A Leading Member Case Study “The mission of a Leading Member SMSF is to look after and provide for generations of the bloodline of the originating Leading Member of the family SMSF. It is the highest calling and turns an SMSF from a simple investment vehicle into a multi-dimensional environment to protect and grow the superannuation wealth and benefits of members.” Grant Abbott, author of the Guru’s Guide to SMSFs

1. The Royal Solution

We have been through the various types of SMSFs, including a DIY fund, a common or average SMSF, a Family SMSF and now, above and beyond all of them is the Leading Member SMSF. Simple, secure, effective and a way of putting a moat around family wealth and control of family investments. It ensures, through the control of various family structures and wealth by a succession of Leading Members that bloodline or lineage is protected and, in some cases, are the only parties to any distribution of income or benefits from these structures.

LightYear Docs is the only document and strategy provider that offers such structures including Family Trusts, Leading Member SMSFs and also Lineage Wills, the time has come for many Australians to create and build their Leading Member castle.

And the inspiration?

We have to look no further than the current British Crown and its descendant bloodline. Starting with the Leading Member of the Crown, Queen Elizabeth II, the lineage passes to the next in line, in this instance Prince Charles if he remains alive at the time of the Queens death.

Failing that, it will pass to Elizabeth’s grandson, Prince William – a secure lineage if there ever was one. And unchallengeable. You certainly wouldn’t hear Prince Andrew complain or challenge the passing of the royal power to Prince William if Charles was not alive or able to be a successor to the Queen. And, who remembers the other Prince – Prince Edward? He is still bloodline but not a leading member of the Royal

Family.

And where does the latest addition Meghan Markle fit? In bloodline or lineage terms, she is nowhere but her child Archie will be as he is bloodline.

And, so it is with a Leading Member SMSF and of course a bloodline or lineage Will. More than a Family SMSF, a safe and secure environment for a bloodline generation after generation. And with six members to be allowed into a SMSF, the Leading Member SMSF is a great tool.

Let’s start to look at what makes up a Leading Member SMSF.

2. Who and what is the Leading Member and why?

An SMSF under section 17A of the SIS Act 93 consists of 4 members, all of whom must be directors of a corporate trustee. While we are here, a Leading Member SMSF, like the Royal Family lasts for generations which means we need a Trustee that stands the test of time, hence a corporate trustee. But not any corporate trustee, a special purpose Leading Member SMSF Corporate Trustee (“LMSCT”). The foundation of this special, special purpose SMSF Corporate Trustee is that the Leading Member (see below) owns all the shares and thus ultimately controls the SMSF. It is similar to the appointor of a Discretionary Trust or for those using the LightYear Docs Discretionary Trust, the Leading Appointor. Importantly when the Leading Membership transfers because of the death or mental incapacity of the Leading Member, the outgoing Leading Member’s shares are automatically cancelled, and new shares are issued to the incoming Leading Member.

So, who is the Leading Member?

This is the person who controls the Fund. They have power to appoint and remove members, ensure any death or other benefits only go to the Leading Member’s bloodline, can veto any Board decision of the corporate trustee if it runs counter to protecting lineage.

Let’s look at the Lightyear Docs Leading Member SMSF Deed – www.lightyeardocs.com.au to delve into this key feature of a Leading Member SMSF1.

Simple and sweet and a process that can be achieved in a similar vein in a Family Trust with the Appointor passing to Successor Appointors who are also the same lineage as the Appointor of the Trust.

Like the Appointor, the Leading Member of the Fund controls the goings-on in the Fund. Of course, the other Directors have a vote on the Board but at the end of the day, the Leading Member has the power to appoint and remove members and the Trustee. And as noted above in any Board meeting the Leading Member has a power of veto.

1 Can you imagine what the British Royalty would be like without a Leading Member. Every rag tag, genetically-tied member of the Royalty would make a claim. Warring factions, and with all that money, power, property and loot at stake, it would take centuries for the courts to rule on any claim. But then again, a Court does not have power over the throne so bear arms it would be.

“The Leading Member is the initial person who is hereby provided with the power to appoint and remove a Member or Trustee and is appointed as the Leading Member of the Fund. When the Leading Member no longer has legal or mental capacity or dies, the next Leading Member is to be the that person previously nominated in writing by the Leading Member as the successor Leading Member and bloodline of that Leading Member. If no such nomination, the eldest bloodline child of the Leading Member who is a Member of the Fund is to become Leading Member and if none, the Member the Trustee so appoints. The process of Leading Member succession is to continue on indefinitely.”

Warning: There is no member application process for a Leading Member SMSF. It is a process of appointment of a lineage member to the Fund. Of course, they need to consent to their being a member and importantly, agree to abide by the Governing Rules of the Fund and the wishes and desires of the Leading Member. It is their choice and more importantly, their responsibility to protect the castle. If the proposed member is not up to it, then they should not join. Simple! And any member may also be terminated from the Fund, for example, where they separate from their spouse and endanger the Family SMSF wealth. The Leading Member may terminate the Member and bring them back in post separation. There is a long line of precedent for termination of Members in employer super funds where a member is no longer employed by the contributing employer.

3. But Section 17A requires all Members to be Directors?

Section 17A indeed requires all Members to be Directors, provided they have legal capacity. But like any company not all Directors have to have an equal vote. On some Boards, a Director may represent a major shareholder and have sway over key decisions of the company and the Board. In other circumstances, each Director may have an equal vote with a Chairman holding a casting vote. Yet in others, where a company is run across multiple jurisdictions, a Director from that jurisdiction may hold the casting or only vote for matters relating to that jurisdiction.

Importantly the Constitution of a LightYear Docs LMSCT provides:

a) The Leading Member with the final vote or veto on who can be appointed as a member of the Fund;

b) The Leading Member has the final vote or veto on who can be removed as a member of the Fund. This is vital where a bloodline member becomes bankrupt or divorced;

c) A member of the Fund seeks to run their own separate investment strategy in their Fund and desires to acquire a residential property under a commercial LRBA. The member as Director can be provided with the power to make decisions, such as repairs and renovations to the property provided such actions do not breach the Superannuation Laws. Although, at all times, the Leading Member has the power to veto;

d) On the death of a member of the Fund, the member has put in place a set of binding directions (a SMSF Will) that has been signed and executed by the Member and the Leading Member of the Fund. The SMSF Will provides for the Member’s executor to be appointed as a Director of the BSCT under the condition that only that Director has the power to deal with the distribution of death benefits under the deceased Member’s SMSF Will.

e) A Member goes overseas and provides an Enduring Power of Attorney to the Leading Member, the Leading Member takes full control of the investment strategy and the making of investments for that Member while they remain overseas.

