Effective death benefit protection

SMSF members always want their death benefits to be distributed to the people they nominate and even often want to prevent certain individuals from receiving them. LightYear Docs director and founder Grant Abbott examines the strategic options that can facilitate the desired outcome.

Legal challenges over death benefits are only increasing in number, making it more important for advisers to be able to formulate strategies ensuring the end recipient is the person the deceased member chose. The following scenario explores the options available to practitioners and their efficacy.

Introduction: A grandfather’s last stand

John Hamilton, an 82-year-old retiree from Melbourne, is facing the fight of his life. Not against cancer, though the doctors have given him less than a year to live, but against a system that could strip his grandson, Liam, of his rightful inheritance. His superannuation fund, built over decades of hard work, stands at $1 million and John has promised it all to Liam.

But there’s a problem. His two adult children, Ben and Sandra, want it all, despite, according to John’s words, “being hopeless with money”. Here’s why.

Ben, once a promising lawyer, spiralled into a gambling addiction burning through his father’s generosity over the years. Sandra, struggling with bipolar disorder, has been in and out of psychiatric facilities. Both have been draining John dry financially for decades and he wants no more of it.

In contrast, Liam is different. At just 14, he has been living with his mother, John’s daughter-in-law, Kate, ever since Ben abandoned them. John has been quietly paying for Liam’s private school fees, costing $1500 a month, to ensure he gets the best education possible.

Now, as the final curtain closes, John wants only one thing – to ensure every dollar of his SMSF wealth goes to Liam and not his children.

What is your advice to John on how to look after Liam? How many strategies can you think of? You would be surprised to know there are at least 10.

Typically, an expensive and well-reputed estate planning lawyer has recommended a testamentary trust (TT) to cover the super and the family home for $25,000 in fees, but John isn’t convinced. He has heard SMSFs offer powerful wealth-protection tools if used correctly.

This is not just an estate planning issue, but a battle for family SMSF wealth protection.

Strategies to secure Liam’s benefits

Below are my top strategies to ensure the SMSF death benefits are allocated to Liam.

1. A TT via John’s will – receiving the SMSF death benefits in line with the estate planning lawyer’s advice and partitioning for Liam in a super proceeds trust.

2. A family protection trust (FPT) – withdrawing John’s benefits from his SMSF now and gifting them to a newly established FPT for Liam.

3. A strategic SMSF will – this will direct his SMSF benefits into a special purpose SMSF death benefits trust (DBT) for Liam.

4. A pension SMSF will – this will establish an account-based pension (ABP) for Liam and will last until the funds run out.

5. A reversionary pension – commencing an SMSF pension for John with a reversion to be paid to Liam on his death.

As we will see, while a testamentary trust is a common legal tool, it is not the strategy for John due to a guaranteed family provisions claim. As such, the FPT and the SMSF route offer a far superior wealth-protection strategy.

However, before embarking on any of these strategies, the following element must be determined.

Liam’s dependant status

The Superannuation Industry (Supervision) (SIS) Act 1993 and the Income Tax Assessment Act (ITAA) 1936 determine who qualifies as a dependant for the purpose of receiving taxfree super death benefits.

Both the SIS Act and ITAA deal specifically with spouses and children, but not grandchildren. To determine if the SIS Act allows a payment from the fund directly to Liam tax-free, we must establish that Liam is a financial dependant of John.

What is financial dependency?

One of the critical issues when structuring SMSF death benefit strategies is whether the intended recipient qualifies as a dependant under the SIS Act and ITAA. Two landmark cases, Malek v FC of T and Faull v Superannuation Complaints Tribunal, have helped shape the understanding of financial dependence, which is crucial in determining whether death benefits can be received taxfree.

Financial dependence through regular contributions

The Malek case revolved around Antoine Malek, a young adult who passed away with superannuation benefits. He was single, had no children and lived with his widowed mother, Mrs Malek. The key facts of the case were:

• Mrs Malek was receiving a disability support pension of $153 a week, and

• Antoine regularly contributed $258 a week to support her living expenses, including food, mortgage payments, taxi fares, medical expenses and bills.

The legal argument witnessed the following:

• the Administrative Appeals Tribunal (AAT) considered the regularity and necessity of Antoine’s contributions to his mother in determining dependence, and

• the AAT reviewed case law on financial dependence and cited Gibbs J in Kauri Timber Co (Tas) Pty Ltd v Reeman (1973) 128 CLR 177:

“One person is dependent on another for support if they rely on that person to maintain their normal standard of living, even if they could have supported themselves from another source.”

In the decision handed down, the AAT ruled Mrs Malek was financially dependent on her son, Antoine, because she relied on his continuous and regular contributions to maintain her lifestyle. As a result, she was entitled to receive his superannuation death benefits tax-free.

The decision had significant SMSF implications, such as determining:

• a person receiving regular and ongoing financial support from a parent, grandparent, aunt, uncle or friend may be considered, depending on the facts, to be a financial dependant of the provider, and

• ongoing and substantial contributions, such as school fees, rent, a family allowance or other living expenses, may establish dependency under both the SIS Act and ITAA.

