Insurance strategies with SMSF Limited Recourse Borrowing Arrangements
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Presentation slides from webinar presented by Aaron Dunn on 26 November 2013, about structuring insurance arrangements with limited recourse borrowing arrangements within a SMSF. Visit www.thesmsfacademy.com.au online store should you wish to purchase the webinar recording.
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Insurance strategies with SMSF Limited Recourse Borrowing Arrangements
- 1. Webinar: INSURANCE STRATEGIES WITH SMSF LIMITED RECOURSE BORROWING ARRANGEMENTS November 2013
- 2. HOUSEKEEPING • Attendees are muted for the session • Presentation slides can be accessed from the materials tab or URL link in chat box • You can type questions to the presenter from your screen • Q&A Podcast will be made available of all questions following webinar • Webinar recording • • Available to SMSF Academy members within the resource library Available to purchase from online store following the session
- 3. GENERAL ADVICE WARNING This presentation provides general advice only. No direct or implicit recommendations are given in this presentation. This means that the general advice provided has not been prepared taking into account any individual’s financial circumstances (i.e. investment objectives, financial situation and particular investment needs). The SMSF Academy Pty Ltd believes that the information in this presentation is correct at the time of compilation but does not warrant the accuracy of that information. Save for statutory liability which cannot be excluded, The SMSF Academy disclaims all responsibility for any loss or damage which any person may suffer from reliance on this information or any opinion, conclusion or recommendation in this presentation whether the loss or damage is caused by any fault or negligence on the part of presenter or otherwise. © The SMSF Academy, 2013
- 4. EXPLORING THE ISSUES Borrowing undertaken for single acquirable asset (typically property) LRBA loan supported from income and contributions by member(s) - e.g. salary sacrifice Fund exposed to death of disability of members – reduced cash flow, insufficient liquidity Forced sale – reduced sale price, CGT event, wind-up, impact on related business? HOW DO YOU MANAGE THE ASSET CONCENTRATION RISK?
- 5. STRATEGY THE STRATEGY • Trustee purchases life/disability insurance – Extinguish debt and provide liquidity to pay death benefits • Methodology varies depending on type of fund – Relationship between members – Ability to pay death benefit as an income stream • Range of tax & insurance issues
- 6. Webinar – Insurance strategies with SMSF LRBAs TAX DEPENDANTS
- 7. HOW IT WORKS TAX DEPENDANTS • • SMSF John & Jane Citizen are married and members of Citizen Family Super Fund (“SMSF”) Account Balances: • • Property $500k John - $100,000 Jane - $50,000 John $100k Jane $50k • SMSF loan of $350,000 to acquire property valued at $500,000 • incl. ($350k loan) SG contributions of $6,000 for John and $5,000 for Jane p.a. Assumptions: Net rental yield 3.6%, loan interest rate 6% (interest only), both members are under 55
- 8. HOW IT WORKS CASH FLOW POSITION Rent Concessional contributions $11,000 Total inflows SMSF $18,000 $29,000 Interest 2 x life policies $350k Property $500k incl. ($350k loan) Operating costs ($21,000) ($2,000) Life premiums Total outflows * Insurance premiums of $500 per member deducted from respective member accounts John Jane ($1,000)* ($24,000) Super Fund Tax ($750) Net cash flow (surplus) $4,250
- 9. Insurance strategy Requirement to consider a contract of insurance for one or more members Insurance Premiums Need to give consideration where premiums are to be deducted from? Tax deductibility Deductible to extent proceeds are aligned to satisfying a condition of release Insurance proceeds How are the insurance proceeds to be applied? Has discretion been provided for the Trustee? www.paratus.com.au
- 10. HOW IT WORKS CASH FLOW POSITION Rent SMSF Concessional contributions Total inflows 2 x life policies $350k Property $500k incl. ($350k loan) Interest Operating costs Life premiums $18,000 $5,000 $23,000 ($0) ($2,000) ($0) Pension Total outflows John $450k Jane Accumulation $50k Death Benefit Pension $450k ($18,000) ($20,000) ($870)* Net cash flow (surplus) * Assume 95% ECPI tax deduction Tax $2,130
- 11. SUMMARY Insurance used to extinguish debt Death benefit paid as a tax effective income stream Avoided forced sale of property ISSUES? Governing rules must permit insurances and income streams Premiums must be deducted from member accounts Future cash flow obligations for the fund? Insured amount required of $700k – alternatives?
