Business property in a SMSF - the advantages and disadvantages

David Glen discusses the advantages and disadvantages of holding business property in SMSFs, and outlines some factors for planners to consider when advising their clients on the topic.

In conversations with advisers around the country, I’m hearing that small business clients are increasingly looking to fund the purchase of illiquid assets, such as property, through their self-managed super fund (SMSF).

This can have some distinct advantages.

Capital appreciation of the property is taxed at an effective rate of 10 per cent, with a reduction to zero if the realisation occurs during the pension phase, and the progressive relaxation of borrowing restrictions inside SMSFs that we have seen over recent years also means that SMSF investments can be geared in certain circumstances – an attractive prospect for many business owners.

However, in situations where there is more than one business partner (and hence more than one member of the SMSF holding the business property), members – and their advisers – should be aware of the potentially serious consequences on the business’ liquidity should one of the partners/members become totally and permanently disabled or die.

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As the popularity of holding business property in SMSFs grows, so does the need for awareness and understanding of this issue.

Potential liquidity risk – and solution

The fallout from holding illiquid business assets, such as business property, in an SMSF can be severe should a member die or become totally and permanently disabled.

This is because, in many cases, the business property assets may need to be liquidated in order to pay the required benefit to the member or their family from the fund – which not only could take time to resolve, leaving the member and their family in limbo, but a ‘fire sale’ could result in a lower than market price for the property.

Meanwhile, the sale of the business property could have serious consequences for the viability of the business. 

Given this potential scenario, it’s not surprising that liquidity protection insurance for SMSFs holding business property is increasingly on the radar for advisers looking after small business clients. 

Liquidity protection insurance enables a benefit to be paid to the member or their beneficiary in the case of death, while enabling the other SMSF members to keep the business property assets intact. 

Many advisers have asked me why conventional life insurance products would not be appropriate in this situation.

The fact is, conventional life insurance payouts are simply provided to the policy-holder or their estate – no provision is made for other members of the SMSF. Therefore, they would not be compensated for the loss of their business partner.

Thinking about compliance 

While liquidity protection insurance may seem like an attractive option for some SMSFs holding business property, we are seeing uncertainty among some advisers on how best to advise their clients on this relatively new area – particularly around the compliance and tax requirements.

It’s important to understand how liquidity protection insurance is seen under the Superannuation Industry Supervision Act (1993), best known as SISA.

When considering recommending liquidity protection insurance to clients, the following compliance issues should be considered:

Does it meet the sole purpose test? It is submitted that liquidity insurance lies within the parameters of both the core and ancillary purposes, and therefore passes the sole purpose test.

Does it meet investment strategy requirements (SISA regulation 4.09)? Liquidity protection insurance will usually contribute to satisfying these regulations, which obligate trustees to address liquidity issues when setting investment strategies.

Does it meet SISA regulation 5.02, which stipulates that premium expense must be allocated on a ‘fair and reasonable’ basis and all members benefit equally from cover?

This can be more of a grey area for the adviser and the fund trustees, but I would suggest that age and health issues of the members need to be discussed openly and objectively up-front, with premium cost allocated pro rata.

Equally, in the event of a claim, payments must be allocated on a fair and reasonable basis (SISA regulation 5.03). To avoid possible dispute, agree how this will be done with the trustees at the outset.

Tax considerations

When turning their attention to the tax treatment of liquidity protection insurance in super, advisers should bear in mind that it is no different from the treatment of any life insurance within superannuation.

It is submitted that premiums are tax deductible under section 295-65 of ITAA 97, while liquidity insurance provides the requisite ‘superannuation death benefit’ or ‘disability superannuation’ benefit required by law.

In case of claim due to the death of a member, claims proceeds are tax free if paid to a dependant for tax purposes. Otherwise, a portion of the claim proceeds may be assessable in the hands of the recipient. 

Total and permanent disability claims proceeds are tax free if the member is over 60 but is otherwise paid on a formula basis. 

However, I would always argue that the allocation of claims benefits should be made directly to member accounts rather than to the fund reserve, as this could have adverse tax implications.

Allocation from reserves can count towards members’ concessional contribution caps in certain circumstances, which could particularly pose issues for those approaching retirement.

Action plan

Liquidity protection insurance can be a worthwhile safeguard for SMSF clients but, as we have seen, a number of factors need to be taken into account in deciding the most appropriate way to administer it.

If you and your clients do decide to proceed with taking out such a policy, this 10-step guide may help ease the process:

The 10-step guide

1. Carry out an asset and liability review with the client
2. Consider liquidity insurance along with other strategies – eg, payment of benefits in pension form only – to ensure it is the most appropriate option.
3. Identify the cover required and select the methodology for allocating premiums and claims proceeds.
4. Review the SMSF trust deed to ensure that insurance in the proposed format is permitted.
5. Brief the SMSF auditor on your proposal.
6. Ensure the statement of advice (SOA) is consistent with other fund documentation.
7. Ensure that the proposal is reviewed by the trustee's tax adviser.
8. Hold a trustee meeting and provide minutes.
9. Once agreed, ensure that the insurance is properly disclosed in annual member statements.
10. Review the insurance annually and update it where necessary.

David Glen is a tax counsel at TAL.