Avoiding the common death trap

Sole-member SMSFs can create several issues when the person in question dies. LightYear Docs director and founder Grant Abbott details a solution ensuring the fund enjoys a smooth transition and conclusion.

It is fairly commonplace for an SMSF to have a single member who is the sole director of the fund’s corporate trustee. However, this can lead to complications upon this individual’s death, including management, compliance and legal issues.

Luckily there is a practical solution that can allow people in this situation to avoid any of these problems.

Case study: The $2 million SMSF with one member

Let’s look at an SMSF with $2 million in assets and a single member, John Smith, who is aged 63. John established a corporate trustee for his SMSF where he was the sole director. The fund was performing well, investing in a diversified portfolio of property and equities, and he had been planning to draw down a pension from the fund in the coming years.

However, John passes away suddenly, leaving the fund in a precarious position. As the sole member and sole director of the corporate trustee, his death creates a number of critical legal, tax and compliance challenges that could jeopardise the fund’s status and potentially the $2 million it holds.

Immediate consequences

Upon John’s death, the SMSF is left without a trustee or a director of the corporate trustee. This creates a vacuum in governance and management, raising a fundamental question: who will take over the role of trustee and what happens to the fund in the meantime?

Who steps in?

With John’s passing, the corporate trustee now has no director, which is a breach of one of the core requirements for SMSFs. Section 19 of the Superannuation Industry (Supervision) (SIS) Act 1993 mandates all SMSFs must have either individual trustees or a corporate trustee with at least one director. Without a director, the corporate trustee is nonfunctional, leaving the SMSF exposed.

If no director is appointed to the corporate trustee within a reasonable timeframe, several compliance issues arise and the fund may lose its status as a registered superannuation fund. This brings us to five critical compliance and operational risks.

Five potential compliance issues

1. Loss of tax concessions and noncompliance status

The SMSF’s eligibility for concessional tax treatment is contingent upon meeting its trustee requirements. Without a trustee, the SMSF may not be a regulated superannuation fund under section 19 of the SIS Act.

Without timely action, the ATO may deem the SMSF non-complying, which could result in the fund being taxed at the highest marginal rate of 47 per cent (including the Medicare levy) instead of the concessional 15 per cent. This could be a significant financial blow to the remaining beneficiaries, reducing the value of the $2 million SMSF. Alternatively, if the fund falls outside of being a regulated superannuation fund, it will be treated as a fixed unit trust for taxation purposes.

2. Breaches of trustee responsibilities

John’s death leaves the SMSF without anyone to manage its day-to-day operations. This includes maintaining records, lodging tax returns, meeting financial statement obligations and ensuring investment decisions are compliant with the fund’s trust deed and the SIS Act.

The absence of a trustee creates a breach of the fund’s obligations under section 35B of the SIS Act, which requires the trustee to ensure all financial and operational duties are maintained. Noncompliance with these obligations could result in further penalties from the ATO.

3. Inability to pay benefits or pensions

With no corporate trustee or director, the fund is unable to action any requests for the payment of death benefits. If John had dependants or had named a legal personal representative (LPR) in his binding death benefit nomination (BDBN), those benefits cannot be paid out without a functioning trustee.

This delay can lead to financial hardship for beneficiaries, particularly if they were dependent on the SMSF’s income, such as a spouse or children. The deceased’s estate could also be left in limbo, further complicating estate planning and distribution.

4. Investment management and loss of control

With no trustee there is no one to manage or oversee the fund’s investments. This lack of control could lead to missed opportunities, poor performance or noncompliance with the SMSF’s investment strategy – again a breach of the SIS Act.

If the fund holds illiquid assets such as property there may be management issues. For example, rental properties within the SMSF would need someone to manage leases and collect rent. Without a trustee, the fund could suffer financially from mismanagement or neglect of its assets. Also, who would operate the fund’s bank account?

5. Risk of legal disputes among beneficiaries

The lack of a clear trustee can also open the door for legal disputes among beneficiaries. If John had family members or others listed as dependants or beneficiaries, disagreements could arise over who should be appointed as the trustee or how the SMSF’s assets should be distributed.

The Gainer case

Case note – In the matter of Gainer Associates Pty Limited [2024] NSWSC 1138

The matter of Gainer Associates Pty Limited concerns the administration of an SMSF following the deaths of its members, highlighting issues of trust deed compliance, trustee discretion and superannuation law. After the passing of Gail and Werner Thelen, the corporate trustee, Gainer Associates Pty Limited, was tasked with distributing a $7 million death benefit. However, a dispute arose when the trustee proposed to divide the benefit between Gail’s partner, Mr Bone, and her estate contrary to Bone’s claim for the entire benefit. Complications included challenges to trustee qualifications and compliance with the SMSF trust deed that required appointing the LPR as the trustee director under section 17A of the SIS Act. Instead the accountant, Mr Heesh, was improperly appointed, risking noncompliance with SMSF regulations.

The court proceedings revealed the complexities of trustee responsibilities and remuneration. While trustees are generally prohibited from receiving fees for services related to SMSF administration, the court allowed partial remuneration under section 17B(2) of the SIS Act for non-trustee-related work. However, $31,900 in fees directly related to Heesh’s director role was disallowed as payment would have caused fund noncompliance. Importantly, the court found Gainer Associates had acted in good faith and sought appropriate legal advice. This judicial advice process clarified the proper death benefit distribution, ultimately ordering one-third to Bone and two-thirds to Gail’s estate, while trustee and estate costs were allocated accordingly.