There are so many more instances where power and looking after the specific needs of Members, the Fund, investments, insurances and the like, where the simple one vote per Director does not fit within a Leading Member SMSF. Remember the mission of a Leading Member SMSF is to look after and provide for generations of the bloodline of the originating Leading Member of the family SMSF.

Unlike other SMSFs the overriding theme is “Safe, Certain and Secure”.

4. Leading Member SMSFs and SMSF Advising

“If you are not doing bloodline planning for your client, you are not thinking beyond the spouse. At so many of my seminars I ask the question – is it important that your money and assets stay within your bloodline? And you know what? 99% of the attendees put their hand up and the 1% who don’t – don’t have bloodline or don’t understand the question. Then I look at their SMSF and wills and bloodline is nowhere to be seen. Whose fault is that? Why

is this happening in million and multi-million-dollar SMSFs? Something is going seriously wrong in SMSF adviser land.” Grant Abbott, author of the Guru’s Guide to SMSFs

The Financial Adviser Standards and Ethics Authority (“FASEA”) has laid down competency standards that an adviser must meet in order to provide advice on an SMSF. These standards were drafted in 2004 and cover the following core competencies:

• FNSASICU503 Provide advice in Superannuation

• FNSSMS601 Provide advice in self-managed superannuation funds

• FNSIAD502 Provide appropriate and timely information and advice to clients

• FNSSMS603 Apply legislative and operational requirements to advising in self-managed superannuation funds.

The competency standards require an existing or new adviser to demonstrate the skills and abilities to advise a prospective SMSF Trustee and member or an existing SMSF Trustee and member on basic strategies for the Fund. With 90% of SMSFs built for two members only and the Fund to be wound up with the last surviving member, the advising time line is terminally short and lacks substance and finesse. It is no wonder that many SMSF Trustees do not see any real strategic value in their SMSFs apart from being able to control their investments.

Now controlling a bloodline – that is a whole new ball game altogether!

In contrast, Leading Member SMSF planning and advising takes into account a much wider set of standards and requires more specialist competencies. Not only must the Leading Member SMSF adviser be able to provide advice on SMSFs but also keep in mind the mission to protect and grow the family’s superannuation wealth for generations to come. It requires strategic and thoughtful planning to cater for future generations.

It is not for all but for those that succeed, the mantle of “Trusted Adviser” is theirs.

5. A Leading Member Case Study – Keeping the Family Farm in the SMSF for the Generations

John Smith is aged 67 and his spouse Sally aged 61 set up the Smith Family SMSF in 2005. They operate as individual Trustees of the Fund and we will see later that their eldest son

Mathew is also a member of the Fund. John has $1.2M in an account-based pension with a 30% tax free component (TBAR = $1.1M). Sally has $800K in an accumulation account with $200k tax free component. Mathew has $100,000 in his accumulation account.

They were working graziers running the family farm in Dubbo through the Smith Discretionary Trust. Their son, Mathew, aged 40 runs the business. John is the sole appointor of the Discretionary Trust. For the 2019 income year taxable income of the Trust will be $600K.

The property is owned jointly by John and Sally who acquired the property in the Year 2000 for $1.2M. It is now worth $2.2M. They do not receive any rent from the Trust for the property and instead receive trust distributions and take the minimum from John’s pension – tax free.

Their son Mathew is married to Mary and has two children, Ben aged 17 and William aged 13 at boarding school. John and Sally live on the property in a homestead with a separate new home for Mathew’s family not far away.

John and Sally also have a daughter, Marie who is a solicitor in Sydney, is aged 45 not married and has $300,000 in Hostplus Super. Mathew is also a member of the Smith SMSF with $100,000 in accumulation.

The investment strategy of the Fund is bank shares and Telstra to the tune of $1.2M with the accounts showing the Fund receiving $70,000 cash dividends and $35,000 of imputation credits. The remaining $900,000 is in fixed term deposits earning 2.3%.

Mathew wants to expand their Canola farm into sheep but needs $500,000 to fix up the property and the fences which have fallen into disrepair. There is no mortgage on the property and John is not keen to mortgage the property to a bank.

6. Solutions

6.1 Convert the Smith Family SMSF to a Leading Member SMSF

First and foremost, the set-up of the Smith Family SMSF is to be commended. It is not a simple two-member terminal SMSF but one that will stand the test of time. At least it has three members but with changes to the number of members potentially, the membership needs to be expanded. The option of a six member SMSF will be available shortly so Marie, Ben and William can all become members of the Smith Family SMSF. However, when dealing with a family and a specific purpose only such as preservation of a family farm or property, one solution may be to run two Family SMSFs with one being the Smith Family Farm SMSF. Remember this point carefully as we move through this case study.

PROBLEM: The fund’s deed is a 2005 deed, well before account-based pensions became law, so there is potentially a problem with John’s pension not being a pension at all but a lump sum account. To be safe and secure from a compliance point of view, trust deeds must be upgraded regularly, the Commissioner of Taxation advises this and so do most SMSF lawyers. Ideally this means every two to three years, however the smarter advisers ensure their clients receive an annual upgrade each year.

Annual Upgrade Service - $99 per Fund maximum: LightYear Docs provides an annual upgrade service for adviser’s clients where Leading Member and standard SMSF deeds are subject to an annual upgrade. It starts with the Trustee of the Fund, with the consent of the Leading Member, to agree to automatically upgrade their Fund’s deed to a new set of Rules released under the LightYear Docs, automated trust deed upgrade offering at www.lightyeardocs.com/annualdeedupgrade. In this case the Trustee, Members and Leading Member are deemed to have consented to use the latest set of Leading Member SMSF Rules as shown on the site. In addition, any automatic upgrade will not alter prior or existing Pensions, Income Streams, SMSF Wills, Binding Directions on the Trustee or Members unless otherwise agree to between the Member effected and the Trustee.

• Individual v Corporate Trustee?

