Tax implications of winding up an SMSF
We are always hearing about the continuous growth in SMSFs, but what happens if we need to wind up an SMSF?
There are many reasons for winding up a client’s SMSF, including:
• No more members left
• No more assets left for the members
• Insufficient funds to cost-effectively maintain the SMSF
• Divorce of the members
While there is plenty of material written about the wind-up process (including the ATO self-help section www.ato.gov.au/Super/Self-managed-super-funds/Winding-up), there is not always enough discussion around the taxation implications of winding up an SMSF.
Getting the right advice can potentially save your clients from some common tax pitfalls, and in some cases may actually provide some long-term benefits that weren’t initially contemplated.
1. Significant unrealised capital gains
A very common issue, especially where the trustees have held the asset over a long period (e.g. property). It does not matter how the trustees look to dispose of the assets, whether it be liquidating into cash or taking an in-specie benefit payment, a capital gain (loss) event will trigger upon disposal. In most cases, some proactive advice may help mitigate this issue.
For example, where the SMSF members are close to, or in retirement, they may be eligible to start drawing a pension from the SMSF. Generally, the assets supporting the pension are exempt from capital gains tax when they are disposed of.
The main issue is where the SMSF is in accumulation phase and a net capital gain arises. In this case the capital gains tax will in effect reduce the members’ overall super balance.
2. Capital losses
On the flip side, a capital loss can be realised during the wind-up process, or carried forward from previous years. It is important to note that any residual capital losses that are not utilised during the wind-up process cannot be transferred to another person or entity and benefit will be lost upon wind up.
While all capital gains and losses are disregarded when the SMSF is in full pension phase, the benefit of having even a small accumulation balance means the net capital loss can be used by future SMSF members.
3. Income tax losses
A similar issue applies where the SMSF is in a net tax loss position. The benefit of the tax loss cannot be transferred to a person or other entity and will be lost upon wind up. Tax losses are normally the result of a deduction that has been claimed on the anti-detriment payment for a death benefit. To maximise the benefit of the carried forward tax loss, you need to consider if the next generation of members can be transitioned into the SMSF.
4. Use of franking credits
Many SMSFs were set up to directly invest in property, which is an illiquid asset. Some of these SMSFs have suffered from poor cash flow as a result of acquiring the wrong type of property, and this may be reason behind the SMSF wind up.
In determining if winding up the SMSF is in the best interests of the members, you may need to consider if a change in asset classes could alleviate the cash-flow issues while still providing a similar return appropriate to the member’s investment risk profile.
One of the benefits of superannuation is the concessional tax rates. Dividends from listed shares can provide the required cash flow as well as the benefit of franking credits. Franking credits are used to offset the SMSF’s tax liability with any excess credits left over being refunded, which in turn provides additional cash flow to the SMSF.
The tax implications can be important but you should also consider the following:
5. Life insurance considerations
The members may have significant insurance policies held in the SMSF (e.g. life, disability and income protection cover). While in some cases these policies can be transferred out of the SMSF, it is vital that you review the member’s insurance needs to ensure they have appropriate cover in place at all times. There are cases where the insurance policies have been cancelled as part of the administration process to wind up the SMSF and left the member (and their adviser) exposed to the risk that suitable replacement cover cannot be obtained afterwards.
6. Asset protection
Superannuation can provide a level of protection from creditors under bankruptcy law (with exceptions). SMSFs can hold business real property that’s used in the member’s business and thereby protects these assets from creditors. Accordingly, the trustee should consider their risk exposure to having their super balance or business assets being seized if they were to wind up their SMSF.
Some benefits of an SMSF holding business real property is it can lease the property back to the business at market rates, which can help build the member’s super balance. The business can receive a tax deduction for the rent paid and these amounts are not counted towards the member’s annual contribution caps.
7. Family super funds
The structure of super funds inherently allows for changes to the members over time. This important concept has seen many SMSFs become family super funds since families seek to transfer wealth between generations and protect legacy assets. This should not be overlooked when considering winding up the SMSF.
The new members can be children or other relatives, or even business associates of the current members. They can take advantage of the SMSF’s tax position whether that is carried forward capital or tax losses, or by deferring capital gains tax by not having to dispose of SMSF assets. This becomes quite a valuable strategy when providing advice around family business succession planning because it can help facilitate the orderly transfer of business assets from one generation to the next.
Jason McLaren, director, Axiom Super Solutions