Bankruptcy affects people in many ways and superannuation is often an afterthought. However, having an undischarged bankrupt as a trustee, or director of a corporate trustee, of a superannuation fund can have significant implications for individuals with SMSFs.
Trusteeship
An undischarged bankrupt is a disqualified person under superannuation law and is not eligible to be a trustee of an SMSF. It is also not possible for an undischarged bankrupt member to appoint their legal personal representative as a trustee.
If an SMSF trustee becomes an undischarged bankrupt, they are required to notify the Australian Taxation Office (ATO) immediately and make alternative arrangements for their SMSF within six months. If alternative arrangements are not made, the SMSF fails the superannuation law definition of an SMSF and ceases to be eligible for any tax concessions. The fund will be taxed at the top marginal tax rate (currently 45%) and the tax rate applies to the fund’s income and the market value of assets just before the start of the year, less the members’ tax-free component. This is the last thing a person needs after becoming bankrupt.
In addition to the tax penalties, civil and criminal penalties may also apply.
Alternative arrangements
There are three primary alternatives to restructure an SMSF:
- Rollover to a public offer fund
- Convert to a small APRA fund (SAF)
- Meet a condition of release.
Rolling over
Individuals may choose to roll their SMSF over to a retail, corporate or industry fund. However, the rollover of the SMSF to these types of funds will trigger a capital gains tax (CGT) event. In addition, any ability to carry forward capital losses will be lost.
When the individual is discharged from bankruptcy and regains the ability to become a trustee, they may elect to roll the fund back to an SMSF and resume the trustee responsibility. However, this will also trigger a CGT event.
Retail and industry funds are also unlikely to be able to accept popular SMSF assets such as property.
Convert to a SAF
To avoid incurring CGT, trustees may choose to transfer the trusteeship to a professional licensed trustee thereby changing the structure of the fund from an SMSF to a SAF. Appointing a new trustee is not a CGT event; the fund (the tax paying entity) continues and therefore no CGT is incurred. Existing cost bases and any CGT losses can be carried forward.
When an individual regains their ability to become a trustee, they are able to convert their fund back to an SMSF structure without incurring any CGT.
A SAF is also likely to be able to accept property as part of a diversified investment portfolio of the fund.
Meet a condition of release
If an individual has met a condition of release they may be able to access their benefit and then wind the fund up within the six month grace period.
Case study - Lee
Lee, 45, is the sole director of the corporate trustee of his SMSF and he has just been declared bankrupt. Lee must immediately notify the ATO that he has become a disqualified person and must also make arrangements to wind up his SMSF.
Lee‘s superannuation assets include an investment property worth $500,000 along with shares, managed funds and cash valued at $1,100,000. The unrealised capital gains are $200,000 on the property and $150,000 on the shares and managed funds.
If Lee elects to roll over his fund to a retail, corporate or industry fund he will trigger a CGT event and the SMSF will need to pay tax.
In addition, Lee may have difficulty finding a retail, corporate or industry fund that will accept his investment property.
If Lee elects to transfer his SMSF to a SAF, there is no CGT event. Assuming that the trustee of the SAF accepts all of Lee’s assets as acceptable investments, Lee will simply be able to appoint a new licensed trustee to his fund via a deed of retirement and appointment that will also convert the fund to a SAF.
Case study – Bel and Sy
Bel and her husband Sy are both 48 and are individual trustees of the B&S SMSF. Bel is about to be declared bankrupt. Bel must immediately notify the ATO when she has become a disqualified person and she and Sy must make alternative arrangements for their SMSF. They have three options:
Option one
They can transfer Bel’s entitlement to another fund and have Sy continue as the sole member of the SMSF. Under this option, a CGT event will occur for Bel as her only option is to roll her fund over. She cannot utilise the change of trustee option since the B&S SMSF is continuing as an SMSF, with Sy as the sole member. Sy will need to appoint another individual trustee or be the sole director of a corporate trustee. If the B&S SMSF incurs capital gains, tax will need to be paid.
Option two
They can wind up the SMSF and each make alternative arrangements. Under this option a CGT event occurs for both Bel and Sy. Any capital gains will attract tax and any capital losses will not be able to be carried forward.
Option three
They can appoint a licensed trustee company and both continue membership of the B&S SMSF. The appointment of a new trustee to the B&S SMSF is not a CGT event. The fund will continue as a SAF rather than as an SMSF.
Summary
The consequences of bankruptcy can have a serious effect on superannuation where the trusteeship of SMSFs is involved. It is important that trustees understand the potential implications to their SMSF and act early to avoid serious penalties.
Julie Steed is Senior Technical Services Manager at Australian Executor Trustees. This article is in the nature of general information and does not consider the circumstances of any individual.