The Fund is currently running with individual trustees which creates significant administrative, tax and compliance problems. It is important to change from individual trustees to a corporate trustee, and in particular in this case, to a Leading Member SMSF Corporate Trustee.

So, the first and most important steps are to:

i) Upgrade the 2005 SMSF trust deed to a LightYear Docs – Leading Member SMSF deed with John being the Leading Member of the Fund2. This is to be completed in accordance with the variation rules of the current deed and can be completed by an adviser for $99.

ii) Set up a LightYear Docs Leading Member SMSF Corporate Trustee (“BSCT”) with John as the Chairperson and sole shareholder of the Smith Family SMSF. As the farm is going to be transferred into the Fund it is best to have a company set up and completed before the transfer for land registry purposes. Set up costs are $99 plus ASIC fees for the new company;

iii) Change the Trusteeship of the Fund from individuals to the Smith LMSCT – the cost of the change of trusteeship is normally $99 but if you use the LightYear Docs Leading Member upgrade service the cost is a maximum $198 for the change of trustee, the Leading Member SMSF upgrade and the establishment of the Leading Member SMSF Corporate Trustee;

iv) Change bank accounts and share registries once the LMSCT is confirmed; v) Discuss with John – the Leading Member whether to appoint Marie as a separate

member into the Fund with a separate investment strategy for her specifically or she can participate in the pooled share and fixed income portfolio – see below on the strategic requirements for Sally to run a sub-fund in the Smith Family SMSF.

6.2 Retire Sally and get ready to commence an account-based pension with a separate investment strategy and auto-reversion options

2 Sally is not lineage of bloodline of the Leading Member John but under the LightYear Docs deed she is deemed to be one while she remains in a spousal relationship with John. If divorced, she will be automatically removed from the Fund. On John’s death her membership remains afoot at the discretion of the new Leading Member – Mathew Smith.

SIS Regulation 6.01(7) provides that a person is deemed (that is right deemed) to be retired under the superannuation laws where they have given up one form of gainful employment after they have reached age 60. This is the case even though they remain in full time employment. Given that Sally will seek to use the retirement exemption for the disposal and transfer of the farm to the SMSF, a full retirement should be considered.

When Sally commences an account-based pension her Pension Transfer Balance Account (TBAR) will be credited with the amount standing to her credit in the accumulation account transferred to commence the pension. She currently has $800,000 in superannuation benefits in her accumulation account and if we satisfy the retirement condition of release this would be credited to her TBAR but the longer she waits, strategically the worse off that she is. Why is that?

1. Setting a base for the TBAR. The earlier we set up a pension the better as any growth post testing is not tested again. The longer we delay that growth post age 60 the growth eats into TBAR capacity. If Sally does not commence a pension until age 65 then, assuming her accumulation balance had grown to $1.1M then that is the amount tested. That is a huge difference particularly if she is continuing to contribute into the Fund and we cannot forget the property which is to be transferred in as an in-specie contribution on her behalf.

2. Getting the Right Investment Strategy Under the LightYear Docs SMSF deed and also the Leading Member SMSF deed the member has the option of creating a sub-fund, much like a wrap account, where they can hold specific investments for an account. For example, Sally may commence an ABP with the farming property as it has solid income to pay a pension but surplus cash can be invested in a range of growth stocks (given the income is sufficient to meet the ABP’s pension valuation factors and Sally’s income requirements). Any investment income and growth earned on the pension sub-fund gets credited to Sally’s pension account.

But there needs to be an auto-reversionary ABP option.

Setting up a plain vanilla ABP that ceases on the death of Sally can create estate planning problems. A strategic adviser would put in place a range of estate planning options attached to Sally’s pension to cover the following three circumstances:

i) Sally dies and the pension is to revert directly to another person as allowed under the Superannuation Laws. This may be by way of a continuation of the income stream if allowed or by way of a commutation of the pension if the recipient is a child over age 18 who is not financially dependant.

ii) Sally dies and the pension recipient noted in the auto-reversionary is not alive at the time of Sally’s death. There needs to be a contingency of who the pension passes to next, this may be her grandchildren if she can show that they are financially dependant upon her.

iii) Sally dies and there are no beneficiaries so that the benefit gets paid to Sally’s legal estate however with terms and conditions such that it can only be paid to Sally’s lineage or bloodline.

Strategic Note: Each of these options is catered for in the LightYear Docs ABP and to a lesser extent TRIS. In Addendum A at the back of The Strategist we look in detail at some of the more important issues relating to the creation of an income stream or pension in a SMSF.

6.3 Contribute on behalf of John and Sally by the Smith Family Trust

John and Sally are close to retirement so why contribute on their behalf?

If you look at your role as a family adviser, rather than just advising John and Sally, then we can see, across the entire Smith Family as detailed in the facts of the case study that John and Sally are the best family members to contribute on behalf of for three reasons:

• Access: If retired they have full access to their super and any withdrawal as a lump sum or pension is tax free post age 60.

• Contributions can continue to be made: The Smith Family Trust can put in place employment agreements with both of them, provided they do work around the farm and instead of cash salary, the Trustee of the Family Trust can make a deductible contribution on their behalf into the fund3.

• John and Sally can fund the Family with tax free pensions and lump sums: Many parents and grandparents help contribute to the welfare, living and school expenses of their children and grandchildren. We noted the ability of Sally to run a sub-fund with the farm as part of the pensions’ investment strategy which would mean that surplus cash may be withdrawn to fund Ben and William’s school and ultimately university fees. As there is no tax on withdrawals this is a very effective means of funding the family. However, it will diminish the amount in Sally’s pension account. The same applies for John.

i) Can the Smith Family Trust make tax deductible contributions for John and Sally?

The Trustee of the Smith Family Trust will be entitled to a tax deduction for contributions made on behalf of its employees – John and Sally - see under section 290-60 of the ITAA 97. Accordingly, there needs to be put in place a formal employment agreement, which is available from LightYear docs for $99 per agreement and would cover salary sacrifice instead of cash.

Strategy Note: The limit on employer super contributions is not linked to services provided. In ATO TD 2005/29 the Commissioner provided an example of how contributions not linked to the amount of services provided are a deduction and Part IVA does not apply:

3 Section 292-85(2)(b) provides that a member’s non-concessional cap is equal to their general transfer balance cap for the income year – which is currently $1.6M. This is the sum of the member’s accumulation and pension accounts.

