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Cutting through the confusion with SMSFs and insurance

By Jeffrey Scott
June 15 2016
3 minute read
Cutting through the confusion with SMSFs and insurance
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Following ATO interpretative decision 2015/10, there has been confusion among SMSF practitioners and their clients regarding cross-member strategies and buy-sell agreements.

In Australia, there are 2.1 million actively trading businesses, 1.3 million small businesses that are sole proprietors, 584,000 that employ one to four employees, and 197,000 that employ five to 19 employees, of which most are deemed to be micro-entities with a turnover of less than $2 million. Small businesses employed approximately 4.5 million people in 2012-13, with one third of the businesses owned by people over age 50.

Most SME owners view their business not only as a source of income while they are working, but also as a primary means for funding their retirement. Almost 25 per cent of all self-employed Australians have no superannuation. This means that most small business owners will be looking to sell their business to fund all or part of their retirement, and to do this in the most effective manner they normally require a few things: someone to buy their business, appropriate valuation of the business, valid legal agreement, and a funding mechanism. In the event of death or permanent incapacity of the existing business owner, life insurance is a common means of funding a buy-sell agreement.

With these various changes, some people implemented buy-sell strategies inside SMSFs. Two such strategies raised the ire of the ATO.

Cross-member strategy – prohibited from 1 July 2014

From 1 July 2014, cross-member strategies within an SMSF have been prohibited. The ATO further clarified this view with a recent interpretative decision.

The cross-member strategy involves the members effectively holding insurance policies over each other to provide the required liquidity should one of the members die or become disabled. The ATO believes this arrangement would breach the sole purpose test.

For example, in relation to a two-member fund comprising unrelated business partners, the trustee would acquire a life policy over each member but would then hold the policy over the first member (Mark) in a segregated investment pool for the second member (Peter) and then hold the policy over Peter in a segregated investment pool for Mark. The premiums for each policy would then be deducted from the relevant member’s benefits, ie, the premiums for the policy held over Mark would be deducted from Peter’s account. It should be noted that this type of arrangement was previously permitted by the ATO. The ATO has confirmed that the arrangement is prohibited and that any proceeds received from the policy over one member could not be allocated directly to a different member’s account.

Previously this type of arrangement was used to either extinguish debt under a limited recourse borrowing arrangement (LRBA) within the SMSF, or to fund a buy-sell arrangement between the two members via the SMSF.

Funding a buy-sell agreement with life insurance benefits via an SMSF – prohibited in most situations.

The ATO clarified where an SMSF purchases a life insurance policy on behalf of one of its members that is "a condition and consequence" of a buy-sell agreement, then the SMSF will be in breach of the sole purpose test.

The specific example provided by the ATO highlighted a number of concerns. The sum insured amounts on the life insurance policies held by the SMSF, and the contributions received by the SMSF to pay for the life insurance premiums, was adversely influenced by the specific valuation of the business, terms and conditions contained in the buy-sell agreement. They should have been influenced by the needs of the spouse, family, or other beneficiaries.

The SMSF was not part of the agreement, the types of insurance cover were permitted within superannuation, and the benefits were paid in accordance with normal conditions of release, and were paid to a valid superannuation beneficiary, which all complies with the Superannuation (Industry Supervision) Act (SISA) and Superannuation (Industry Supervision) Regulations (SISR).

The insurance proceeds of the SMSF were being used to fund the buy-sell agreement upon the death or permanent incapacity of the member and thus were not being used exclusively to provide a death or retirement benefit to a member of the fund, nor were the benefits "incidental, remote or insignificant". This was deemed to be in breach of the sole purpose test under s62 of the SISA.

The second issue was the surviving business partner was not required to make any payments for the transfer of equity of the business upon the death or permanent incapacity of the departing business partner. Thus, a person who was not a member of the fund obtained a benefit (albeit indirectly) from the SMSF, and it was deemed to be a provision of financial assistance. This was deemed to be in breach of s65 of the SISA.

The ATO has stated that there may be particular situations where a buy-sell agreement that is funded by life insurance benefits inside a superannuation fund may not breach the sole purpose test. We await their guidance on this issue.


While life insurance is an excellent funding mechanism for buy-sell arrangements in the event of death or total and permanent disablement of a business partner, there are numerous potential complications by placing such an arrangement inside an SMSF. If in doubt, place the agreement and the life insurance funding the agreement, outside the SMSF.

Jeffrey Scott, senior development manager, BT Financial Group