The prevailing extreme sharemarket volatility against a background of record low interest rates highlights critical advantages and disadvantages of self-managed super for business owners. This investment environment can truly separate the SMSF winners from the losers.
Ranking high among the potential SMSF winners are SME owners who have long held their business premises in their SMSFs for security of tenure, asset protection, business-succession planning, tax-efficiency and estate planning – plus to save for retirement. This tie-in with the owners’ businesses and their super funds can be critical for their investment success.
With their SMSF portfolios anchored by their business premises and perhaps other commercial property, many of these business owners would probably have been unfazed by the most recent sharemarket volatility.
Sue Prestney, a partner at PwC Private Clients, told SmartCompany many of her clients with long-held commercial property in their SMSFs have been doing very well with strong rental yields and capital growth. As Prestney emphasises, such SMSFs own highly valuable direct property portfolios that would be more difficult to create today given the restrictions on super contributions.
However, extreme sharemarket volatility in recent weeks highlights the plight of those business owners (among others) who have SMSF portfolios that are dominated by Australian shares, term deposits and cash while being poorly-diversified across at least the main asset classes.
Trustees of such SMSFs may have been more likely to have been unnerved by high volatility and more tempted to follow the investment herd by selling after stock prices had fallen.
According to an Investment Trends survey of almost 4000 SMSF trustees in April, SMSFs then held 41% of their overall assets in Australian direct shares with more than half of this invested in financial/banking and resource stocks.
Further, 35% of the cash holdings of SMSFs in April were regarded as “excess cash”, reports Investment Trends. This is cash that would normally be invested in other asset classes – a proportion that tends to rise during increased market volatility. (Tax office statistics show that cash and term deposits made up 26% of SMSF assets in March – a much, much higher percentage than for the big super funds with balanced portfolios.)
Here are critical advantages and disadvantages of SMSFs from the perspective of business owners in particular:
1. Separation of your personal and your business assets
Prestney says her SME clients use their SMSFs to separate their business assets from their retirement savings. These clients often take a family whole-of-portfolio approach, taking the extent of risk held by their businesses as well as by their super and non-super assets into account when selecting investments for their SMSFs.
A temptation for business owners is to treat their businesses as their only retirement savings. And therefore if their business fails, their retirement savings are lost. One of the attributes of super for business owners is its inherent asset-protection.
2. Ownership of your business premises
The Australian Superannuation Handbook 2015-16, published by Thomson Reuters and edited by Stuart Jones, features an excellent table comparing the advantages and disadvantages of SMSFs. And near the top of the list of advantages Jones lists the way that an SMSF can “complement a small business structure”.
Prestney says the way many of her SME clients complement their business structures is to acquire their business premises in their self-managed funds.
Numerous small-medium business owners hold their business premises in their SMSFs for tax-effectiveness, asset-protection, succession planning (for family enterprises) and security of tenancy.
Their businesses pay a commercial rent to their SMSF landlords. In turn, their SMSFs pay concessional tax on the rent and typically benefit from many of the usual tax breaks available to landlords – including tax deductions for interest on a property loan.
Significantly, business real estate is one of the limited types of assets that SMSFs are allowed to acquire from related parties including members.
And business real estate is one of the few types of assets that SMSFs can lease to related parties, including the members’ businesses, without a limit on its value under the superannuation in-house asset rules.
Martin Murden, a director of SMSF consulting and auditing with the Partners Wealth Group, says family businesses make “great” tenants provided the business is successful.
3. Your business succession planning
A popular goal among family SME owners is to hold their business premises in their family SMSF through generations as part of their business and personal succession planning.
However, Prestney says a challenge for her clients wanting the family business premises to remain in the family SMSF after the business founder’s death is the requirement in superannuation law that a member’s superannuation benefits must be paid out upon death.
This means that an SMSF would need enough assets in addition to the business premises to pay death benefits when necessary. This can be particularly difficult for younger family members to achieve given the annual caps on contributions.
4. Flexible estate-planning strategies
“For example,” Jones writes in the Australian Superannuation Handbook, “a member aged 60 or over can quickly withdraw benefits tax-free prior to death to avoid death benefits tax [otherwise payable by, say, a financially-independent adult child]. This illustrates the ability of SMSF trustees to move extremely quickly – a key attribute for business owners who may have built up considerable wealth in their super funds.
5. Greater and more flexible asset protection
Assets held in a super fund are legally inaccessible to trustees in bankruptcy – provided contributions or asset transfers were not made with the “main purpose” of avoiding creditors. This makes super such a critical means of asset protection for SME owners, particularly as there is no dollar limit on the protection.
As discussed, many SME owners place their business premises in an SMSF partly as an asset-protection strategy.
6. Otherwise unaffordable assets
Family-owned SMEs – run by the founders and their adult children – often pool their superannuation assets in the one SMSF. This enables the fund to buy high-cost assets such as business premises and other direct property that the fund could not otherwise afford.
