There are SMSF tips and traps that you need to be aware of. What are these, and what may happen for any of them? Find out in this article.
If you manage your SMSF or Self Managed Super Fund, then you probably already know that there are a plethora of rules and regulations that trustees have to abide by when they are making decisions for their SMSF.
Unfortunately, some trustees try to do things themselves and in some cases get things seriously wrong. Some mistakes can be very costly so it’s important that you, as a trustee of your SMSF, know the traps and avoid them at all costs.
The following are a few case studies taken from real-life examples. Learning the lessons from these case studies should hopefully help you avoid them down the track.
IN THIS ARTICLE
SMSF trustees are accountable
SMSF funds are not your money
The sole purpose test
Other common mistakes
One of the first things that an auditor will look at in an SMSF audit is that all the assets of the SMSF are held in the name of the superfund. Here is the story of an SMSF trustee who got this wrong from the very start:
Steve* had just started his SMSF as a result of a property guru convincing him that it would be a good idea to buy a residential SMSF property investment. They had charged him very high fees to set up his SMSF and organise the purchase of a property. Steve had rolled over his industry super fund into his SMSF and used these funds for the deposit on the property but he had signed a contract on the property in his name and to make matters worse, had taken out a loan in his name to fund the purchase.
It came time for Steve to organise the first year’s annual compliance work (financials and tax return) for his new superfund. Unfortunately for Steve, there was no way to lodge a tax return for his SMSF without the fund becoming non-compliant.
Steve had two possible solutions to solve his ownership problem. One solution was to get a personal loan for the amount of the deposit paid to purchase the property and pay that money back into the SMSF. The other alternative was to visit his bank, explain the issue and request that the loan be transferred to the SMSF’s name and at the same time get the ownership of the property transferred to the SMSF as well.
There would be significant costs involved in the second option including the costs to set up a company and bare trust and the additional stamp duty to change the ownership. The costs of ignoring the issue and not adopting either of the solutions could potentially be hefty fines from the ATO as well as possibly the loss of up to 47.5% of the value of the fund’s assets
However, if Steve could demonstrate that while he had done the wrong thing in using SMSF funds to fund a personally held asset, he had realised his error and fixed the problem then the ATO would possibly be more lenient and the financial cost to the super fund itself could be mitigated. Again, unfortunately for Steve, despite advice and assistance from his accountant, he was unable to deal with the problem emotionally and refused to deal with the problem promptly, so much so that even after another 18 months the problem still wasn’t fixed.
- Always seek advice from an expert before you set up an SMSF.
- Explore the costs involved before you engage someone to help you to make sure you aren’t being ripped off.
- Seek advice before making a major purchase or investment in your SMSF– the ramifications of getting it wrong can be expensive to fix.
- If you make a mistake, fix it as soon as you can, and tell the ATO about it. The ATO have special channels open to SMSF trustees to report potential non-compliance issues. They want trustees to be compliant and they help as much as they can where trustees are trying to fix the issues and do the right thing.
SMSF TRUSTEES ARE ACCOUNTABLE
Fred* had been ‘managing’ his SMSF for over 8 years but had not organised for the compliance work to be undertaken for the last six years.
He arrived at his accountant’s office with boxes of folders and had quite a lot of supporting documents filed in various places. After hours of trying to marry up supporting documents to the transaction in and out of the bank account the accountant finally discovered that the client had used his SMSF money to fund a 1/3 share of a property development deal.
In and of itself, this can be done by an SMSF. However, some issues were identified that caused a great deal of extraneous work and costly fixes for the SMSF:
- There was no written agreement anywhere on file and he was unable to provide one. The 1/3 ownership was only evidenced by references to 1/3 payments and 2/3 reimbursements on the bank statements.
- The SMSF bank account was used to pay for up to 100% of expenses relating to the development and on occasion received money from the other 2 ‘partners’ to reimburse the SMSF for their share of the development expenses.
- There was no supporting documentation provided for the development even though the SMSF bank account was used to fund it. Fred’s view was that other people looked after all that so he believed that the SMSF didn’t need any supporting documents.
- The SMSF’s proceeds from the sale of the property were only banked 12 months after the actual sale but there was no contract of sale provided to support this.
In addition, Fred had:
- Loaned his son money from the SMSF and
- Taken money from a friend to ‘invest’ in shares on his friend’s behalf in the SMSF and then paid that money back in bits and pieces over a 2 or 3-year time period.
Very luckily for this client, the issues were largely solved by completely ignoring the fact that SMSF money was used to bankroll a property development. As there was no evidence of ownership, it was easier to treat all the incoming cash as either personal super contributions and all the outgoing cash as SMSF pension payments. However, this solution only worked because Fred had:
- Reached preservation age and could technically withdraw funds from the super fund; and
- Was also still working so was eligible to contribute to the SMSF.
If he hadn’t met both of these criteria he would have breached the rules and his fund would have been non-compliant. Luckily, he only got away with having to pay fines for late lodgement and a very big accounting bill.
- Clear ownership of assets is a must for SMSF investments.
- If an SMSF pays for expenses that aren’t related to the SMSF then these either need to be reimbursed or treated as a lump sum or pension withdrawal if possible.
- An SMSF can’t lend money on an ad-hoc basis, especially to family members. If there is no agreement in place it could be a breach of the arm’s length rules and potentially the in-house asset rules. All loans must be on an arm’s length basis – this means that there needs to be a formal loan agreement with a set payback date and there must be market-rate interest charged.
- An SMSF can’t borrow without a limited recourse borrowing arrangement in place and certainly can’t borrow from a friend to invest in a range of shares.