- 12. Webinar – Insurance strategies with SMSF LRBAs NON-TAX DEPENDANTS
- 13. HOW STRATEGY WORKS NON-TAX DEPENDANTS SMSF STRATEGY OPTIONS 1 2 Un-associated members (e.g. business partners) Or Parent/Adult child relationship Reserve allocation strategy Member allocation strategy 3 Member-cross insurance strategy
- 14. NON-TAX DEPENDANTS • • $120k each Acquired $1,000,000 commercial property, using LRBA and leased back to business • SMSF loan of $655,000 to acquire property • Property $1,000,000 Less: loan ($655,000) Cash $15,000 Each member has $120,000 account balance • SMSF Curly, Larry & Moe are unrelated business partners and established the Three Stooges Super Fund (“SMSF”) $10k of super contributions made by each member Assumptions: Net rental yield 4.6%, loan interest rate 9% (P&I); negligible interest on cash account
- 15. EXAMPLE - NO INSURANCE CASH FLOW POSITION Rent Concessional contributions Property $1,000,000 Less: loan ($655,000) Cash $15,000 $30,000 Total inflows SMSF $46,000 $76,000 Interest ($58,000) ($8,000) Operating costs ($2,000) Tax $120k each and $10k of annual contributions Principal ($2,400) Total outflows Net cash flow (surplus) ($70,400) $5,600
- 16. EXAMPLE – NO INSURANCE REVISED CASH FLOW POSITION Rent Concessional contributions Property $1,000,000 Less: loan ($655,000) Cash $15,000 $20,000 Total inflows SMSF $46,000 $66,000 Interest ($58,000) Principal ($8,000) Operating costs ($2,000) Tax $120k each and $10k of annual contributions Total outflows Net cash flow (shortfall) ($900) ($68,900) ($2,900)
- 17. WHAT TO DO? • Insufficient liquidity to pay death benefit – Make NCCs of $60k each? – Increase contributions to $15k each? • Likely to result in forced sale RESERVE ALLOCATION STRATEGY Take out three life & TPD policies over each member Value of each policy $775k ($655k + $120k) Premiums paid from fund general expenses Allocate proceeds to fund reserves
- 18. RESERVE ALLOCATION STRATEGY REVISED CASH FLOW POSITION Rent Concessional contributions 3 x life policies $775k $30,000 Total inflows SMSF $46,000 $76,000 Interest Property $1,000,000 Less: loan ($655,000) Cash $15,000 Principal ($8,000) Operating costs ($2,000) Insurance premiums $120k each and $10k of annual contributions * Insurance premiums deducted from the general expenses of the fund (not member accounts) ($58,000) Tax Total outflows Net cash flow (surplus) ($3,000)* ($2,400) ($70,400) $2,600
- 19. RESERVE ALLOCATION STRATEGY REVISED CASH FLOW POSITION SMSF Rent Concessional contributions Total inflows Property $1,000,000 Less: loan ($655,000) Cash $15,000 $46,000 $0 $46,000 Interest ($0) Principal ($0) Operating costs Death benefit paid as Lump Sum $120k $120k each and $10k of annual contributions Additional $655k of cash remains in fund reserves. Payout outstanding loan. ($2,000) Tax ($6,600) Total outflows ($8,600) Net cash flow (surplus) $37,400
- 20. RESERVE ALLOCATION STRATEGY 24% member 76% reserves Transfers from reserve: Allocations subject to concessional contribution cap unless: • Fair & reasonable manner to all members; and • Less than 5% of value of member’s interests at time of allocation Insurance is cost prohibitive? • • Consider taking insurance policy to the extend the loan is reduced to a manageable level E.g. insurance of $338,000 ($120k + 1/3rd of debt)
- 21. SUMMARY Insurance used to pay benefit and extinguish or reduce debt Avoided forced sale of business property ISSUES? Results in large reserve of $775k – potential crediting issues* Premiums not deductible within the fund Outcome appears inequitable? * $362,500 excessive (per member) and included within individual assessable income, with amounts taxed at MTR, plus concessional contributions subject to Div 293 tax.
