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Super and death case studies part 3 – tax issues where BDBN directs death benefit payment of large property in-specie

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Three-part series

This article is the third in a three-part series setting out practical solutions to common issues in super, tax and estate planning, with a particular focus on the tax impact of payments to beneficiaries.

Paying death benefits in specie

Most modern SMSF trust deeds allow for lump sum benefits, including death benefits, to be paid in kind (or ‘in specie’) by transfer of an asset or assets from the SMSF to the beneficiary.

This is reflected under reg 6.01 of the Superannuation Industry (Supervision) Regulations 1994 (SIS Regs) which defines a ‘lump sum’, for the purposes of the payment standards under the SIS Regs, to include an asset.

Therefore, if a member wishes to direct a particular asset of the SMSF to be transferred to a specific beneficiary on their death, they can do so via a binding death benefit nomination (BDBN). This might be considered where, for example, the asset is used in the family business, and the member wants to direct the asset to an adult child who is closely involved in the family business.

What is often not fully considered as part of such a direction is the potential tax consequences of the transfer, particularly where:

  • the asset is carrying a large capital gain and is of significant value;

  • the asset is the main asset of the SMSF (i.e., the SMSF has very little liquidity); and

  • the recipient is not a death benefit dependant of the deceased member.

The below case study considers how these tax issues might arise, and how they can be addressed by proper planning.

Case study – tax issues where BDBN directs SMSF death benefit payment of large commercial property in-specie

Liane is the sole member of an SMSF. The main asset of the SMSF is a commercial property valued at approximately $5,000,000 (the Property). The SMSF has held the Property for many years, and the Property has a cost base of $1,000,000. 

The Property is leased to a related family business at commercial rates. 

Liane is in receipt of an account based pension from the SMSF ($2,000,000). The SMSF has a small amount of cash, but due to the ‘lumpy’ asset mix of the SMSF, the SMSF’s accountants are having trouble ensuring the rent flowing from the Property is enough to satisfy Liane’s minimum pension payments, as well as maintaining some liquidity in the SMSF.

Liane wants the Property to stay in the family upon her death. Liane makes a BDBN directing her death benefits in the SMSF to be paid to her adult daughter, Wendy, to be satisfied by way of in specie transfer of the Property to Wendy.

Liane dies and in accordance with Liane’s BDBN, the SMSF trustee transfer the Property in specie to Wendy.

Liane’s total balance in the SMSF on her death was $5,100,000, being represented by the value of the Property plus $100,000 cash.

Liane’s super (both pension and accumulation) is 50% taxable and 50% tax free component.

Tax considerations on payment of lump sum in specie death benefit

  • As Wendy is not a death benefit dependant, the SMSF trustee must withhold death benefit tax at a rate of 17% (including Medicare levy) on the taxable component of Liane’s death benefits. Based on a balance of $5,100,000, 50% of this will be taxable component ($2,550,000), meaning the SMSF trustee must withhold $433,500 tax on the death benefit payment.

  • A CGT event occurs for the SMSF when transferring the Property to Wendy, as there is a change in the beneficial and legal ownership of the asset. As the Property was not wholly supporting the payment of Liane’s pension, part of the net capital gain on transfer of the Property will be included in the SMSF’s assessable income for the year as follows (assuming no capital losses, deductions, franking credits etc):

    • SMSF is 39.2% in pension phase

    • $5,000,000 – cost base of $1,000,000 = $4,000,000 capital gain

    • Apply general 1/3 CGT discount: $4,000,000 x 1/3 = $1,333,333.33

    • $4,000,000 - $1,333,333.33 = $2,666,666.67

    • The non-exempt proportion (i.e., 100% - 39.2% = 60.8%) of the SMSF’s net capital gain included in the SMSF’s assessable income: $2,666,666.67 x 60.8% = $1,621,333.34

The $1,621,333.34 of statutory income from the transfer of the Property will be included in the SMSF’s assessable income and taxed at the usual 15% rate of tax. This results in a tax liability on the transfer of the Property as follows:

  • $1,621,333.34 x 15% = $243,200

  • Stamp duty may be payable by the transferee (exemption may be available depending on the jurisdiction).

  • The SMSF trustee therefore has a withholding tax liability of $433,500 and a CGT liability of $243,200 in relation to the payment of the in specie death benefit. The SMSF may also have other income tax liabilities (e.g. from earnings on assets in accumulation phase). However, as the Property was the main asset of the SMSF, the only assets remaining is approximately $100,000 in cash.

  • This places the SMSF trustee in an impossible position. It is obligated to transfer the property to Wendy but to do so will result in a tax obligation of $676,700 (plus other administrative costs). Given the SMSF doesn’t have sufficient funds to pay such tax, it effectively cannot comply with its obligations under the BDBN.

Possible solutions

  • The SMSF trustee is bound by the terms of the SMSF trust deed and Liane’s BDBN to transfer the Property as an in specie death benefit to Wendy. One option is for Wendy to disclaim the benefit under the BDBN, and then the SMSF trustee exercise its discretion as to how to pay Liane’s death benefits (including the form of the death benefits). For example, the Property could then be sold and the net proceeds (after payment of taxes and administrative costs) could be paid to Wendy.

  • The SMSF trustee could seek a direction from the Supreme Court that the Trustee could satisfy its obligation to transfer the Property partly by way of in-specie and partly by way of sale to Wendy (ie to give the SMSF sufficient funds to pay its liabilities).

  • As part of Liane’s succession planning, she could explore options for keeping the Property in the family while smoothing the tax impacts. For example, Wendy and others in the family could be admitted as members to the SMSF, and their contributions could be used to add liquidity. This liquidity could then be used to pay out Wendy’s death benefits instead of transferring the Property (in which case, the immediate CGT impact would be minimised), or to pay the SMSF’s tax liabilities on transfer of the Property as an in specie death benefit.

  • Liane could take the property out of her super fund before death and bequeath it to Wendy under her will. This would avoid the withholding tax but the SMSF would still require funds to pay the CGT. This could be achieved, for example, by turning off or turning down the pension.

Phil Broderick
Principal
T +61 3 9611 0163 l M +61 419 512 801  
E pbroderick@sladen.com.au    

Philippa Briglia
Special Counsel
T +61 3 9611 0174 | M +61 449 404 801
E: pbriglia@sladen.com.au

Jan Harnischmacher
Associate
T +61 3 9611 0158
E joh@sladen.com.au

Philippa Briglia