We all know SMSFs are the fastest-growing sector of the super industry and this trend is likely to continue.
While the establishment and growth of SMSFs receive plenty of attention, little importance is paid to the other end of the SMSF life cycle – when an SMSF is no longer appropriate.
There are many instances when clients may need an SMSF exit strategy, so it is important to understand the alternatives available.
Loss of capacity and disability
As clients age, the loss of capacity as a result of dementia or other illnesses is an increasing source of concern for SMSF trustees.
There are currently more than 410,000 Australians living with dementia. By 2025, this number is expected to reach 530,000.
If an SMSF trustee loses mental capacity, they cannot continue in the role of trustee and so are unable to be a member of an SMSF. There are no legal issues with a person who lacks mental capacity being a member of a public offer fund or a small Australian Prudential Regulation Authority fund (SAF). However, there may be practical problems for such a person becoming a member of a public offer fund or a SAF if they do not have an enduring power of attorney. Having an enduring power of attorney for SMSF trustees is essential.
Why do members need an exit strategy?
An exit strategy may be needed if a fund’s investments include assets that cannot be accepted by retail funds, such as property, limited recourse borrowings, private companies or collectables. Many retail funds do not offer the range of listed investments available to an SMSF.
One of the most desirable features of an SMSF is its ability to control the timing of tax events, particularly the disposal of assets that result in a capital gain. If the fund is wound up prematurely, any capital gains will be crystallised and any capital losses cannot be carried forward. This is particularly undesirable if clients have not yet met a condition of release and have thus not been able to commence retirement-phase pensions.
If one or more members die or can no longer be a trustee, it is important to consider the attitudes and abilities of the remaining members. Do the surviving members have the desire and/or ability to manage the SMSF in the future?
Exit strategy alternatives
There are three primary exit strategies for an SMSF. The SMSF can roll over to a public offer fund, convert to a SAF or pay benefits to members if they meet a condition of release.
Rolling over to a public offer fund is a capital gains tax (CGT) event. Any gains will be realised and tax will be payable. If capital losses exist, they cannot be carried forward.
Members will also need to consider the range of investment options available in a public offer fund and this may also be a significant issue. If the SMSF has assets that cannot be accepted, how do the members feel about disposing of the assets? If the SMSF has business real property that the SMSF members are running the family business from, its sale may be highly undesirable.
An alternative to a public offer fund is to convert the SMSF to a SAF. A SAF is an SMSF with a professional licensed trustee. The professional trustee company manages the fund for the benefit of the members and is responsible for all compliance, regulatory reporting and administration of the fund.
The conversion from an SMSF to a SAF can avoid the imposition of CGT if clients retire as trustees of the fund and appoint the professional licensed trustee. The fund (the tax-paying entity) continues uninterrupted and does not dispose of any assets; there is simply a change in trustees. There is no change of tax file number or Australian business number.
Nearly all of the legislative concessions that apply to SMSFs are also available in SAFs, including the ability for members to direct trustees in respect of death benefits and investments.
Moving to a SAF may help members who wish to retain particular investments, such as a unique shareholding, real property or collectables, which will generally be allowable as part of a diversified investment portfolio.
If the members have met a condition of release, it is possible to simply pay the member benefits and wind up the SMSF. When winding up an SMSF, it is important to ensure trustees make adequate provision for fund taxes and expenses that may be incurred as a result of the wind-up. In addition, there are a variety of reporting obligations that must be complied with.