The Importance of Estate Planning for SMSFs

The Importance of Estate Planning for Self-Managed Superannuation Funds

by Geoff Cameron geoffc@mdl.com.au

Self-managed superannuation funds (SMSFs) have become increasingly popular as a method for managing wealth to be used in retirement.

A key reason for the popularity of SMSFs is that they can offer a greater degree of choice and control over your superannuation benefits compared to “traditional” retail and industry superannuation funds.

However, the greater choice and control offered by SMSFs comes at the cost of responsibility for ensuring that your SMSF is structured appropriately to tie in with your overall estate planning goals.

Structuring your SMSF to ensure that your entitlements pass to the people you wish to benefit in the event of your death requires careful estate planning, which is difficult to get right without professional advice and assistance.

Failure to get the estate planning for a SMSF right can lead to undesired outcomes and bitter disputes among those who are left behind.

Case Study – How Inadequate SMSF Estate Planning can lead to Undesired Outcomes and Disputes

The consequences of not properly tying entitlements in a SMSF into the overall estate plan were graphically illustrated in the case of Katz v Grossman [2005] NSWSC 934. The facts in this case were as follows.

• A SMSF was established by a husband and wife. They had two children, a son and a daughter. The husband and wife were the members of the SMSF and they initially acted as the individual trustees of the fund. The wife died before the husband, leaving the husband as the sole member of the SMSF.

• By law, a single-member SMSF must always have either:
  • two individuals as trustees; or
  • a company as trustee, of which the member may be the sole director and shareholder.

• The husband, as the surviving member and trustee of the SMSF, appointed his daughter to be the second individual trustee of fund. As trustees, the husband and the daughter determined that the whole of the wife’s entitlement in the SMSF should be distributed to the husband.

• It was the husband’s intention that after his death, his wealth, including his entitlements in the SMSF, be divided equally between his son and daughter. In his Will, the husband appointed his son and his daughter as executors, and distributed his estate equally between them. He also made a non-binding death benefit nomination in relation to his entitlements in the SMSF, specifying that he wished his entitlements in the SMSF to be distributed to his son and his daughter equally.

• On the husband’s death, the daughter was left as the sole trustee of the SMSF. By law, the appointment of a second trustee of the SMSF was necessary before the husband’s entitlements in the SMSF could be distributed.

• The son and the daughter had the power, as executors of the husband’s Will, to agree to appoint a second trustee to the SMSF. The son’s view was that he should be appointed as the second trustee of the SMSF. However, the daughter refused to agree to the son being appointed as the second trustee of the SMSF. A deadlock between the son and daughter arose – no agreement between them could be reached as to who should be appointed as the second trustee.

• The daughter then used a power, afforded to her as the last surviving trustee of the SMSF by legislation dealing with the replacement of a deceased trustee where the person/s with power to appoint a new trustee were unable or unwilling to do so, to appoint her own husband as the second trustee of the SMSF.

• As trustees of the SMSF, the daughter and her husband then determined that the whole of the deceased’s entitlement in the SMSF (which amounted to more than $1,000,000) should be distributed to the daughter, totally excluding the son.

• The son commenced legal proceedings seeking to overturn this, claiming that the appointment of the daughter’s husband as a trustee of the SMSF was invalid.

• The son’s claim was dismissed by the court. In its judgement, the court observed that the daughter’s actions were unfair and clearly contrary to the deceased’s intention that his wealth be shared equally between his son and his daughter. However, the court had no choice but to conclude that because of the deadlock between the son and the daughter as executors over the appointment of a second trustee for the SMSF, the daughter was entitled to exercise the power available to her as the last surviving trustee of the SMSF to appoint a new trustee.

• Accordingly, the daughter’s appointment of her husband as the second trustee was held to be valid, and their decision as trustees to distribute the deceased’s whole entitlement in the SMSF to the daughter was effective.

This outcome could have been avoided if there had not been two crucial shortcomings in the estate planning process in relation to the SMSF, namely:

• failure to structure the trusteeship of the SMSF in a manner that would ensure that control of the SMSF would pass to both the son and the daughter; and
• failure to implement a legally binding arrangement to ensure that the son and the daughter would benefit equally from the deceased’s entitlement in the SMSF.

Had these shortcomings been appropriately addressed by the deceased during his lifetime, the daughter would not have been able to act as she did and the dispute would never have arisen.

Structuring the trusteeship to ensure that control of the SMSF would pass as intended

In relation to the trusteeship of the SMSF in Katz v Grossman, we have seen that the deceased chose to appoint his daughter as the second individual trustee of the SMSF following the death of his wife. This decision left open the potential for a deadlock between the son and the daughter as executors regarding the appointment of a new trustee of the SMSF following the deceased’s death. This in turn allowed the daughter to exercise power as the sole surviving trustee to appoint her husband as the second trustee of the SMSF.

