“The most common contravention [for SMSF compliance] relates to members having accessed their retirement savings early which is often reported as a loan to member or a payment standards breach.”
— Justin Micale, ATO
SMSF and small-business advice
In our experience, advisers are often very good at documenting the reasons for super switching advice, but many struggle when it comes to advising related entities or structures. Similarly for specialist aspects of their recommendations, advisers often work with, or in effect take instruction from tax advisers and lawyers, but they often aren’t very good at documenting and managing these third-party relationships..
These failures are both compliance risks and financial liabilities, but more importantly they signify missed opportunities to deepen the advice conversation and provide better, more rounded, and more effective advice.
A clear case in point is Self Managed Super Fund (SMSF) advice for small business owners.
Business structures can be complex and available tax returns and financials may not be up-to-the-minute; it is true that sometimes it can be hard to get to the heart of what assets and income are available for use. However, advisers frequently forget the fundamental consideration that a trading trust or trading company is not the same legal entity as the individual, and there are important implications for this. Cash in a company account is not the same as cash in a client’s personal account when it comes to making non-concessional contributions (NCCs) to super.
Consider the following simplified example of an advice file we recently reviewed:
Client details:
Age, relationship & dependents: 36; single; one dependent (15-yo)
Occupation: Director, self-employed (plastering business)
Wages (from business): $200,000
Living expenses & mortgage,: $100,000;
PAYG income tax: $60,000
Net cashflow per annum: a $40,000 surplus
Assets outside super (personal):
$600,000 house, $100,000 cash at bank, $40,000 car
Liabilities: $450,000 mortgage; $30,000 car loan; $20,000 loan from business
Assets inside super (retail fund): $100,000
Business assets (held in a Pty Ltd company; client was sole shareholder): $450,000 cash; $200,000 plant & equipment
Business NPAT (after wages): $250,000 in FY20-21; $90,000 in FY19-20
Personal insurance: Life, TPD & income protection (to age 65) in force, personally owned
Advice details (April 2022):
Referred by: Accountant, from an accountancy business related to the adviser’s planning business
Reason for seeking advice:
- Advice about purchasing a commercial premises for operating the client’s business from – and whether to purchase through super.
- The client was also considering subdividing the property in future and selling half, but this was not a primary goal.
Key advice provided:
- Set up a new SMSF (corporate trustee) and rollover existing superannuation to the SMSF
- Make $40,000 concessional contributions in June 2022 (including carry-forwards), and maximise concessionals thereafter
- Make $110,000 non-concessional contribution in June 2022.
- Make $330,000 non-concessional contributions in July 2022.
- After July 2022, purchase a real business property from which to operate the business: if purchase price > $500,000 (to be determined), utilise a limited recourse borrowing agreement as required. If purchase price $500,000 or less, use cash (no LRBA).
Alternative strategies
- Not making concessional or non-concessional contributions
- Retaining existing super
- Individual trustee for the SMSF
General Observations
The SoA contained many of the necessary, standard warnings and considerations relating to advice about SMSFs. However, from a compliance and client best interests perspective, six issues were quickly apparent:
- The SoA did not disclose the implications of the client sourcing the cash for the non-concessional contributions.
- The client was young and the recommended contributions represented a large part of his financial wealth – but this impact was not clearly highlighted in the SoA.
- The SoA or file did not contain any details of the conversations with the client’s accountant, or how the scope of advice was defined with respect to taxation and business structure advice.
- There was a high level of investment concentration risk resulting from the advice.
- There was inadequate consideration of alternative strategies.
- The advice was rushed.
There were other compliance issues beyond this, but for today, we will focus on the main problems.
Product replacement
For the cash that was going from company ownership to personal ownership to superannuation ownership, the SoA provided a table showing that the cash owned by the business was being replaced with cash owned by the SMSF and provided comparison costings based on that.
However, the implications of the intermediate step – the transfer from company name to individual name – were not referenced in the file and were not outlined in the SoA.
Under S947D(2)(c) of the Corporations Act, an SoA must disclose information about “any other significant consequences for the client of taking the recommended action that the providing entity knows, or reasonably ought to know, are likely”.
In the above example, the client needed to obtain about $400,000 of cash from his company in order to make the NCC. This would typically involve either a dividend, a payment of a wage or director’s fee, or the use of a complying loan under Division 7A.
Each of these has potentially material consequences for the client. For example, wages or dividends would likely mean a personal income tax liability.
Alternatively, a complying loan at the reference rate of (at the time) 4.52% would not be tax-deductible to the client if it was used to make a non-concessional contribution to super, and would have specific criteria that needed to be met (e.g., a maximum term of 7 years if not secured over real property).
It would also be an asset of the company and a liability for the client, which could be material in the event the company became insolvent.
The big picture wealth effect
The client above had $150,000 of equity in the home, and after the advice would have very little cash at bank. The assets of his business would also be reduced materially.