7. Minimisation or elimination of CGT
Many business owners have a general strategy of holding their business premises and other direct property in their SMSFs until their funds begin to pay a superannuation pension. This is because no capital gains tax (CGT) is payable once an asset is backing the payment of a pension. The strategy, of course, applies to any growth assets such as shares and is subject to investment considerations.
8. Unique retirement savings opportunities for small business owners
Contributions of proceeds from the sale of small business assets that qualify for particular small business capital gains tax (CGT) concessions – the so-called 15-year ownership or the retirement exemptions – do not count towards the annual non-concessional (after-tax) cap on super contributions if within a lifetime limit. (The indexed limit for 2015-16 is $1.395 million).
This strategy may provide a means for eligible vendors of small businesses to rapidly boost their super savings while minimising or eliminating CGT from the sale.
9. Other standard advantages of SMSFs
- Ability to quickly buy or sell assets: SMSF members can almost instantly change their investments and/or the asset allocation of their portfolios. With large funds, there is sometimes a frustrating lag between when investment changes are requested and when those changes are executed.
- Means to invest differently: SMSFs enable members to invest in a way that is generally not available in most large super funds. For instance, SMSFs can hold direct property, unlisted shares and other not-so-common assets. SMSFs can invest in their selection of investment fund managers and direct shares (large super funds are increasingly allowing members to invest in direct shares).
- Potential to cut costs: SMSFs with larger balances may have lower fees than many large super funds, much depending upon the circumstances. This is because administration costs of a self-managed fund are more or less fixed – no matter its asset value. And SMSFs that invest directly rather than through managed investment funds are not liable for fees based on a percentage of their asset values.
- Way to avoid administrative weaknesses of big super funds: With an SMSF, the trustees are really in control. You can act decisively when making investment decisions and more or less ensure that no mistakes are made in the administration of your fund.
1. Time consuming for busy SME owners
A pressing question for busy owners of thriving businesses is whether they really have enough time to proper run an SMSF – even if intending to rely heavily on professional assistance.
A survey by Investment Trends earlier this year found that 45% of SMSF trustees found finding the time to make investment decisions was one of the “hardest aspects” in managing an SMSF.
2. Business experts not necessarily investment experts
SME owners by character tend to be confident in their own abilities. That is partly why their businesses may be thriving. That independent approach is one reason business owners are among the biggest supporters of self-managed super.
But just because someone is good at business doesn’t mean they are good at investing. Their independent nature may discourage them from seeking specialist professional advice.
3. Temptation for business owners to become overly involved
The tax office, as regulator of self-managed super, readily acknowledges the vast majority of SMSFs are husband-and-wife funds dominated by one spouse and self-confident business proprietors tend to fall comfortably into the role of dominant trustee.
One of the downsides of having a dominant trustee is what will happen to the fund’s investments and its administration if that dominant trustee were to become seriously ill or perhaps die.
4. Risk of business premises dominating investment portfolio
Superannuation law does not prohibit a fund from owning just one asset such as the valuable premises of the members’ family business. While this can be seen as an opportunity, it is also a potential trap for SME owners.
Certainly, some fund trustees specifically decide to have SMSF portfolios dominated by a single property asset, perhaps after considering the diversification of their other super and non-super investments. Afundamentalprinciple of sound investment practice is to spread risks and opportunities with appropriately-diversified portfolios.
5. Risk of divided loyalties
Potential conflicts of interest can arise if a family business struggles to pay rent on business premises owned by their family SMSF. While the principals of a family business may need the premises to keep trading, the trustees of the family SMSF – typically the same people – must legally maintain the fund for the sole purpose of paying member retirement benefits.
Apart from the sole purpose of superannuation, SMSFs are prohibited from providing financial assistance to members, says Martin Murden of the Partners Wealth Group. This includes giving rent relief to troubled family businesses.
6. Strict control over investment practices including dealing between a business owner and an SMSF
Almost 60% of reported contraventions by self-managed super funds involve illegal related-party transactions between a fund and its members, their families or their related entities. Another 25% of reported contraventions involve a failure by SMSF trustees to separate super fund money from their personal or business assets.
SMSF trustees who own SMEs are particularly vulnerable to becoming involved in illegal related-party transactions including the use of super money to prop-up businesses experiencing financial difficulties.
Business owners considering setting up an SMSF should consider the:
- Sole-purpose test (a super fund must be maintained for the sole or core purpose of providing retirement benefits).
- SMSF trustees are barred from providing loans or financial assistance to members or their relatives – even under commercial terms.
- SMSFs are generally prohibited from making loans, providing leases or having investments with related parties and entities that exceed five per cent of its total asset value. (Certain exceptions apply including business real estate.)
This means dealings between the members’ businesses and their SMSFs must be extremely limited.
7. Other standard disadvantages of SMSFs
These include stiff penalties for serious breaches of superannuation law; high, uncompetitive costs of running a low-asset SMSFs; the risk of losing interest – particularly as members age; and the need to plan carefully about what will happen to an SMSF following a member’s death.