Putting in place an SMSF will is the most effective method to make sure death benefits are allocated to the proper recipients, Grant Abbott writes.
Estate planning is the key to addressing and putting in writing, where allowed, your client’s wishes for their family, SMSF, super estate and estate upon their death. It extends beyond assets, monies, bequests and can include the distribution of reserves, creation of bloodline SMSFs and much more. Without a specified plan, fights and legal disputes more often than not engulf the estate, even over small amounts of money. Witness the continuous cases and legal action in the SMSF space where executors seek to take action against the remaining trustees to recover from the estate, often to no avail.
This means it is vital to have a comprehensive SMSF and ordinary estate plan in place for your clients that covers the multitude of possibilities that may arise in today’s modern society. For the most part a will is the essential legal document that deals with the disposition of a person’s estate in the event of their death. The major problem with a will is it cannot be used to deal with a person’s superannuation benefits. There is a long line of case law where the payment of death benefits from a superannuation fund is determined in accordance with the governing rules of the superannuation fund and not in accordance with the terms of the deceased’s will (see McFadden v. Public Trustee for Victoria  1 NSWLR 15 at 22).
1. The SMSF will v BDBN
Until recently the disposition of a member’s superannuation benefits in the event of their death has not been by way of will, but through the use of death benefit nominations, both binding and non-binding, given to the trustee of the fund. Death benefit nominations are generally sufficient for smaller SMSF estates, but for more sophisticated estate planning, now required to minimise estate taxes on superannuation benefits as well as provide asset protection, the SMSF will is the key document.
An SMSF will allows a member of a fund to provide the trustee of the fund with specific written instructions that must be followed in the event of the member’s death. Some lawyers will call it a set of binding death benefit directions, but for ease of client communication I strongly suggest the term ‘SMSF will’ is used so there is no legal impediment. In that regard, the instructions under an SMSF will may include the provision of super death benefits in a manner and form detailed, who shall be the replacement trustee in the event of the death of the member, which super interest a specific death benefit is to be paid from and whether such benefit is to be made by way of a distribution of a specific fund asset, and what to do with reserves. These are areas beyond the bounds of a binding death benefit nomination (BDBN).
2. SMSF estate planning options
There are effectively four ways to make provision for dependants or others via a member’s legal estate:
- The trustee may pay a lump sum from the fund with a deceased members benefits to a dependant or the trustee of their legal estate from a current pension or lump sum benefits. For tax dependency, this includes any child under the age of 18 and will be discussed in detail below. Additionally, the payment of any benefit may be satisfied by the trustee of the fund transferring assets to the beneficiaries personally in accordance with an SMSF will. However, great care should be used in this process as the concessional tax status may be lost – generally this requires the use of a promissory note.
- The trustee may pay a pension from the fund from a deceased member’s benefits to a tax dependant. A tax dependant includes a child under the age of 18, however, the pension must cease by no later than age 25. The pension may be paid out of the deceased member’s pension or accumulation benefits provided a BDBN or SMSF will is in place.
- Ideally the deceased member may have an existing pension in place that has a reversionary interest, meaning upon death the pension continues on in the name of the reversionary beneficiary. There may be more than one reversionary beneficiary – subject to Superannuation Industry (Supervision) (SIS) regulation 6.22 and thus allowing it to pass between generations and families.
- Any insurance proceeds from a life insurance policy held by the trustee may be used to increase the benefits in the deceased member’s account or taken into a reserve in the fund for the benefit of current and future members of the fund.
3. The importance of the trust deed
In accordance with the provisions of the superannuation laws, specifically section 55(1) of the SIS Act 1993, neither the trustee of a superannuation fund nor any other person can breach any of the governing rules of the fund. Such a breach may jeopardise the fund’s complying status and thus concessional tax status. Additionally it may render the trustee liable to significant monetary penalties or being replaced by a trustee appointed by the ATO taxation commissioner.
The governing rules are defined under section 10(1) of the SIS Act to include the fund’s trust deed and any other rules made by the trustee of the fund, including a BDBN and/or SMSF will made on behalf of a member. Therefore, before an SMSF estate plan can be created, a thorough review of the trust deed must be undertaken to determine if the provisions of the deed allow an SMSF will or BDBN to be established. This is an absolute requirement when you look at Katz v Grossman  NSWSC 934 and Donovan v Donovan  QSC 26. Plus, and this is a giant warning, it is crucial to note and follow the procedural requirements laid out in the deed and governing rules. If the deed says a BDBN must be in an approved form published by the trustee and there is no form, then any BDBN under that deed is invalid.
As an example, and without having to go deep into the rules of a deed, the following strategy guide on SMSF wills is taken from the NowInfinity trust deed and governing rules.
“A SMSF Will created on behalf of a member may cover a number of formal and informal directions, each of which can be made on a standalone basis, including the following:
i. No nomination
If the member does not make a nomination over some or all of his superannuation benefits in their SMSF will then the trustee has the discretion to determine where a deceased member‘s death benefits are to be distributed. In this instance distribution of the deceased member‘s death benefits are totally at the unfettered discretion of the trustee.
ii. Non-binding death benefit nomination
The member provides the trustee with a written nomination as to how some or all of their death benefits may be distributed in an SMSF will. Ultimately the trustee retains control of the distribution of the death benefits as was seen in Katz v Grossman. This method may apply where a member‘s death benefits are to be distributed to a single beneficiary, for example a spouse, who is to remain as the major trustee of the fund. On the death of the member they can seek advice of a SMSF estate planning specialist to determine the best option for them in terms of taking death benefits.
iii. Binding death benefit nomination – non-lapsing
A BDBN allows a member to direct the trustee of the fund what proportion of their superannuation benefits are to be paid in the event of their death. Generally this will not include asset disposition, who can be the replacement trustee on death, what to do with reserves and so on – the highly important things.