TD 2005/29 Example

14. Mary is a computer consultant who provides her professional services through her private company to a number of clients, all of whom refuse to contract with her personally but insist on obtaining her services through a contract with her company. The company employs Mary to provide programming services to its clients and employs her husband Derek to provide administrative support. Derek obtains a market value salary for his administrative work for the company, but the company provides superannuation contributions on his behalf to a complying superannuation fund up to his age-based limit of $95,980. The company provides the remainder of its fee income, net of expenses, to Mary as remuneration for her services. Mary’s remuneration consists of salary and a superannuation contribution of $4,500, representing 9% of her salary (the minimum level of superannuation support required under the superannuation guarantee scheme). Mary’s salary is lower than it would have been if the company had not made such a high superannuation contribution on behalf of Derek. However, Derek provides valuable service to the company for which he is fairly remunerated, the company makes genuine superannuation contributions on his behalf, and there are no unusual features to the arrangement. In the circumstances Part IVA does not apply.

Case Study Option

The Smith Family Trust has agreed to pay John and Sally each a $75,000 salary sacrifice payment pursuant to a valid employment agreement. As they are farmers there will be genuine work done that fits in with the Commissioner’s example under TD2005/29. This means that the Smith Family Trust will get a tax deduction of $150,000 reducing taxable income of the Trust from $600,000 to $450,000.

ii) The SMSF Tax Position for the Smith Family SMSF

From the Fund’s perspective the 2 x $75,000 contributions would be assessable to the Trustee of the Smith Family SMSF as taxable contributions. Potential tax payable on these contributions (i.e contributions tax) is $150,000 x 0.15 = $22,500 but remember the imputation credits of $35,000. These can be used by the Trustee of the Smith Family SMSF to reduce that tax.

Strategy: The $35,000 of franking credits has the potential to shelter $233,333 of taxable income. The $150,000 of taxable contributions helps.

iii) John and Sally’s personal taxes – individual level

For each of John and Sally their personal income taxation position is as follows:

• Superannuation benefits – tax free lump sum or pension as over age 60

• 2018-2019 concessional contributions cap: $25,000

• Salary sacrifice excess concessional contribution: $50,000. This excess is to be added back to John’s assessable income. Sally is the same.

• First Personal Assessment in March 2020 based on any pension or lump sum drawdowns. Nil as John and Sally are over age 60.

• The trustee of the Super Fund lodges its tax return in March 2020 showing excess concessional contributions of $100,000 = 2 x $50,000.

• Amended Assessment issued by the ATO once the Fund’s and the personal income tax returns are married up in order to tax the excess concessional contribution at John’s marginal tax rate – see section 291-15 of the ITAA 97. There will be an add back of the Excess Concessional Contribution of $50,000 plus an ECC Charge on any tax payable4.

• The Tax Assessment for each Individual based on the ATO simple tax calculator: $50,000 = $7,797 which does not take into account any low income tax offset.

• Section 291-15(b) provides a 15% tax offset on the $50,000 of taxable income is $7,500.

• So total tax payable on a $75,000 contribution is $297 and the ECC would be $25 for the period to March 2020.

• The end result of a $75,000 superannuation contribution is $322 which can be paid directly by Sally or John. Compared to a distribution from the Smith Family Trust of $75,000 where tax payable is $15,922 – a significant tax saving.

Note: The low result is from the use of the franking credits in the SMSF to reduce the contributions tax liability.

6.4 Transfer the Family Farm into the Smith Family SMSF and Lease back

The family farm is currently valued at $2.2M and is jointly owned by Sally and John so any contribution of the farm into the SMSF will be valued at $1.1M for each of them. John’s Total Superannuation Balance is $1.2M and Sally’s is $800,000. These are important as section 292-85(2) of the ITAA 97 provides that any non-concessional contribution (“NCC”) in excess of the member’s Total Superannuation Balance of $1.6M is excessive.

Issue: Do they have NCC capacity to make the transfers into their fund?

Let’s take this in steps for each of them by looking at John, who has the most superannuation first:

• We are proposing that an in-specie contribution (see promissory note strategy later) of his joint interest in the family farm will be made by John into the Smith Family SMSF;

• John can apply the small business tax concessions for the sale of an active asset being the farm provided he meets the relevant small business conditions. Here we need to be careful as the business is run through a trust for which he is appointor and receives distributions, as does his spouse and affiliate Sally. It is crucial to ensure that this step is 100% perfect. We need to ensure that he and Sally both receives distributions to show that they are active beneficiaries of the Trust and able to claim the exemption. It is advised, given the complexity and importance of this part of the advice that legal tax advice is sought from TGA Legal.

4 The ECC is set at a current rate for the June quarter 2019 of 4.94% which accrues on a daily basis from the start of the income year in which the contribution is made until the assessment is made and paid.

• Provided the farm is an active asset then, as John and Sally have held it for 15 years Sub-Division 152-B of the ITAA 97 provides that there is no capital gains tax payable provided certain conditions are met:

o The asset is an active asset o It has been held for 15 years o The holders of the asset are over 55 and the disposal is in connection with

retirement of the owners of the active asset.

• In terms of the “retirement” condition it is important that both John and Sally retire from all employment at the time of disposal of the property to the SMSF (although they may take up further employment at a later stage). This may require a tweaking of the Smith Family Trust strategy of employing Sally and John. A better and safer strategy is for them is to receive trust distributions and claim a personal tax deduction pursuant to section 290-150 of the ITAA 97. The same contributions deduction process follows with the trust making a distribution of $75,000 to both Sally and John. Following the distribution both John and Sally would contribute $75,000 to the Smith Family SMSF.

• Importantly Section 292-100(2) of the ITAA 97 provides that all or part of the capital proceeds from the disposal are excluded as a non-concessional contribution for NCC cap testing purposes, provided the NCC amount falls under the CGT cap of $1.48M for the 2018-2019 income year: section 292-105.

• Strategy Trap: The exemption details a requirement that capital proceeds are exempt. This generally means cash rather than an in-specie contribution so a Promissory Note rather than an in-specie contribution should be considered to make the strategy work.