- 22. MEMBER ALLOCATION STRATEGY Trustee acquires life & TPD policy on member and allocates any proceeds to member accounts Considerations: • Governing rules allow trustee to allocated proceeds to member accounts • Must be on fair & reasonable basis (SISR 5.03) Includes deceased member’s account Premiums paid from general fund expenses Alternatively, do you consider holding insurance outside of the fund?
- 23. MEMBER ALLOCATION STRATEGY REVISED CASH FLOW POSITION Rent $30,000 Total inflows 3 x life policies $775k $46,000 Concessional contributions SMSF $76,000 Interest Property $1,000,000 Less: loan ($655,000) Cash $15,000 Principal ($8,000) Operating costs ($2,000) Insurance premiums $120k each and $10k of annual contributions * Insurance premiums deducted from the general expenses of the fund (not member accounts) ($58,000) Tax Total outflows Net cash flow (surplus) ($3,000)* ($2,400) ($70,400) $2,600
- 24. MEMBER ALLOCATION STRATEGY SUMMARY: • SMSF Property $1,000,000 Less: loan ($258,000) Cash $15,000 • • • Insurances used to pay death benefit and partially clear debt - $258k shortfall Potentially avoids forced sale No reserve created Larger insured amount needed to get same result • • Curly $378k Larry $378k Moe $378k Death benefit paid as Lump Sum $378k Part of proceeds paid to deceased beneficiaries • • $1,162,500 x 3 policies Intended outcome? Partial tax deduction on premiums
- 25. CROSS-MEMBER INSURANCE STRATEGY Policy over one member held in a segregated investment pool for another member Considerations: • Premiums are deducted from relevant benefits • Proceeds treated like investment income and allocated to relevant member benefit ATO confirmed: • Ok to cross-insure within SMSF • Allocation on fair & reasonable basis • Allocation not from reserve Ref: ATO Super Technical Sub-group minutes, March 2013
- 26. CROSS-MEMBER STRATEGY SMSF Property $1,000,000 Less: loan ($655,000) Cash $15,000 Insured amount = 50% of loan + 50% of alternate member balances Curly – cross-member policies of $387,500 over Larry & Moe Larry – cross-member policies of $387,500 over Curly & Moe Moe – cross-member policies of $387,500 over Curly & Larry
- 27. CROSS-MEMBER STRATEGY SUMMARY: • SMSF Property $1,000,000 Less: loan ($0) Cash $15,000 • • • • • • Debt extinguished and death benefit paid Avoided forced sale No shortfall No reserve created Premiums not deductible Equitable? Total insured amount $2.325m • Curly $507.5k • Larry Moe $507.5k $120k Death benefit paid as Lump Sum $120k Same as reserve allocation strategy Relevant even where no borrowing
- 28. SUMMARY OF OUTCOMES STRATEGY Proceeds allocated to deceased member Premiums deducted from member accounts Reserve created Premiums deductible MEMBER ALLOCATION % X X % RESERVE ALLOCATION X X X MEMBER CROSS-INSURANCE X X X
- 29. FROM 1 JULY 2014 ANY INSURANCE POLICIES MUST ALIGN TO CONDITION OF RELEASE Grandfathering of existing insurance arrangements established prior to 1 July 2014 Life insurance proceeds exempt from CGT (s.118-300, ITAA 1997)
- 30. 3 KEY TAKE-AWAYS TODAY… Consider how to best structuring insurance prior to enter into the arrangement – what are the risks? How do you best manage those risks? Understand the relationships of fund members and how death benefit payments must be dealt with – what role will insurance play in managing the risks? Ensure that the fund’s governing rules allow for the insurance strategy to be implemented and comply with the operational requirements of the various strategies
