When it comes to setting up and running a self-managed super fund (SMSF) there are many rules and regulations dictating what you can and cannot do.
Many people set up an SMSF to have greater control over their investments or their operating costs, but one wrong move could cost you a lot.
In fact, it could cost you as much as 47% of the balance of your fund.
So it’s really important to ensure your SMSF is compliant.
You see…under the Superannuation Industry Supervision (SIS) Act and Australian Taxation Office (ATO) there are strict requirements for the operation and management of the SMSF.
Any contravention can make your fund non-compliant and the ATO can penalise the fund by up to 47% of the fund assets.
Depending on the severity of the infringements you could even face criminal charges.
And the worst part? It’s much easier than it sounds.
You see, many SMSF funds are prepared with a set-and-forget policy, which can lead to major issues when legislation changes or circumstances change.
An SMSF is administered by the ATO and as such, changes to legislation do not automatically update an SMSF trust deed in the same way that we see with industry and retail funds.
The only way to pick up new legislation is for the trustees of an SMSF to individually make the change.
Do you see how you could easily go awry?
Operating an SMSF with old and outdated legislation is a prime example of how an SMSF can become non-compliant.
On top of these legislative update requirements, many SMSF deeds have errors or omissions which can lead to either noncompliance or poor performance.
And this is mainly due to a poor understanding of what strategies are allowed (as opposed to poor performance due to asset choice).
It’s important to remember that operating an SMSF (with the help of your advisors) is about understanding the legal requirements and available options as well as investment choices.
Here I’ve listed the key errors and omissions which could see you and your fund placed in hot water.
5 most common mistakes in an SMSF
- Failing to change the ownership title of individual assets when members join or leave the fund
Each member of the SMSF must be a trustee (the trustee is the name that appears as the legal owner with the share registry or property title etc).
Therefore, if a member dies or members join or leave the fund then the ownership title of the individual assets must change if the trustee is an individual.
This is not the case if the trustee is a company.
This will also have an impact if the fund has any borrowings as banks will require to approve the title change.
The ATO applies penalties for any contraventions, and these are applied per trustee so not changing the ownership title of the individual assets can significantly increase the penalty charge for one contravention.
- Binding Death Nominations that aren’t in line with the SMSF deed
There are several forms by which a member can pass on their superannuation balance on death and a Binding Death Nomination (BDN) is one of these.
The BDN must be exactly in line with what the SMSF deed prescribes.
The problem is that all too often they do not, which then means it is a non-binding nomination.
With no prescribed distribution the trustees, or even the courts, can intervene and decide on how the deceased members' death benefits are to be distributed.
This can mean that the deceased members' wishes are ignored.
- The SMSF is invested in related entities
There are strict rules about what an SMSF can invest in.
For example, an SMSF cannot invest in a related party (which is where the SMSF has over 50% ownership or control) - this would be a contravention.
This rule also extends to related parties of the member, as a member is defined as associated or related parties, which means that most relatives are combined to determine ownership and control.
The main exemption to this rule is an SMSF can invest up to 5% of its assets in a related party BUT it must also satisfy the sole purpose test so not any investment is allowable.
Another exemption applies to property that allows an SMSF to invest in a debt-free unit trust holding commercial property or for residential property an SMSF can invest with debt under a prescribed loan arrangement.
- Having no formal strategy
All super funds including an SMSF must have a formal strategy that should be in writing and in sufficient detail to prescribe asset allocation, expected returns and the requirements of the members.
The strategy is a forward-looking instrument and as such should be reviewed periodically, or at the very least, annually.
Not only should it be specific, but it should also take into account the funds and the members' needs especially if any members are in the pension stage where periodic cash payments are required.
- Not keeping on top of your assets
Assets should be regularly valued to ensure they are meeting strategy expectations.
For example, certain assets such as collectables and real estate must be insured for replacement value.
It’s also important to remember that assets are for the benefit of providing retirement income and a pension which means that assets cannot be for the current enjoyment of members.
In other words, you cannot display paintings in your home that are owned by the SMSF or keep vintage wines in your personal wine cellar.
7 most common omissions in an SMSF
While omissions are not a contravention, they may cause the fund to operate at a suboptimal level, so it’s important that you’re not leaving out anything that could cost you in the long term.
Here are the 7 main ones to watch out for.
- Not having the right type of pension
There are two main pension types - the typical one is that when a member dies that member balance is passed to an approved person.
This means that assets are sold, and Capital Gains Tax (CGT) is paid.
It may not then be possible for those funds to be returned to the fund by another member due to contribution caps or limits.
The sale of assets may also be at an inopportune time in the market, and you cannot sell part of a property in a multi-member fund.
If you require a more flexible approach for the retention or payment of the deceased members' funds, then an alternative pension type is required.
- Not wording the SMSF deed effectively
The typical SMSF is written in a way that requires the sale of assets and the cash used as payment of the deceased member’s balance.
This will require the assets to be sold, which triggers CGT and takes the funds out of a safer environment for asset protection and tax concessions.
Again, a correctly worded SMSF deed can give greater flexibility for the retention of the deceased members' funds to remain in the SMSF.
- Not managing individual spousal balances
There are strict limits on the size of funds allowable and this can cause issues with contributions and the tax-free components allowable on retirement.
In a happy spousal relationship, there can be various strategies that will allow the build-up of members' funds between the spouses which means you can manage the various caps, including a cap on the overall size of the members' balance.
Failing to take advantage of this strategy could see the fund lose out.
- Death member payments with disproportionate spousal balances
Death member payments with disproportionate spousal balances can cause asset sales in non-liquid assets such as property.
This can be avoided in certain circumstances by allowing funds to remain in super.
- Not taking advantage of death members' benefits when property is in SMSF
SMSF deeds are normally written in a way that would require the sale of a property on the death of a member.
Whereas a correctly worded deed can allow the property to be retained in super in many cases.
- Not having a successor director
If a fund has only one member then if individual trustees are in place the legislation requires a second nominated trustee, which is usually a family member.
This can cause tension as a fund member must now have another person in the decision tree and that second person also takes on a legal obligation.
In these situations, a one-member fund can have a corporate trustee with that member being the sole director.
This solves this problem, but what happens at their death?
There can be a lag between death and the transfer so if important decisions need to be made then the fund could be in limbo.
We would recommend that all single-director companies including an SMSF trustee have a successor director strategy put in place.
- Not voting equally when the fund has multiple members with different balances
Voting is made based on a show of hands (i.e. 2 outvotes 1) and the members' fund balance has no impact on voting rights, which means someone with $1,000 has the same voting power as someone with $1 million.
In some family situations, this can cause friction especially if a BDN has not been legally executed as we discussed above.
However, changes to the trustee company and SMSF deed can allow proportional voting.