An alternative option that was available to the husband was that, instead of appointing his daughter as the second individual trustee of the SMSF after his wife’s death, he could have appointed a company to be the sole trustee of the SMSF. It would have been permissible for him to be the sole director and shareholder of the company – he would not have needed to appoint a second shareholder or director. This would have given him the ability to:

• control all decisions of the company as trustee of the SMSF during his lifetime; and
• ensure that control of the company would pass to both his son and his son daughter following his death.

Control of a company is determined by who holds its shares, as it is the shareholders who have the right to appoint the company’s directors.

In the case of the deceased, he would have been able to gift his 100% shareholding in the company to his son and his daughter equally in his Will.

By giving the son and the daughter each a 50% shareholding in the company in his Will, neither would be able to resolve to appoint a new director/s of the company without the other’s agreement.

Accordingly, the son would have been able to insist on being appointed as a director of the company along with the daughter.

Once they were appointed as directors, the son would have been able to insist on an equal distribution of the deceased’s entitlements in the SMSF.

In short, if the husband as the surviving trustee and member of the SMSF had appointed a company solely controlled by him as trustee of the SMSF and gifted the shares in that company to his son and daughter equally, this would have prevented the daughter from appointing her husband as a second individual trustee of the SMSF, and

How are entitlements in a SMSF dealt with on death?

The second key failure in the estate planning process for the SMSF in Katz v Grossman was the failure to lock in the distribution of the deceased’s entitlements in the SMSF in a manner that would ensure that the son and daughter would benefit equally from those entitlements.

It is important to understand that a member’s entitlements in a SMSF (and indeed any superannuation fund) are not automatically distributed by the member’s Will on death.

Rather, the member’s entitlements in the SMSF are distributed by the trustee/s of the SMSF in accordance with the terms of the SMSF deed. Accordingly, the terms of the applicable SMSF deed must be carefully reviewed as part of the estate planning process to determine how a deceased member’s entitlements can be distributed.

Generally (though not always, particularly in the case of older SMSFs) the terms of SMSF deeds require the trustee/s of the SMSF to distribute a deceased member’s entitlement in the fund as follows:

• if the deceased member had a valid Binding Death Benefit Nomination (BDBN) in place in relation to their entitlements in the SMSF at the time of their death – in accordance with the terms of the BDBN; or
• in the absence of a valid BDBN, the trustee/s of the SMSF have discretion to distribute the member’s entitlements to one or more of the deceased member’s:
  • spouse – a person who was lawfully married to or in a civil partnership or a de facto relationship with the deceased member;
  • children – this can include adopted children and step-children;
  • dependants – this can include any person who was financially dependent on the deceased member;
  • a person with whom the deceased member had an interdependency relationship – that is, any person with whom the deceased member was living and had a close personal relationship involving the provision of financial or domestic support and personal care; or
  • legal personal representative/s – this includes the executor/s of the deceased member’s Will or the administrator of the deceased member’s estate.

In Katz v Grossman, the deceased could have made a BDBN directing that his entitlements in the SMSF be distributed equally between his son and his daughter. A valid BDBN must be followed by the trustee/s of a SMSF.

However, he had not made a valid BDBN. While he had nominated his son and his daughter as beneficiaries of his entitlements in the SMSF in equal shares, the nomination was non-binding – as such, it amounted to nothing more than an expression of his wishes. Whatever one might think about the morality of their actions, the daughter and her husband were under no legal obligation to distribute the deceased’s entitlements in the SMSF in accordance with his wishes. In the absence of a valid BDBN, they were entitled to exercise discretion as trustees of the SMSF regarding the distribution of the deceased’s entitlements among the eligible beneficiaries as listed above.

Had the deceased in Katz v Grossman made a valid BDBN directing that his entitlements in the SMSF be distributed equally between his son and his daughter, it would not have been open to the daughter and her husband to exercise discretion to distribute the whole of his entitlements to the daughter.

Closing Observations

The comments in this article about the shortcomings of the estate planning process in relation to the SMSF in Katz v Grossman must be viewed in the context of the facts of the particular case, and must not be taken as legal advice applicable to every SMSF.

The appointment of individuals or a company as trustee/s of a SMSF, and the desirability of making a BDBN to provide for the distribution of entitlements in a SMSF, requires consideration of a broad range of factors. There is no “one size fits all” approach to estate planning for SMSFs. The appropriate estate planning solutions in each case will be heavily influenced by, and will vary according to, the unique circumstances and goals of each person.

There are also important issues that need to be considered in terms of the taxation of superannuation entitlements paid to persons who are eligible to receive the entitlements of a deceased member of a SMSF. While distributions of a deceased member’s entitlements in a SMSF to certain classes of eligible recipients may be made tax-free, distributions to other classes of recipients are taxable. It is important to understand the taxation implications of a proposed distribution of entitlements from a SMSF prior to the distribution being made.

A decision as to the best way to structure your SMSF to tie in with your estate planning goals should only be made after obtaining and carefully considering legal, taxation and financial advice tailored to your specific circumstances.