- Data entry costs you money. Every line item in an SMSF bank statement has to have a corresponding entry in the bookkeeping software used to produce the end-of-year financials and tax return – this is an audit requirement. So whereas an accountant can sometimes do end-of-year summary transactions for a small business this isn’t the case for an SMSF. This means that the more times you transfer money between accounts, make super contributions, take out money, and buy and sell shares – the more you are going to be charged in fees. You needn’t let this restrict the way you operate your SMSF but think about whether what you are doing is necessary. In this case study, the client treated his SMSF bank account as his account – there were hundreds of small withdrawals for a range of building costs, rates, and family loans, each of which had to be entered and accounted for separately – time-consuming and very costly.
- Every transaction should have some form of supporting documents to satisfy audit requirements. These include documents like dividend statements, rates notices, contract notes and receipts for SMSF-related expenses like accounting.
SMSF FUNDS ARE NOT YOUR MONEY
James’s* SMSF had not lodged a tax return for 5 years and in the last return that was lodged, the SMSF was fined 46.5% of the value of the fund because James had taken out funds to keep his business afloat even though he didn’t meet any of the conditions of release.
There were four members of the fund, James and his wife and their two sons. James had not told any of the other 3 members of his actions in taking out the funds to provide to his business or of the ATO’s subsequent penalties.
The SMSF’s returns and financials were bought up to date. However, the fund wasn’t able to be closed down due to the large debt owing to the ATO. Even with selling the SMSF’s one asset, there was still a considerable shortfall owing to the tax office and of course, there were no funds left for any of the members. The ATO could potentially target the assets of the trustees outside of super.
- All trustees must be involved in decision-making, as all trustees are jointly responsible and liable.
- Your member balance in an SMSF is not your money to do with whatever you like – there are rules surrounding how and when you can access your funds.
- Always ask for advice if you are unsure what you can and can’t do in your SMSF.
THE SOLE PURPOSE TEST
The value of Brian’s* SMSF was down to $280,000 from about $600,000 the prior year. Brian had invested in 2 speculative mining companies, one of which had stopped trading and one had fallen in value by about 90%. The remaining assets in the SMSF were held in cash.
The accounting for Brian’s SMSF was very straightforward. There were no issues with bank statements or supporting documents as it was all provided. Brian even asked for advice on how to contribute as much money as possible to fund in the current year. This was easy for the accountant to provide advice on – a mix of concessional (he was self-employed) and non-concessional using the bring-forward rule.
Brian then proceeded to let the accountant know that he intended to trade Forex with the contributions. Let’s be clear here, accountants are not able to provide any financial-related advice so have to be careful how they approach situations where they feel uncomfortable with how the client is considering managing his fund. All the accountant could officially do was stress the importance of the sole purpose test and how the investment strategy needed to match the assets held by the fund.
- Always ask if what you are doing or is what you are investing in going to meet the sole purpose test and what is your reasoning.
- Make sure your fund is diversified.
- Make sure you consider risk as part of the SMSF investment strategy and in the day-to-day investments the fund makes.
OTHER COMMON MISTAKES
The following are a list of mistakes that are easy to make but if you know the basics of the SMSF rules, which you are obliged to know as an SMSF trustee, then they are easy to avoid:
Cashflow in retirement
With the increasing trend of purchasing property in an SMSF, cashflow in retirement, if the pension is supported with underlying property assets, can become an issue. If there are no other assets to pay a pension other than property, what are the trustees going to do when the minimum withdrawal rate is higher than the rent received? If minimum pension payments aren’t met, pension mode may cease or decrease significantly and if you have to sell a property then capital gains may have to be paid on part or all of the gain.
Short term loans to the fund
We touched on this earlier in one of our case studies but another example is when the super fund needs a short term loan to cover an expense or a deposit. Trustees might think that loaning funds to the SMSF and paying them back when funds are available is ok, but the practice is fraught with danger and not encouraged. If money put into the fund is not repaid within a reasonable timeframe it would need to be treated as a contribution and couldn’t be reimbursed.
Paying SMSF expenses from personal accounts
This is not best practice and is not encouraged. A better way would be to ask for bank details and do a bank transfer or if all else fails write a cheque. If there is absolutely no way of avoiding using a personal credit card as some suppliers only have a single method of payment then the solution is as soon as practical the SMSF must reimburse the member for the payment of the SMSF expense and a file note or minute made of why the member had to pay for the expense personally. Where it gets problematic is when the trustee forgets to reimburse themselves for the expense.
In this case, the expense has to be treated as an optional contribution and cause problems if a member has already reached their contribution limits. It can also mean that the SMSF loses out on a legitimate tax deduction if the trustee is unable to provide a receipt.
Not drawing down minimum pension payments
If you have a pension, you know that there is a minimum percentage you have to draw which is based on your age and the starting balance of your pension account. Withdrawals need to be managed and if the minimums are not met this causes a problem. A pension has to be commuted, a new smaller amount pension has to be backdated and commenced, and an actuarial certificate has to be paid for to work out what’s taxable and what’s tax-exempt all for the sake of not managing the withdrawals. This issue is now compounded because the ATO has moved to a real-time reporting regime so this solution may not work in future as the ATO will have to be notified of pension changes within certain timeframes.
If you have read the case studies and the costly mistakes and are thinking, it’s all too hard and dangerous, then please be reassured that it needn’t be. With just a few simple guidelines in place that you impose yourself, a basic understanding of the ATO rules and asking for advice from your accountant, managing your SMSF needn’t be a major problem.
*Names have been changed
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.