• From a stamp duty perspective in NSW there is much good news: NSW Duties Act - 62A Transfers to self managed superannuation funds (1) Duty of $500 is chargeable on a transfer of, or an agreement to transfer, dutiable property from a member or members of a self managed superannuation fund to the trustee or custodian of the trustee of the self managed superannuation fund but only if:

(a) there are no other members of the superannuation fund (besides the member or members transferring or agreeing to transfer the property) or the dutiable property is segregated from other fund property, and (b) the property is to be used solely for the purpose of providing a retirement benefit to the member or members transferring or agreeing to transfer the property, and (c) if there is more than one member transferring or agreeing to transfer the property, the property is to be used for the benefit of those members in the same proportions as it was held by them before the transfer or agreement to transfer.

• Once the farm is in the Smith Family SMSF it needs to be leased back to the Smith Family Trust at market value rates. The lease will need to be in writing and LightYear Docs offers commercial leases on its site for use by advisers. A written valuation from an agent or valuer will also need to be prepared in relation to the value of the property to be transferred into the SMSF.

6.5 Consider the use of SMSF No 2

The current Smith Family SMSF has three members: John, Sally and Mathew. We are considering Marie however at the end of the day John and Sally want the farm to pass to Mathew solely on their death. Marie, if appointed as a member to the Smith Family SMSF will be provided with a sub-fund. This is an innovation in the LightYear Docs SMSF trust deed and the Leading Member SMSF trust deed (which we will deploy in this strategy). The sub-fund rule in the relevant deeds is Rule 3.7.

Rule 3.7: Member’s Individual Sub-Funds If the Trustee creates sub-Funds for Members under these Rules and as allowed under the Superannuation Laws, Fund Members have all rights and entitlements as contained in the Member’s sub-Fund. These may include, but are not limited to:

i) The accumulation of superannuation benefits directed and dedicated to that specific member;

ii) The payment of a superannuation or other benefit to the Member;

iii) Who the Member appoints as a replacement Trustee or director of the Corporate Trustee in the event of death or legal disability;

iv) The investment strategy and the investments that may be held specifically for the Member or one or more of the Member’s superannuation interests or other benefits;

v) The Member’s Enduring Power of Attorney;

vi) The Members directions as to the disposal or use of their Superannuation Benefits in the event of their death (a SMSF Will) or mental or physical incapacity (SMSF Living Will) provided any such direction has been signed by the Member and witnessed by two non-related and non-beneficiaries;

vii) The Member’s Will;

viii) Any Member health directive;

ix) Any other right or entitlement that the Leading Member agrees to in relation to the Member sub-fund.

This means that Marie can have her own member sub-fund in the Smith Family SMSF alongside John and Sally’s new pension accounts plus Mathews accumulation account. The farm would not form part of her superannuation investment strategy which is to be localised to her account only.

However, the problems that arise with transferring the farm into the Smith Family SMSF are as follows:

Issue 1: Farm Contribution is tax Free Component

The contribution of the farming proceeds into the Fund is a non-concessional contribution. Ideally it would form a strong base for an account based pension as any income on it, given the farm rental provides good cash flow, would be tax free. More importantly any growth

on the underlying investment will be retained in John and Sally’s pension assets plus the commutation of any pension for the benefit of Mathew would be tax-free component and not taxable in his hands.

The key problem about the farm being transferred into the Smith Family SMSF is that John currently has an account based pension worth $1.2M (original TBAR test at $1.1M). It has only 30% tax free component which if commuted and paid to Mathew as a lump sum on his death, would trigger a 17% tax on the taxable component of any payment.

Our strategy requires John to commence another account based pension with 100% tax free component from the CGT small business concession transfer however his TBAR would limit any such transfer to $500,000 only. This means the remaining $600,000 relating to the farm transfer would stay in his accumulation account.

For Sally, she has an accumulation account with $800,000 that has $200,000 of tax-free component. Post the farm transfer this will rise to $2M with $1.4M tax free component. Any pension created from this mixing pot of accumulation funds would be 70% tax free only. Sally can only commence a pension with $1.6M – her TBAR.

Issue 2: Non-Concessional Exemption

It is vital that the contribution of the Farm into the Fund is excluded from the non-concessional contribution rules under section 292-100 of the ITAA 97. In order to do so it must meet the 15 year small business active asset exemption. The problem that John will face immediately and Sally to a lesser extent if it is treated as NCC, and not exempt, section 292-85(2) of the ITAA 97 provides the general rule for the NCC cap and in particular, sub-section (b)

(2) Your non-concessional contributions cap for a financial year is:

(a) unless paragraph (b) applies--the amount (the general non-concessional contributions cap for the year) that is 4 times your concessional contributions cap under subsection 291-20(2) for the year; or

(b) if, immediately before the start of the year, your total superannuation balance equals or exceeds the general transfer balance cap for the year--nil.

If the farm transfer is an NCC then the contribution, when added to John’s current Total Superannuation Balance of $1.2M would put him in excess by $700,000.

If the 15 year retirement rule is not applied then John can use the $500,000 small business CGT exemption which is also excluded from his NCC calculation. But this means that there is still $600,000 which will be a NCC and factored into the strategy.

Warning: Great care must be had to strategically fit all components into the lowest tax paying strategy.

Issue No 3. Keeping the Farm to the Family that farms

The overarching desire by many farming families is to ensure that the farm is passed down generations and more importantly only to members of the family that farm. Clients want – SAFETY, SECURITY AND CERTAINTY.

Strategy – SMSF No 2: The Smith Family Farm SMSF

I have thought long and hard about this and given the importance, not of tax (which is a given) but the desire of keeping the farm in the Fund for members of the family who farm. A strategy that I would offer to the Smiths is to establish a second fund solely for the benefit of John and Sally along the lines of section 62A of the Duties Act (NSW). At a later stage Mathew, Ben and William can move into the Fund when the six member SMSF becomes law.

The only asset of the Fund would be the farm at this stage. But from an estate planning and tax perspective we want to have the farm as the core pension asset for the family which requires the following in building the Smith Family Farm SMSF, the adviser will need to:

1. Leading Member SMSF

The Smith Family Farm SMSF is the perfect vehicle for a Leading Member SMSF. In that regard the Leading Membership and it’s succession is as follows:

• Leading Member No 1: John Smith

• Leading Member No 2: Mathew Smith

• Leading Member No 3: Sally Smith

2. Sally’s Pension

Sally has not commenced a pension yet so, once the farm transfer to the newly formed Smith Family Farm SMSF has concluded we will set up an account based pension with the $1.1M which will be 100% tax free5. In the Smith Family SMSF (the No 1 SMSF) we will use her remaining TBAR credit of $500,000 to establish another account based pension with a 25% tax free component – the current proportion standing to her credit. The Family Farm SMSF pension with the 100% tax free component is a perfect death benefit to Mathew, her son, who is a SISA dependant but not a tax dependant. Any lump sum he receives will be tax free.