Partial financial dependence counts

The Faull case extended the principle by confirming even partial financial dependence is enough to qualify as a superannuation dependant. The key facts of the case were:

• Llewellyn Faull, a 19-year-old, died unexpectedly,

• his mother, Mrs Faull, was employed and earning $30,000 a year, and

• Llewellyn contributed $30 a week to her as board and lodging.

The legal issues were:

• whether $30 a week was enough to establish financial dependence, and

• whether Mrs Faull was relying on this payment for her standard of living.

The decision for this case saw the AAT rule financial dependence does not require total reliance. Since Llewellyn’s contributions augmented his mother’s income, she was deemed financially dependent. As a result, she was entitled to his superannuation benefits tax-free.

The implications for SMSFs were:

• even small, consistent payments can establish dependency, and

• if a grandparent provides regular school fee payments, medical costs or allowances to a grandchild, that individual may qualify as a financial dependant.

Application to John’s case

Applying Malek’s and Faull’s cases to John and Liam’s case, we can argue:

• John has been paying $1500 a month for Liam’s private school fees. This is a substantial and ongoing contribution, and

• Liam’s mother earns an income, but Liam relies on John’s financial support for education and living standards. Therefore, Liam should qualify as a financial dependant under the SIS Act and ITAA.

Given this status, John can:

1. Directly pay a pension or lump sum to Liam via an SMSF will.

2. Provide for Liam as a reversionary pension beneficiary.

3. Bypass the estate completely, avoiding family provision claims from his father and aunt.

4. Prevent his children from accessing Liam’s SMSF inheritance.

5. By leveraging these landmark cases, John’s SMSF strategy shields his wealth from legal challenges and ensures it remains within his bloodline.

6. Of course, it would be safer for John to seek a private binding ruling (PBR) from the ATO to confirm his available actions.

Let’s now assess the five strategies suggested above and their efficacy for John’s predicament.

Option 1: TT

A TT is one created under John’s will that would hold his SMSF proceeds for Liam. The arguments for using one would be:

• it provides control over how the funds are spent,

• it ensures asset protection against creditors or future family disputes, and

• Liam, as a minor, benefits from adult tax rates on trust distributions.

But there are drawbacks such as:

1. The SMSF death benefits must first go to John’s estate:

o this means they can be contested by Ben and Sandra under Victoria’s family provision laws, and

o Ben and Sandra as children could argue for a fair share of the estate.

2. Probate and delays:

o the final payouts could take months, even years, if contested, delaying Liam’s access to funds and will cost in the hundreds of thousands of dollars in legal fees.

Clearly the TT exposes John’s wealth to unnecessary risk and is the least attractive option.

Option 2: setting up an FPT

The second option is for John, while he is in his final year of life, to withdraw his benefits from his SMSF and gift it to an FPT that has himself and then Liam as family protection appointors. Unlike most discretionary trusts, an FPT does not have named beneficiaries due to the inherent trustee removal issues by beneficiaries. Upon John’s death, Liam and his bloodline children will be beneficiaries of the trust with exclusions for spouses or stepchildren. It extends to bloodline relatives as well.

The benefits in this strategy are the gift by John prior to his death ensures the super benefits are tax-free and a PBR confirming Liam is a dependant does not have to be sought. Also, as the gift happens prior to John’s death, it is not caught up in any family provision claim.

The downsides are any distribution from the FPT to Liam prior to age 18 will be assessed at the penalty tax rates for trust distributions to minors. Further, as Liam is under 18, he cannot be a director of the corporate trustee, raising the issue of who will hold that role until he becomes an adult. Liam, however, can be the family protection appointor as a minor.

Option 3: death benefit pension

An SMSF will is a set of strategic directions encapsulated in the governing rules of the fund that go beyond standard binding death benefit nominations essentially built for industry and retail superannuation funds. Further, section 102AG of the ITAA enables the creation of a DBT when John dies where his death benefits will be channelled into that trust. The beneficiary will be Liam and his bloodline children.

The advantages of this strategy are Liam will be taxed at adult tax rates, the DBT is protected from any family provision claim and his benefits will be protected from any future litigation or family law action against him.

However, Liam will be subject to tax on distributions and he cannot be a trustee or a director of a corporate trustee until age 18.

Option 4: account-based pension

The SMSF will can provide that, on John’s death, his benefits are to be paid as a pension to Liam. Since Liam qualifies as a financial dependant, he can receive a pension from the SMSF and, as he is not John’s child, the commutation rule at age 25 does not apply.

The advantages of this course of action are the pension is assessable income, but Liam will receive a 15 per cent tax offset and the underlying income and capital gains in the fund are tax-exempt. In addition, the benefits will not be caught up in any family provision claim and Liam will be provided with a constant income stream and may be tailored with limited commutations written into the SMSF will and pension documents.

Unfortunately, if this strategy is used, the death benefit is not protected from litigation or any family law or de-facto separation agreement and the ABP will be tested against Liam’s transfer balance cap, which may limit future super contributions.

Option 5: reversionary pension

In this case, John can commence an ABP now and have Liam as a reversionary beneficiary. This approach produces the same outcomes as option 4, however, as the pension is from John, who was receiving it tax-free, it will also be tax-free to Liam. All other advantages and disadvantages from option 4 apply.

Conclusion

There are another five strategies that can be brought to bear for John and Liam. The most important thing is to remember to take into account the SMSF, estate planning and asset protection elements.