Therefore, at only 36 years of age, the client had effectively lost access to a material part of his wealth. This would potentially greatly reduce his financial flexibility in coming years. The client’s business was profitable at the time of the SoA – but this was not a guarantee it would remain so.
As Justin Micale from the ATO recently stated, “the most common contravention [for SMSF compliance] relates to members having accessed their retirement savings early which is often reported as a loan to member or a payment standards breach … accessing the assets of the SMSF for any use where a condition of release hasn’t been met, even if it’s to support a member’s business, constitutes early access … we find the main drivers of regulatory contraventions are financial stress, poor record keeping and a lack of understanding of the rules.”
In the case of the client above, the likelihood of him experiencing financial stress would potentially increase after implementing the recommended advice due to having less resources available outside of super.
These issues and risks were not adequately highlighted in the SoA. It did contain standard warnings about the need to meet conditions of release – but there was no clear, concise and effective statement explaining the material reduction in the client’s non-superannuation assets.
If the adviser had better highlighted the issues relating to product replacement, i.e. the impact of the change of ownership from business to personal to superannuation, it is likely that he would also have been better able to highlight the “big picture” issues for the client.
On the positive side, the adviser’s file note did refer to the benefit of asset protection afforded by superannuation, and this was a genuine benefit of the strategy. That said, this was not identified as a key driver of the advice and was not specified as a client goal in the SoA.
Documenting third-party discussions and advice
The adviser had held water-cooler discussions with the client’s accountant, but none of the content of these were documented.
The scope of advice in the SoA did not refer to the accountant and explain the demarcation between the taxation or structural advice provided to the client by the accountant, and the financial advice being provided by the adviser. There was no evidence to support the assertion that the accountant recommended that company cash be used as the source of funds for a non-concessional contribution.
In any event, following the file review, the adviser confirmed with the accountant that the intention was for a complying (Division 7A) loan to be used to provide funds for the client to make the NCCs.
It is important to note, however, that the Australian Financial Complaints Authority has made it clear (e.g., in AFCA Decision 676803) that with respect to advice provided by third parties, an adviser is “required to bring an independent mind” to the client’s needs when preparing and providing personal financial advice services. In other words, notwithstanding that the adviser is not a taxation expert, he or she still needs to think through the issues at hand and not just accept de-facto direction from a third party.
Concentration risk
Whilst obtaining a present benefit it is not consistent with the Sole purpose test for superannuation, it is undeniable that there can be synergistic benefits for a client when a business owned by a client rents a commercial premises owned by the client’s superannuation fund.
However, in the case study above, that synergistic benefit was only available to the client as long as the business was successful, operational, and needed a commercial premises.
It also meant that there was a very big concentration risk for the client – in that everything depended on the business continuing to go well. The client would have a very low level of diversification of assets – which could also fall afoul of ATO monitoring.
Inadequate consideration of alternative strategies
The file showed minimal or no documented consideration of relevant alternative strategies.
For example, the business could have provided a related-party loan to the SMSF, instead of the client making NCCs to super. Similarly, if the client borrowed from the business, the funds could have been on-lent to the SMSF.
This would have limited the cost price of the property the client could afford, but would have meant $440,000 was not locked away for 24+ years.
A second alternative was that the client could have made the recommended $40,000 concessional contribution but then a much smaller initial NCC to super – for example $110,000 – and then utilised an LRBA to fund the difference between the purchase price and the available SMSF funds.
A third option was that the client could have purchased the building through a different ownership structure – for example a discretionary trust – given that he only had $100k in super in the first place.
This is not to say that any of these strategies were superior to the recommended strategy –but simply that in the circumstances, given the gravity of the changes being recommended for the client, options such as these should have been considered.
When implementing the advice, the client ended up purchasing a property for about $500,000, so an LRBA was not utilised, just contributions to super. If the client had been made aware of the full consequences of the recommended approach and also that he had other relevant options, he may have preferred to opt for a strategy such as utilising a related party LRBA.
The advice was rushed
The adviser moved the advice process along rapidly because the client was keen on purchasing a property, and the 30 June deadline for making contributions in the current financial year was only two months away.
However, if we had to identify an archetypal situation where care should be taken, advice should not be rushed and appropriate third-party professionals should be consulted, it would be with respect to large non-concessional contributions by a young person with limited financial resources to his or her superannuation.
It is a genuinely “irreversible” transaction and can have life-changing consequences, for better or worse.
To Be Continued
This illustrates why it is important to have both a high-level and a granular view of a client’s relevant circumstances when making recommendations about setting up an SMSF.
In the next Three Hit Tuesday, we’ll analyse aspects of the example case study in more detail, from three separate perspectives.
In the meantime, we invite you to review ASIC INFO 205 and ASIC INFO 206 about giving advice on SMSFs, think about Related party loans and then consider the above case study with relation to issues such as:
- Client informed consent
- Managing the conflict of interest vis-à-vis the referrer
- Estate planning
- Capacity for the client to obtain finance in future
- Asset protection
- Interaction with Licensee policies e.g., gearing