This is a great option but would result in the farm being transferred eventually from the fund to Mathew. The transfer would preferably not be to the estate6 but rather directly out of the Fund to a Leading Member Discretionary Trust for the benefit of Mathew. This prevents any other family member taking an action under the Family Provisions Act NSW, thereby protecting the family farm.

Strategy Trap: The adviser must ensure that any lump sum payment to Mathew comes from a pension commutation not a payment from the Fund’s accumulation side (when the pension ceases) as the Trustee of the Fund will be up for capital gains tax on the transfer of the property out.

5 We should also set up a pension in the No 1 fund, the Smith Family SMSF with the remaining $500,000 of TBAR Sally still has. But it is important to set up the pension in the Family Farm SMSF first then the pension in the Smith Family SMSF. 6 If the farm is transferred to the estate, even if directed toward a testamentary trust, Marie may challenge the transfer under the Family Provisions Act (NSW).

In terms of Sally’s pension (like John’s pension) it is important to assess and pre-determine the reversionary pension beneficiary, bearing in mind that it is there to ensure the family farm is held as long as possible in the Family Farm SMSF.

The questions that the SMSF adviser needs to determine are as follows:

1. Who is going to be the reversionary beneficiary and how will the farm be protected for the Smith bloodline?

2. Who is going to be the reversionary beneficiary if they are not alive at the time of the pension member’s death?

3. Will there be a second or third reversionary and will the intermediate reversionary beneficiaries take income only with any commutation prohibited in order to stretch the pension as long as possible?

4. Would the pension member like a clause where any bloodline dependant at the time of the member’s death shares jointly in the on-going reversionary pension?

5. What happens if there is no-one left? Will the commutation lump sum go to the estate or should it go into a fixed trust for the benefit of the pension member’s lineage only?

Some of Sally’s issues apply equally to John, so let’s take time to consider his position.

3. John’s Pension

John’s current pension in the Smith Family SMSF is more problematic. As advised above, provided the farm transfer meets all of the conditions of a 15 year CGT exemption such that capital proceeds are not treated as NCC, the farm contribution for John of $1.1M can be used to fund a 100% tax-free component pension in the Family Farm SMSF (the No 2 Smith SMSF).

However, John has an existing pension that has been tested for TBAR for $1.1M thereby limiting the remaining TBAR credit to $500,000. The best advice for John is to roll back $500,000 from his current pension to his accumulation account in the Smith Family SMSF so his TBAR is debited with the $500,000. This would allow and enable him to set up the $1.1M pension in the Family Farm SMSF.

As advised with Sally, John needs to set in place reversionary options for the Family Farm SMSF pension to ensure the farm resides in the Fund for as long as possible. The following strategy is suggested to put in place in the pension documentation:

i) John’s auto reversionary pension to pass to Sally if Sally has the TBAR capacity on John’s death. But it is important to ensure that Sally only receive a lifetime income stream so that the pension cannot be commuted, and nor can she take any more pension payment (excluding the minimum pension payment) that the fund has cash from farm lease income. This is to ensure the farm stays in the fund for as long as possible and does not have to be transferred to cover her pension payments.

ii) Upon Sally’s death we have to be careful paying the farm to Mathew for a number of reasons:

• Mathew cannot continue the pension under the current superannuation laws. He would have to take a lump sum which would require the transfer of the farm out of the fund to Mathew which may open it up to an estate challenge;

• If a lump sum is paid out on the termination of the pension, the income stream generally ceases so any capital gain will be subject to tax as the farm forms part of the accumulation side of the fund but with the reversion and partial commutations we can get around that;

• One benefit is that the superannuation death benefit will consist of tax free components which will be tax free in the hands of Mathew.

iii) Alternatively, we can transfer the pension to the grandchildren Ben and William7 as joint owners, provided they are dependants for the purposes of the Superannuation Laws With the auto reversionary pension now a bloodline multi-generational pension, the farm can remain in the Smith Family SMSF as an asset backing Ben and Williams pension. Importantly, if either Ben or William die, the pension reverts to the surviving pension member.

iv) The amount of pension that Ben or William can take in any income year is to be assessed in order to ensure no forced disposal of the family farm to pay the pension.

v) The Smith Family Trust would continue to run the farming business with the rent from the Family Trust for leasing the farm being paid to the SMSF.

vi) Mathew’s superannuation benefits can also consist of the farm in part, particularly when Mathew is retired. Whether a pooled or separate investment strategies are to be used is to be assessed on an annual basis.

vii) SMSF Wills and insurances should be completed for every member of the Fund – see below.

The build and running of a Leading Member SMSF takes SMSF advising to the next level. It stretches the imagination, gets the creativity going and requires a lot of back and forth with the family on who gets what, how they get it and more importantly, when will it be forfeited if it is detrimental to the family.

6.6 SMSF Insurances and Leading Member SMSFs

The SIS Act 93 and the SIS Regulations 1994 provide that the Trustee of a Fund must draft an insurance strategy as part of the Fund’s investment strategy. The insurance strategy is to take into account the insurance needs of its members.

The Commissioner of Taxation provides the following narrative on the ATO website in respect of SMSF Insurances and the needs of Fund members:

“When preparing your investment strategy, you're required to consider whether to hold insurance cover for each member of your SMSF.

7 The pension can be continued in the name of Ben and William at the time of Sally’s death or John could make them first reversionary pension beneficiaries – provided that they are financially dependant upon the pension member at the time of their death. A good adviser will ensure that dependancy is achieved as best as possible (nothing can be guaranteed) and that a Dependancy Declaration from the LightYear Docs platform is used to provide evidence of the dependancy. Importantly the limitation of pensions for children only to age 25 does not apply to grandchildren.

Your SMSF can generally provide insurance for a member for an event that is consistent with one of these conditions of release of the member's super:

• death

• terminal medical condition

• permanent incapacity (causing the member to permanently cease working)

• temporary incapacity (causing the member to temporarily cease working).

