It might not even be an issue with the death or disablement of members but with the lumpy assets themselves. Real property can be damaged or destroyed, tenants might default on their rental obligations, people who use the property (particularly where the fund owns commercial property) might be injured or worse, all of which presents significant liabilities for the trustee of the fund.
There are cases I’ve come across where members have had to borrow against other assets (a step that is not ideal and sometimes not possible for retirees) just to make contributions to the fund to raise the capital to then cover extraneous costs or to pay out a death benefit. It is messy and tax inefficient. For the trustee to fund a death benefit payout by way of in specie transfer of real property takes the property out of the tax-effective superannuation environment and can be costly in terms of legal and transaction costs, stamp duty and capital gains tax. Another implication is where trustees have borrowed to acquire the property using a limited recourse borrowing arrangement. The loan needs to be repaid, and the death or disablement of a member can again effectively destroy a long-term wealth accumulation strategy that was generally costly to implement and can be more costly to unwind.
A simple solution
The solution is risk insurance. However, when most financial planners and accountants think of superannuation and risk insurance, it’s with the notion that Member A and Member B have a sum insured of life, total and permanent disablement and perhaps some salary continuance cover. On the death or permanent disablement of the member, the trustee allocates the amount of the insurance paid to the member’s account and it is paid out under the relevant condition of release. General insurances, such as landlord’s cover, building and contents cover and third party liability cover, set up to cover the real property and other risks, is perhaps not too much of a stretch for trustees to consider, but very rarely have I seen advice provided to trustees on adequately insuring the fund itself against the death or disablement of a member. It’s a fairly simple concept but one that needs to be seriously considered. The idea is that if a member dies or becomes disabled, the trustee holds insurance on the lives of the members that is not paid to the member’s account but is applied to, say, the limited recourse borrowing to repay it, or to help fund the death or TPD benefit, thus alleviating the need to sell the property.
Make provision in the deed
The most important thing – and I cannot stress it enough – is the quality of the drafting of the trust deed. The governing rules of the fund determine the use of insurance proceeds. It therefore needs be written into the deed with full discretion allowed to the trustee and because the cover is capital in nature, the trustee is not entitled to a deduction on the cost of the premium.
Monies received by the trustee on a successful claim form part of an insurance reserve. On repayment of debt (such as a limited recourse loan), the increased value of net assets of the SMSF can be reflected in members’ accounts for the benefit of the deceased and surviving members. Depending on the governing rules, the key-person insurance proceeds can effectively allay the need to sell or transfer the property which can keep the property within the tax-effective superannuation environment for the benefit of the surviving members.
Factors to determine
But should the amount insured be for the full value of property, the amount of the member’s account balance, the amount of debt, or that member’s portion of the debt? The answer will come down to individual planning and will invariably depend on what outcome the trustee is trying to accomplish. The more insurance, the more the cost to the fund and, as mentioned, premiums will not be tax deductible. In addition, there is the issue of the insurability of the members. It is also important to note that additional amounts allocated from a reserve for a member are classified as concessional contributions (s 292-25(3)) and count towards the concessional contribution cap. The conditions are set out in the Income Tax Assessment Regulations (reg 292-25.01).
There are alternatives to the trustee owning the insurance policies directly. Life insurance might also be held by the family business or cross-owned by the members outside the fund, which might allow the business or surviving members to purchase an interest in the real property held by the fund to allow the death benefit or TPD benefit to be paid by the fund.
There are consequences including stamp duty, capital gains tax and transaction and legal costs. Not to forget that this also leads to a portion of the property being owned outside the tax-effective superannuation environment.
In a nutshell
To sum up, it is critical for the fund’s long-term wealth creation (and wealth protection) strategy, that adequate insurance be put in place to meet the fund’s liability to pay lump sum benefits. There is some care required in the drafting of the deed and management of ownership and costs of cover, but there are tangible benefits to the trustee and the members in allowing for lumpy or illiquid assets to continue to be held in the tax-effective superannuation environment.
