- Are you the trustee of a self-managed super fund (SMSF)?
- Do you have any large assets that may be difficult to sell or divide between fund members?
- Do you have a plan for distributing cash to a member or a beneficiary when you need to?
How does it work?
One of the advantages of having your own SMSF is the variety of investments you can hold. That includes the ability to invest in large assets such as rental properties or business premises. Ideally, these investments will be held for the long term to help grow your wealth, and eventually support you during retirement.
However, there’s always a possibility that you may need to offload some of the SMSF’s most significant investments to meet its obligations – which can create a problem if the SMSF has large assets like property that may be slow or difficult to sell in an emergency.
As an SMSF trustee, you are required by law to have an investment strategy. Among other things, the strategy needs to consider any potential liquidity issues for the fund.
What does it mean for me?
There are two common scenarios where a liquidity trap may arise.
1. Owning business property in your SMSF A growing number of small business owners in Australia use SMSFs to hold their business premises.
This can be an effective strategy for tax and estate planning, but liquidity problems can arise in certain situations. One example is the unexpected death or permanent disablement of one of the SMSF members – whereby the fund may be required to pay out a lump sum benefit to the member or their beneficiaries. Dealing with the emotional and lifestyle adjustments can be enough of a challenge, but you also need to consider how your super fund would be affected in such a situation.
2. Undertaking a borrowing strategy inside super Another popular strategy for SMSFs is taking out a loan to buy more investments than it could otherwise achieve. In these scenarios, your SMSF’s main focus is to reduce this debt – perhaps by using rental income and/or super contributions. It’s also likely the bank lending to the SMSF has counted on those contributions continuing.
This ongoing need for funding presents a challenge if one of the SMSF’s contributing members pass away, or stops working. A well-structured funding plan for the SMSF can help manage scenarios like these. A common example is using life insurance to provide liquidity to the fund member or make loan repayments in the event of a fund member’s death or permanent disablement.
Strategy in action-NO LRBA loan-property bought with cash
John and James are business partners both aged 45. They have an SMSF holding their business premises (currently valued at $390,000).
Both John and James have agreed that should either of them pass away, the remaining partner is to keep the business premises in the SMSF and pay out the death benefit as a lump sum.
The SMSF also has $10,000 cash. In total, the SMSF has assets of $400,000 and for the purpose of the example, let’s assume that each of their member balances is $200,000.
Let’s say the SMSF Trustees took out Term Life and Total and Permanent Disablement policies on the lives of both John and James for $400,000 each.
If John was to pass away, the cash proceeds from the insurance policy would be paid to the fund. The fund’s assets would then be as follows:
Fund Assets Pre death John James Total
Business premises 195,000 195,000 390,000
Cash 5,000 5,000 10,000
Fund’s total net assets 200,000 200,000 400,000
Trustee receives $400,000 term life insurance payment
Fund Assets Post death John James Total
Business premises 0 390,000 390,000
Cash 400,000 10,000 10,000
Fund’s total net assets 400,000 400,000 800,000
If the insurance was held at the member level, i.e. insurance premiums paid by the member, the fund will not have sufficient liquidity to pay the death benefit to John’s beneficiaries, as his member investment balance ($200,000) plus the insurance amount ($400,000) is $600,000, but there is only $410,000 cash in the fund.
If John’s beneficiaries do not wish to receive the death benefit in the form of a pension, the lack of liquidity may mean that the property must be sold to pay John’s death benefit.
However, if John and James decided that their SMSF Trustee should hold this insurance cover at the fund level, i.e. insurance premiums paid by the fund as a fund (Trustee) expense, then John’s beneficiaries would receive a death benefit of $400,000 (investment balance of $200,000 and insurance proceeds of $200,000), with the remaining balance of the insurance benefit allocated to James.
Going forward, James’s member balance will be $400,000 ($800,000 of the fund’s total net assets minus $400,000 death benefit), and therefore there will be sufficient liquidity for James to continue to hold the property in the SMSF.
Prior to implementing this type of liquidity strategy, it is important to consult a specialist to ensure this arrangement is allowed by the SMSF’s governing rules and trust deed, set up correctly and that the personal insurance needs of the member are considered and noted.
The keys points:
Who owns the insurance-Trustee or the member(s)
Who pays for the insurance cost-Trustee as an expense or the member from their account?
Does your fund trust deed and accounts provide for the Trustee Reserve account?
For more information on how Azure Group can help with your SMSF questions please email ourteam@azuregroup.com.au.
DISCLAIMER/WARNING – GENERAL ADVICE ONLY
The information provided in this article is General Information only, so does NOT take into account your objectives, financial situation and needs.
Before acting on any information contained in this website you should consider the appropriateness of the advice having regard to your objectives, financial situation and needs.
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