Trauma insurance

Trauma insurance typically pays a lump sum if the insured person is diagnosed with a critical illness or injury as specified in the policy, such as cancer, stroke, coronary bypass or heart attack. The lump sum is paid regardless of whether the insured person ceases work or becomes permanently disabled. This is not consistent with one of the conditions of release of the member's super, so SMSFs generally cannot provide trauma insurance for their members8.

To meet the sole purpose test, the following conditions must be met:

• any benefits payable under the policy must be paid to a trustee of the SMSF

• those benefits will become part of the assets of the SMSF at least until such time as the relevant member satisfies a condition of release

• the policy was not acquired to secure some other benefit for another person, such as a member or member's relative.”

The Smith Family SMSF Case Study

For the Smith Family Farm SMSF the Trustee of the Fund has provided life insurance cover for Mathew payable to his family including Ben and William. The cover chosen by the Leading Member of the Fund, John Smith is $2M. Mathew, in co-ordination with the Leading Member of the Fund, completes the following SMSF Will conditions, which is binding upon the Fund Trustee and also the Executor to Mathew’s estate.

1. Upon the death of Mathew, the Trustee of the Fund, along with the Funds insurance broker is to follow up all insurance proceeds payable to the Fund as a consequence of the death of the member;

2. The Trustee of the Fund is to use earnings of the Fund to pay for Mathews funeral as directed in his SMSF Will;

3. The Trustee of the Fund is to pay $750,000 tax-free to Mary as spouse of Mathew on the condition that Mary does not challenge Mathew’s Will nor the Smith Family Trust. Any challenge would see the payment used to benefit Mathew’s children Ben and William.

8 However, SMSFs can continue to provide trauma insurance benefits to a member if it is a continuation of insurance benefits for that member that existed before 1 July 2014. In this situation the member can vary the level of the cover, and any associated premiums, after 1 July 2014.

4. As Mary would be the guardian of Ben and William while they are under age 18 and also it may be dangerous providing an open-ended income to either boy, the following terms for their superannuation bequest from Mathew is as follows:

a. A lump sum payment of $20,000 b. The remainder to be placed in an income stream with a mandated minimum

as per the SIS Regulations but a maximum of 10% per annum. c. The pension is to be non-commutable until just prior to the 25th birthday of the

eldest child still alive whereupon the Trustee will commute the pension and place the proceeds into a Bloodline Family Trust on behalf of the pension beneficiary.

d. At any time, the Leading Member of the Fund, John Smith, can commute part of the pensions to pay for school fees, cars, holidays or for any discretionary spending the Leading Member so desires at the request of the pension beneficiaries.

Of course, there can be many more strategic options. However, the main concept is the importance of insurance to protect and grow the Smith Family Farm SMSF, particularly if the main contributor and family member running the family farm dies or is incapacitated. Just as much as it is important for Mathew to have life insurance, all members except for John and Sally should have permanent disability insurance so that the Smith Family SMSFs can use any proceeds from an insurance payout to fund a lifetime income stream to cater for their disabilities.

And just to finish on a strong note. See how we have left John Smith in charge of extra discretionary payments for Ben and William, over and above their mandated pension payments? I can guarantee Ben and William will become very close to their grandfather at least until their pension can be commuted. Of course, the commutation payment could go into a Bloodline Family Trust established by John Smith with John as Appointor and Trustee to protect the beneficiaries from bankruptcy or more importantly, divorce.

ADDENDUM A

Account Based Pensions – Beauty or the Beast

1. Introduction to Income Streams

I started my legal professional life as a tax consultant with KPMG and was thrown, deep end, into the world of annuities and income streams thanks to my client of the time, Citicorp Life. Company created and sold five year annuities with and without a residual capital value9. In the space of two years they had sold $1 billion of annuity product and KPMG’s consulting fees were $200,000 for the period. A great way for me to learn the ins and outs of annuities, plus superannuation as many were funded by members from rollover money.

Annuities v Pensions: At the end of the day an annuity and a pension are just income streams which have the same characteristics. However, an annuity is only offered under law by insurance companies and registered organisations. The same income stream if offered by the Trustee of a Super Fund would be a pension.

An income stream, whether an annuity or pension may be for a term, for life or reversionary which means it passes onto the next person nominated as reversionary. It may be multi-reversionary so that it passes from one pension member to the next, then to the next and so on. Generally if there is a chain of reversionary beneficiaries there is no ability to commute the pension, as this would destroy the ability to keep on passing the income stream down a lineage or bloodline.

Importantly there is a HUGE body of law around income streams with the first legal definition given by Sir Edward Coke (born 1552; died 1633). During his incumbency as Lord Chief Justice of the King's Bench, 1613-1620, be defined an annuity as "a yearly payment of a certain sum of money granted to another in fee, for life or years, charging the person of the grantor only."

Apart from English law, which is very close to Australian common law, the first ever income streams were seen in Egypt in 2500BC10. Income streams have a long history and still going strong in Australia, particularly with the mutated account based pension. But, in my experience, they can be things of beauty or absolute beasts. And the determinative factor as to which side of the ledger they fall on is the skill of the adviser building and maintaining them.

9 A residual capital value or “RCV” for short is a final lump sum payment at the end of the income stream which is a return of capital. A RCV zero means the capital is returned across all the annuity or pension payments like principal and interest on a loan. A RCV 100 means that at the end of the term of the income stream the last payment consists of the original capital of the income stream. 10 If you would like a scholarly journey on annuities then the go to paper is THE EARLY HISTORY OF THE ANNUITY BY EDWIN W. KOPF - https://www.casact.org/pubs/proceed/proceed26/26225.pdf

2. The Accounts Based Pension – Beauty in it’s Legal Form

Prior to 1994 there were no laws tying a pension to a member’s account. Simply put, a member gave up their superannuation capital to be paid an income for a term certain, life or reversionary. Once acquired there was no going back, the member’s capital had been converted to income and was guaranteed by the Trustee of the super fund.

The demand for pensions and income streams to be tied to underlying investments chosen by the pension member came into vogue in 1994 with the introduction of the allocated pension. An allocated pension was an investment product where the pension member invested their superannuation monies or rollovers with a pension payment requirement to take a minimum and no more than a maximum pension payment based on pension tables. The pension was commutable, which is a legal term for converting the pension to a lump sum, which was an easy task as it was the value of the pension’s underlying investments. Unlike the traditional pension or annuity where the sum invested is gone, with the allocated pension the capital was not lost but plainly visible. It was the first account based pension.