- 31. Webinar Q&A Podcast in followup email Any final questions? Follow up email with survey for your valuable feedback www.thesmsfacademy.com.au/webinar-survey
- 32. NEXT WEBINAR Thursday, 12th December 2013 12:00pm, AEDST CHANGING FACE OF SMSFs • • • Proficient Latest technical & regulatory update on issues impacting SMSFs Included for members Non-members: $99 (incl. GST) – Keep an eye out for special offers! 11:00am 9:00am 11:30am 12:00pm 12:00pm 12:00pm
- 33. Aaron Dunn The SMSF Academy www.thesmsfacademy.com.au SMSF Dunn Right, http://thedunnthing.com Follow, Like or connect with Aaron and the SMSF Academy: FOLLOW, LIKE OR CONNECT WITH US
Editor's Notes
- The importance of discretion in how to deal with insurance proceeds.Raised within NTLG Super Technical sub-group questions where governing rules allow the member’s death benefit to only include some of the insurance proceeds.
- In the event of John’s death, the fund would receive cash proceeds of $350,000. Given the premiums in relation to the policy were deducted from John’s account balance, the proceeds would need to be allocated towards the death benefit interest. Jane as a tax dependant beneficiary could commence a pension with the proceeds of the death benefit in her own name. With the proceeds received from the life policy, this amount could be used to extinguish the debt, effectively leaving the fund in the same net position.The fund’s cash flow would now be shown in the slide above, with the main differences being the:Removal of the interest expense ($21k)Obligation to take pension payments ($18k)Life insurance premiums can cease for Jane ($500)The fund would remain cash flow positive and Jane is in receipt of an income stream to support her lifestyle requirements.
- The commercial building is negatively geared but for the contributions being made by the three business partners that make up the shortfall.
- The risk in running this strategy without any insurance is that should anything happen to one of the business partners (e.g. Moe), this would put a significant strain on the arrangement and immediately places the remaining partners into a negative cashflow position. To cater for this, Curly and Larry would need to look to increase their contributions to $15k to support the now shortfall – this would be dependent upon whether they are able to do this?? Alternatively, they could seek to move from P&I back to interest only for a period of time, subject to the bank allowing them to do so.However, a more significant problem arises… the fund has a liability to pay Moe’s death benefit as a lump sum to his nominated beneficiary/ies.To retain the property, Curly and Larry would need to contribute a combined $120k of cash (i.e. $60k each) to enable the death benefit to be paid. Otherwise, they are likely to have to enter into a forced sale, which would have consequences for their business. Consideration would also need to be given to the validity of the SMSF if the asset sale was required.
- Given that the fund only has one asset and given the inadequate cashflow in the fund after Moe’s death, the fund would most likely be required to enter into a forced sale of the property.The alternative is to take out sufficient insurances to extinguish the debt (or reduce to a manageable level) and provide the liquidity to pay out the death benefit. In this case, the total insurances are $775k multiplied by the 3 members.
- The commercial building is negatively geared but for the contributions being made by the three business partners that make up the shortfall.
