Lately we have had a few queries and concerns from some advisers regarding this issue and given there so many SMSF being established out there some may not be compliant as a couple of advisers had picked recently after reviewing clients insurance arrangements.
The last thing anyone would want is for their SMSF to be in breach of the sole purpose test which can have enormous repercussions via the ATO on this fund via penalties plus the adviser / accountant that has provided the advice for the non compliant structure.
As always, we hope you find this information useful and remember, educating is key with all your financial decisions.
Can your clients use their SMSF to fund their buy sell agreement?
Buy sell insurance protects business owners and their respective estates. It provides funding for the business owner’s exit from the business as a result of an involuntary event such as: death, terminal illness, TPD or specified traumatic condition. When coupled with a buy sell agreement, it helps ensure all parties get what is rightfully due and in the best interest for the continued success of the business.
That is, the remaining business owners can purchase or obtain the exiting owners share of the business (thus retaining control) and the exiting business owner (or their estate in the case of death) receives the proceeds of the insurance policy.
As such, buy sell insurance policies are generally owned and paid for by the owner. This method of ownership has a number of advantages including: simplicity, scalability, portability and is exempt from CGT. However, some clients have chosen to fund buy sell insurance via their SMSF, possibly to help with cash flow or because they believe it to be more tax effective. Many have debated whether or not this breaches the sole purpose test.
Summary of circumstances
A member of an SMSF and his brother run a business through a company in which they are the only two shareholders. The SMSF’s only other member is the Member’s spouse and the SMSF has a corporate trustee.
To ensure they have a succession plan in place for the company, the Member and his brother enter into a buy-sell agreement which requires:
• The SMSF to purchase a life insurance policy over the life of the Member with the insured amount based on an agreed market value of the Member’s interest in the company.
• The company to make additional employer contributions to the SMSF to be used to pay the premiums on the policy.
• On the death of the Member, the following will happen:
- Insurance proceeds are to be paid to the SMSF’s Trustee
- Trustee will add the proceeds to the Member’s account
- Trustee will then pay all of the benefits of the deceased Member (including the insurance proceeds) to the Member’s spouse
- Member’s shareholding in the company will be transferred to the Member’s brother and the Member’s spouse will relinquish all claims on the
- Member’s shareholding in the company
Consequently, under the buy-sell agreement, the SMSF is required to purchase a life insurance policy that wouldn’t otherwise have been acquired and the brother would obtain full ownership and control of the company on the Member’s death without paying any consideration.
Reasons for decision
Sole Purpose Test
The SMSF’s purchase of the life insurance policy in accordance with the term of the buy-sell agreement does not meet the sole purpose requirements of section 62 of the SISA. The sole purpose test generally prohibits trustees from providing any benefits that do not align with a core purpose (ie providing retirement or death benefits) or certain ancillary benefits such as invalidity benefits.
The ATO also specified that the sole purpose test requires exclusivity of purpose. However, the test may still be satisfied where an SMSF provides benefits that are considered incidental, remote or insignificant.
In this particular case, although the SMSF is allowed to be maintained for the provision of death benefits, the sole purpose test was breached as the insurance policy was only acquired because of the buy/sell agreement and the brother (a non-member of the SMSF) would receive significant benefits in the form of not having to pay for the insurance premiums and, in the event of the Member’s death, receiving 100% ownership of the company without paying any consideration. These benefits could not be considered incidental, remote or insignificant.
Provision of financial assistance to the Member’s brother
Paragraph 65(1)(b) of the SISA prohibits a SMSF trustee or investment manager from assisting a member or relative of a member using SMSF resources and therefore providing financial assistance. The ATO found that the arrangement in this case breached the prohibition on providing financial assistance to a member or relative due to the significant nature of the benefits provided to the brother (ie the payment of premiums and total ownership of the company without paying any consideration as mentioned previously).
The ATO has provided a clear warning to advisers and their clients when considering the use of SMSFs to purchase buy sell insurance. Itconfirms that the sole purpose test may be breached in these circumstances and legal advice should be sought before proceeding.
We strongly advise discussing with your financial advisor before entering such agreements.