For SMSFs the allocated pension was funded by the Trustee of the Fund from direct investments such as shares or commercial property.

In 2007 a new style of pension was introduced with the name “account based pension”. The pension was a simplified version of the allocated pension and had the following rules:

1. The pension once commenced could not be added to by way of capital. Any addition of capital would have to be a commutation of the pension back to the member’s accumulation account with a new pension commenced. This is often referred to as a rollback and commencement of a new ABP.

2. A minimum pension must be taken each year. The minimum pension valuation factors can be found at Schedule 7 of Part 2 of the SIS Regulations 1994.

3. The capital of the pension cannot be used as security on a borrowing.

The beauty of the account based pension is that the member is in control, particularly in a SMSF, of the underlying investments (as trustee) and, subject to the minimum pension payment requirement, the amount and timing of payments coming from the pension each year.

The benefit for the pension member over age 60 the pension is that payments are tax free in their hands and importantly the underlying investment earnings are tax free.

However the real beauty is in the estate planning side of the equation. Section 302-65 of the ITAA 97 provides that any income a person receives as a result of a reversionary pension that is payable to the member on the death of a prior member who was age 60 or more is tax free.

Example One – Spouse: John Smith is age 62 and has an account based pension with a reversionary to his second wife Susie, aged 48. John dies and the pension immediately becomes payable to Susie. Any pension payments to her are tax free even though she is under age 60.

Example Two - Grandson: John Smith above has been paying his 17 year old grandson James a living allowance of $600 per month to help with his schooling and living expenses. John has made James his reversionary beneficiary. On John’s death, if the trustee of the fund is satisfied that James is a dependant for tax and super purposes the pension can be paid to James and the on-going pension payments are tax free pursuant to section 302-65.

As noted in our earlier discussions of income streams a reversionary beneficiary may have a reversionary. For example, the pension payable to Susie could continue onto a further reversionary beneficiary, say the grandson James Smith, if there was an account balance on her death. Likewise, the pension would continue tax free as John was over age 60 when the pension originally commenced.

When these pensions are commuted section 302-60 provides that the lump sum will be tax free. For TBAR purposes on the death of a member and a passing of the pension to a reversionary beneficiary, the reversionary beneficiaries TBAR is credited 12 months from the date the pension became payable The amount credited is the amount in the pension account on that date 12 months post pension commencement. If the death benefit reversionary is a child there are further rules, however SIS Regulation 6.21(2) provides a limitation on child pensions for those under age 18 or 25 if they were financially dependant on the member. For most ABPs which start once the member is age 60, the child TBAR rules are limited to a very small group of beneficiaries and may be found at section 294-170 of the ITAA 97.

SUMMARY:

The account based pension is an income stream of beauty thanks to its payment flexibility (apart from minimum pension payments) and wide investment choice in a SMSF. Compare this to an annuity offered by a life insurance company where a fixed capital investment of $500,000 for a 65 year old will purchase an annuity with a set annual payment for life that could be as little as $15,000 per annum if a reversionary pension.

The ABP Beast

i) The Basic ABP

Most SMSF pension members have a simple account based pension. This is a damnable beast as it means when the pension member dies the pension ceases and all of the pension benefits go back to the deceased member’s accumulation account. Naturally this can be used to provide a new pension to a dependent such as a spouse provided there is an adequate binding death benefit nomination or favourable trustee in place (otherwise expect a fight).

The problem is that where the pension has been created with tax free component (such that all income and gains earned on the pension account are also tax free component), the instant it rolls back to the deceased member’s accumulation account, any gains will be taxable component. In addition, if the deceased member was running an accumulation account at the time with varying taxable and tax free components, the pension get blended and the strategy of quarantining tax free component for non-dependant tax beneficiaries (meaning a lump sum commutation is tax free) will disappear or be curtailed.

To put it bluntly the basic ABP is a real beast and one for the DIY super fund NOT for a SMSF put together by a well-trained SMSF adviser.

ii) The Reversionary ABP

The reversionary ABP can be simple but can be plain dumb. I have seen, on so many occasions an ABP put in place where the pension reverts to the spouse only and everyone thinks the world of the strategy. Simple and effective if the spouse is alive at the time of the death of the pension member.

But if they are not, the pension ceases and all the problems above apply. And if this is the last member of the fund, who gets what?

BIG BEASTLY TRAP: Most SMSFs these days have corporate trustees, particularly if there is only one member. The problem with the corporate trustee is when the last member dies, succession becomes a beastly issue. To that end, the majority of constitutions provide that the directors can appoint a new director, but what happens if there are no directors left. The alternative is the shareholders can appoint a director, but this is where the problem lies. The shares will form part of the deceased’s estate and if the Executor is in control, they could appoint themselves as director – if they knew what to do. The alternative is the shares are passed to a beneficiary of the estate who would instantly control the fund. The ghosts of Katz v Grosman and Donovan v Donovan would see a potentially nasty situation evolve. I have recently advised on a case, seemingly too late where it cost $120k legal fees to resolve because there was no one left in the fund but children from a first marriage and a second spouse fighting. If only - a well thought out plan from the start would have been impregnable.

So the reversionary pension can be beautiful in its underlying estate planning strategies but we need to cover the following:

1. Who is going to be the reversionary beneficiary? 2. Who is going to be the reversionary beneficiary if they are not alive at the time of

the pension member’s death? 3. Will there be a second or third reversionary and will the intermediate reversionary

beneficiaries take income only with any commutation prohibited in order to stretch the pension as long as possible?

4. Would the pension member like a clause where any bloodline dependant at the time of the member’s death shares jointly in the on-going reversionary pension?

5. What happens if there is no-one left? Will the commutation lump sum go to the estate or should it go into a fixed trust for the benefit of the pension member’s lineage only?

As an adviser if you can get the answers to these questions then you are reading to build some amazing estate planning ABPs and also TRIS income streams. This is the core of the LightYear Docs platform.

Grant Abbott Webinar recording on ABP and TRIS estate planning strategies - To access go to: https://youtu.be/oXTClPHIgDY