With a BDBN in place then upon a member‘s death the trustee must abide by the direction provided it is valid and current.
The advantage of a BDBN is that it provides some certainty as to how the member‘s death benefits are to be paid. The member cannot however provide in the BDBN for a superannuation income stream to be paid to one tax dependant and a superannuation lump sum to another. In some cases depending on the deed, the binding death benefit nomination needs to be renewed every three years. In most case the BDBN will be non-lapsing. It has its place in a complying SMSF but binding death benefit nominations have their disadvantages.
iv. Death benefit binding direction
An SMSF will may also have a death benefit binding direction allowing the member to direct the trustee as to how their death benefits are to be distributed and in what form. Additionally, it can direct the trustee as to who the deceased member’s replacement trustee is to be. This is achieved by writing or embedding into the fund’s governing rules the member’s death benefit binding direction so it has the force of the trust deed and the SIS Act.
The death benefit binding direction inside a SMSF will provides a member with the most secure option in terms of their SMSF estate planning. It is advisable that a member creating, and the trustee accepting, a member SMSF will to both seek expert advice from a SMSF professional, actuary or auditor prior to finalising the document.”
4. Who is a dependant?
4.1 An important taxation question
The issue of who is a tax dependant in accordance with the provisions of the Income Tax Assessment Act 1997 (ITAA) is important when determining how superannuation death benefit payments are taxed.
For tax purposes a tax dependant is:
- the deceased person‘s spouse or former spouse, or
- the deceased person‘s child, aged less than 18, or
- any other person with whom the deceased person had an interdependency relationship under section 302-200 just before he or she died, or
- any other person who was a dependant of the deceased person just before he or she died – that is, a financial dependant.
The meaning of ‘interdependent relationship’ (section 302-200 of the (ITAA); SIS Act section 10A) has been described as “one of continuing mutual commitment to financial and emotional support between two people who reside together”. The definition will include the following:
- a child with a disability who may live in an institution,
- two elderly sisters who reside together,
- an adult child who resides with and cares for an elderly parent, and
- same-sex couples who reside together.
4.2 What is financial dependence?
There have been two noteworthy cases concerning the meaning of financial dependant under the SIS Act 1993 — Malek v FC of T 99 ATC 2294 and Faull v Superannuation Complaints Tribunal  NSWSC 1137. In essence these cases have a fundamental theme that regular and continuing financial support of a person can determine financial dependency apart from the amount of money paid.
Significantly, the Australian Prudential Regulation Authority (APRA) has released a superannuation payments standard guideline – APRA Guideline No.I.C.2 – considering financial dependence. The guideline stipulates:
“There is no need for one person to be wholly dependent upon another for that person to be a ‘dependant’ for the purposes of the payment standards. Financial dependency can be established where a person relies wholly or in part on another for his or her means of subsistence. Nor must the recipient show a need for the money received from the deceased member in order to qualify as a dependant. Moreover, since partial financial dependency can generally be sufficient to establish a relationship of dependence, it is possible for two persons to be dependent on each other for the purposes of the payment standards.”
5. The taxation of death benefits
5.1 The taxation of lump sums
If a lump sum is paid to a tax dependant of the deceased member, it is tax-free. If paid to a non-tax dependant the tax-free component is not taxed and the taxable component is taxed at a rate of 17 per cent. Any untaxed component is taxed at a rate of 32 per cent. It is unlikely a beneficiary of an SMSF estate would have an untaxed element unless there is an insurance payout involved (see below).
The tax-free component of any lump sum is tax-free to both dependant and non-dependant beneficiaries.
5.2 The taxation of pensions
Where the deceased member was in receipt of an income stream consisting of a tax-free component then, irrespective of the age or financial circumstances of any reversionary dependant beneficiary of the income stream, it will be tax-free to the extent there is a tax-free portion.
In terms of the taxable component of any pension, if the deceased pension member was over 60 and in receipt of tax-free income on the taxable component, then the reversionary dependant beneficiary will also receive tax-free pension income. However, if the deceased pension member was under 60 at the time of death and the reversionary dependant beneficiary is under preservation age, any taxable portion of the income stream will be taxed at the dependant beneficiary‘s marginal tax rates. Once over preservation age but under 60, a 15 per cent tax offset is available. For any member of a fund who is over 60, all income streams are tax-free no matter their source.
A reversionary income stream can only be paid to dependants of the deceased member. In addition, they can only be paid to a child dependant until the child is 25, whereupon the income stream must be commuted. The commutation amount is tax-free.
If the income stream consists of an untaxed element, generally the case where the fund has paid life insurance premiums, then different taxation consequences arise. For the dependant of a deceased pension member over 60, any untaxed component is assessable income with a 10 per cent tax offset. This taxation treatment also applies to dependants in receipt of an untaxed component who are over 60 irrespective of the deceased member‘s age. If the deceased member was under 60, and the dependant beneficiary is as well, then the pension income is assessable income.
The determination of the tax-free, taxable and untaxed components of any pension payable on a member’s death is to be considered when creating an SMSF will.