Too close for comfort

SME owners unquestionably dominate the ranks of self-managed super fund (SMSF) members. However, sometimes the relationship between the members’ businesses and their super funds becomes far too close for comfort.

As the Administrative Appeals Tribunal warned in a recent hearing, a SMSF should not be regarded as a line-of-credit to help a business try and survive through financial difficulties.

Stuart Forsyth, assistant commissioner for superannuation, has told SmartCompany that small business owners established a substantial proportion of the 410,000-plus SMSFs under the ATO’s regulation. And Forsyth says that when the minority of funds has serious clashes with the regulator, it is mostly over transactions with their members and their related entities.

It is clear the ATO is keeping a close watch for any SMSFs that provide extensive financial support for their members’ businesses through the global financial crisis in contravention of the Superannuation Industry (Supervision) Act.

There is, however, a considerable lag between the end of the financial year and when funds have to lodge their annual tax and regulatory returns. This lag means the ATO will not gain an impression before well into the 2010 calendar year of the extent that members’ businesses may have turned to their SMSFs for money in response to the global financial crisis.

“It’s important to view the SMSF and the related business [of the member] as completely separate entities,” Forsyth says. And a fund should not be treated as a “prop if the business hits troubled times”.

The potential reliance on funds for business finance in tough times “is something that really worries us”, Forsyth adds.

SME owners who turn to their SMSFs for finance face the risk of having up to almost half of their assets stripped in tax penalties.

The ATO last year declared 100 self-managed funds to be non-complying under superannuation law – mostly on the grounds that members had mixed fund assets with their business or personal assets. This is generally viewed as a last-resort measure by the regulator.

When a fund becomes non-complying, the assets of the fund – less any undeducted contributions (after-tax or non-concessional contributions) – are taxed at the highest marginal rate.

This means, for instance, the assets of a fund that has relied solely on superannuation guarantee, salary-sacrificed contributions or deductible contributions (perhaps by the owner of an unincorporated small business) could forfeit almost half of its assets if declared to be non-complying. The tax penalty is extremely frightening; particularly for funds with sizeable balances and with members nearing retirement.

Forsyth points to a recent decision by the Administrative Appeals Tribunal that upheld a decision by the tax commissioner to declare a SMSF as non-complying. In the case, the husband and wife fund trustees arranged for their fund to lend the husband’s business $211,000 – equal to 95% of the fund’s assets. This was far in excess of the maximum percentage allowable for “in-house assets” under superannuation law. (See point two below.)

SmartCompany’s tax writer Terry Hayes wrote in detail about this case last month.

Just recapping briefly on the case, the business was in dire financial difficulties and the husband was seriously ill. Rather than take professional advice to place the company in administration, the couple enabled the business to borrow from their self-managed fund. Forsyth says that the money had not been repaid after four years.

This should be viewed as somewhat of a landmark case on the dangers of mixing the finances of members’ businesses with their self-managed super funds.

Points that SME owners need to really watch with self-managed funds and their business affairs include:

1. Beware of restrictions on actually running a business through a SMSF

Bryce Figot, a superannuation solicitor with DBA Lawyers in Melbourne, points out that superannuation legislation does not expressly forbid SMSF trustees from operating a business through their funds.

However, Figot warns that trustees should be aware of a series of provisions that may make it extremely difficult. These include that a fund must be maintained for the sole purpose of providing retirement benefits for members. Further, Figot points out that individual trustees or directors of a fund’s corporate trustee are not allowed to receive payment for their services as trustees.

Therefore, trustees working in such a business operated by a fund could not receive a salary or reimbursement of their expenses.

2. Understand the limits on lending by a SMSF to “related” trusts and companies that are owned by members, their partners or their relatives

Under the in-house asset rule in the Superannuation Industry (Supervision) Act, a SMSF is forbidden from making loans, providing leases or having investments with related entitles that exceed 5% of its total asset value.

Compliance with this provision means legal dealings between the members’ businesses and their SMSFs must be extremely limited. One of the very few exemptions to the in-house asset rule is business real estate.

The making of loans from SMSFs to their members’ businesses is one of the issues that keep arising during the ATO’s compliance work.

3. Don’t arrange for your fund to provide personal finance assistance to members or their relatives

This is strictly barred by superannuation law. Even the small concession under the in-house asset test that applies to related entities does not apply for loans to members.

Business owners should really understand this total prohibition on loans to members. Your SMSF is not a moneybox!

4. Keep your fund’s dealings with related parties (including the members themselves and their entities) at a strictly arm’s length basis

In other words, the transactions must be on a proper commercial basis even when permitted within the in-house asset rule or under the extremely limit restrictions regarding acquiring assets from members (see point five).

5. Take extreme care when acquiring assets from members

SMSFs are prohibited from acquiring most types of assets from members or other related parties (including a member’s business). The main limited exceptions to this ban are listed assets and business real estate – obtained at market value. Other exceptions are assets from related parties within the 5% in-house asset rule, discussed earlier.

This should be closely watched in particular by members who aim to sell assets to their SMSFs in an attempt to quickly raise large amounts of cash, perhaps because of difficulties for their businesses flowing from the global financial crisis.