- Where Moe dies and the policy triggers in the fund, the proceeds in accordance with the discretion of the trustees can be retained and allocated to fund reserves. The proceeds can then be used to clear the existing debt and pay the death benefit to Moe’s beneficiaries.The fund has no debt and no future commitment by the remaining member’s to support the cash flow payments. However, it is important to note that the benefits are held in fund reserves – they have not increased Curly & Larry’s benefits. This has resulted in 76% of the fund assets now being held within reserves, with only 24% attributable to the remaining fund members. All allocations from fund reserves must now meet the requirements of 292.25.01 of ITAR 1997, being:the amount is allocated, in a fair and reasonable manner: (A) to an account for every member of the complying superannuation plan; or (B) if the member is a member of a class of members of the complying superannuation plan, and the amount in the reserve relates only to that class of members--to an account for every member of the class; andthe amount that is allocated for the financial year is less than 5% of the value of the member's interest in the complying superannuation plan at the time of allocation;
- In summary, the reserve allocation strategy with insurance proceeds achieves the goals or avoiding a forced sale. However, the fund now has a substantial reserve of $775k, which will be subject to the stringent allocation requirements each year in accordance with Reg. 292.25.01 of ITAR 1997. Crediting could be made within the concessional contributions limits of the members each year (ie. $25k), however this is a significant period of time to allocate out these amounts. This could pose future problems in the event of business departure, sale, etc.An allocation in one financial year could result in a substantial tax bill for the remaining members, with the excess concessional contributions now automatically included within the assessable income of the individual. As the allocation is in excess of $300,000, the low-tax contributions for the financial year (i.e. $25k) will also be subject to the Div 293 tax (additional 15% contributions tax).
- What are some of the alternatives to the use of fund reserves? Could you potentially allocate proceeds to member accounts?If so, the policy would be treated in a similar way to investment income (proceeds) and would need to be allocated on a reasonable basis, as outlined within SISR 5.03. This should also include to the deceased member’s account. In this case, the death benefit would increase which would leave less to repay the debt and would effectively involve Curly and Larry paying premiums for a policy which will in part end up benefitting Moe’s beneficiaries (which they might not want).
- The commercial building is negatively geared but for the contributions being made by the three business partners that make up the shortfall.
- Where Moe dies, the insurance policy is triggered and the fund receives an additional $775k of proceeds. Referring to the NTLG Super Technical minutes of June 2012 and March 2013, the scenarios discussed as technical member questions suggest that such proceeds where treated must be allocated fair & reasonably in accordance with SISR 5.03 between all members of the fund. This includes Moe as a deceased member, whereby the proportion is to be applied to his death benefit to be paid to his beneficiaries.As a result of the inclusion of investment returns to Moe’s death benefit, this leaves a shortfall in extinguishing the loan.As part of the proceeds have been applied to the deceased member’s account, the fund should be entitled to a tax deduction for the premium to the extent that the proceeds applied to a benefit where a cashing condition has been met (i.e. death) – see Schedule 1 of SIS Regs.
- What are some of the alternatives to the use of fund reserves? Could you potentially allocate proceeds to member accounts?If so, the policy would be treated in a similar way to investment income (proceeds) and would need to be allocated on a reasonable basis, as outlined within SISR 5.03. This should also include to the deceased member’s account. In this case, the death benefit would increase which would leave less to repay the debt and would effectively involve Curly and Larry paying premiums for a policy which will in part end up benefitting Moe’s beneficiaries (which they might not want).
- The commercial building is negatively geared but for the contributions being made by the three business partners that make up the shortfall.
- Where Moe dies, the insurance policy is triggered and the fund receives an additional $775k of proceeds. Referring to the NTLG Super Technical minutes of June 2012 and March 2013, the scenarios discussed as technical member questions suggest that such proceeds where treated must be allocated fair & reasonably in accordance with SISR 5.03 between all members of the fund. This includes Moe as a deceased member, whereby the proportion is to be applied to his death benefit to be paid to his beneficiaries.As a result of the inclusion of investment returns to Moe’s death benefit, this leaves a shortfall in extinguishing the loan.As part of the proceeds have been applied to the deceased member’s account, the fund should be entitled to a tax deduction for the premium to the extent that the proceeds applied to a benefit where a cashing condition has been met (i.e. death) – see Schedule 1 of SIS Regs.