diversified?

One of the negatives about owning your business premises in your SMSF is that your fund may have insufficient other assets to adequately diversify its portfolio against risks and to take advantage of non-property investment opportunities.

If a fund is poorly diversified, the retirement savings of the members depend on whether the property turns out to be a good investment. Of course, much will rely on the members’ personal circumstances including their other super and non-super investments.

This article originally appeared on SmartCompany.