Key takeaways

The case underscores the critical importance of a well-drafted trust deed to guide trustees through disputes and compliance challenges. Trustees must strictly adhere to the deed and the SIS Act to ensure lawful fund administration.

Trustees must exercise discretion in good faith, considering all relevant circumstances and seeking judicial advice when disputes arise. Judicial guidance protects trustees and ensures compliance while resolving contentious distributions.

Breaches of the SIS Act, such as improper appointments or non-compliant remuneration, can result in severe tax and compliance risks. The case highlights the necessity for sound legal support to navigate the complexities of SMSF governance and protect the fund’s integrity.

Without a trustee in place to make objective decisions, disputes could escalate into costly litigation, which could erode the value of the fund. Legal proceedings would delay the distribution of benefits and add significant stress to already grieving family members.

How John’s estate and beneficiaries can avoid these pitfalls

1. Appoint an LPR as temporary trustee

One solution would be for John’s estate to appoint an LPR to act as the temporary trustee of the SMSF. The SIS Act allows an LPR to step into the trustee’s role upon the death of a sole member. The LPR would have the authority to manage the SMSF, pay out benefits and oversee the winding up of the fund, if necessary. However, the trust deed must have in place the ability for this automatic appointment.

2. Establish a successor trustee plan

If John had established a successor trustee or appointed another individual to act as the director of the corporate trustee in the event of his death, many of these issues could have been avoided. Proper succession planning within the SMSF, including detailed instructions in the trust deed or binding nominations, is essential for avoiding such complications.

3. Wind up the SMSF

If no suitable trustee can be found, the fund may be wound up with its assets sold and the proceeds distributed to beneficiaries according to the trust deed. This process must be handled carefully to avoid penalties or non-compliance with the SIS Act. However, the Gainer Associates case may see this take years and run legal costs into seven figures.

Case study: a solution for John

Let’s return to the case of John. As the sole director of his corporate trustee, John’s death immediately leaves the SMSF without a functioning trustee, raising multiple compliance issues. The situation becomes critical because, under SMSF regulations, a fund without a trustee cannot operate.

However, this entire scenario could have been easily avoided if John had planned for such a contingency by implementing a successor director solution. Let’s explore how this solution would have ensured a smooth transition for John’s SMSF and avoided many of the problems that arise when a fund is left without a trustee.

What is the successor director solution?

The successor director solution is a strategic mechanism built into the structure of an SMSF’s corporate trustee. It ensures, upon the death or incapacity of a sole director, a designated person –the executor of the deceased member’s estate – is automatically appointed as the new director. This person can step into the role of trustee, preserving the continuity of the fund’s operations and preventing the fund from falling into a governance vacuum.

This solution is particularly crucial for SMSFs with only one or two members as it mitigates the risks associated with losing the fund’s sole decision-maker.

How John should have handled his SMSF

If John had planned effectively, his SMSF would have included a well-drafted successor director clause in the corporate trustee’s constitution or the fund’s governing documents. This clause would have automatically appointed a successor director – typically the executor of his estate – upon John’s death. Here’s how this process would work and the benefits it brings:

1. Immediate appointment of a successor director

Upon John’s death, the executor of his estate, or another designated successor, would automatically be appointed as the director of the corporate trustee. The corporate trustee continues to function, ensuring there’s no gap in governance, and the fund remains compliant with the requirements of the SIS Act.

This automatic appointment avoids the need for external intervention, court applications or delays, ensuring the smooth continuation of the SMSF’s management. The successor director takes over all responsibilities, such as managing the fund’s investments, maintaining compliance and preparing for the distribution of benefits.

2. Continued access to tax concessions

One of the major risks of having no trustee is the SMSF could lose its concessional tax status, leading to punitive taxation at the highest marginal rate of 47 per cent (including the Medicare levy). By having a successor director in place, the SMSF can maintain its compliance as a regulated superannuation fund, ensuring it continues to benefit from the concessional 15 per cent tax rate on earnings.

This is especially important in John’s case as a loss of concessional status could erode a significant portion of the $2 million in assets, leaving his beneficiaries with far less than intended.

3. Uninterrupted investment management

John’s SMSF may have held a variety of assets, including property and equities. Without a trustee in place, these investments could fall into neglect.

Rental income may stop flowing, market opportunities could be missed or critical decisions might not be made.

The successor director ensures there is no break in the management of these assets.

4. Prompt payment of death benefits

One of the successor director’s immediate tasks is to action the payment of John’s death benefits. If he had a valid BDBN or SMSF will in place, the nominated individual would be responsible for paying out the benefits to the nominated beneficiaries.

Without a trustee in place, the SMSF could face significant delays in paying out benefits, which could cause financial hardship for the beneficiaries.

5. Minimisation of legal disputes

SMSFs with no appointed successor director often become the subject of legal disputes, especially when there are multiple potential beneficiaries. Without a trustee, family members may argue over who should control the SMSF, delaying the distribution of benefits and leading to costly litigation.

By having a successor director automatically appointed upon John’s death, the legal framework is clear and disputes over control are minimised as the appointed person is empowered to handle the fund’s operations, reducing the risk of family conflicts.

John’s case illustrates the importance of planning for continuity in the management of an SMSF, particularly when there is only one member involved. By implementing the successor director solution, John could have ensured his SMSF continued to function smoothly upon his death, avoiding serious compliance breaches, tax penalties and legal disputes.