Simple question with not such a simple answer.
We have recently taken on a client who has been advised to setup an SMSF for their new family business venture. As we do not believe that this is in the best interest of the client and because of the fact that there are many others in the same situation, we decided that a more detailed explanation is warranted.
While there is nothing specifically prohibiting SMSF from carrying on a business, there are lot of issues to consider. Do not get caught out by the attractive 15% tax rate and read on…
To begin with, the business must be:
1. Allowed under the trust deed
How often do you read your deed to ensure that this is the case? Has your accountant bothered to read it and explain all the rules and conditions listed in there? While many SMSF trustees who have more traditional investments may not be affected as deeply by the standard rules set out in the deed, situation is very different for trustees who decide to operate business.
2. Operated for the sole purpose of providing retirement benefits for fund members.
If the trustee of an SMSF carries on a business, the ATO looks at it very closely to ensure the sole purpose test is not breached. Cases that attract their attention include those where:
- the trustee employs a family member (they look at things such as, the stated rationale for employing the family member and the salary or wages paid) – it is safe to say that this would be a case for most family businesses
- the ‘business’ is an activity commonly carried out as a hobby or pastime
- the business carried on by the fund has links to associated trading entities
- there are indications the fund’s business assets are available for the private use and benefit of the trustee or related parties.
3. Other practical problems (which would not be a problem if the business was carried on in a non-SMSF environment)
Borrowings and overdrafts
As a business owner, you may run into cash flow issues. Normally, you can overcome them by simply lending the money to your business or borrowing from third parties. SMSF will not be able to do so.
Excluding eligible LRBAs, section 67 would all but prohibit an SMSF business from entering into normal credit facilities.
On the other hand, if your business is doing well and you want to borrow money from it, you are able to do so in non-SMSF environment. Section 65 however prohibits this for the SMSF business.
Non-arm’s length dealings with related parties
These are some of the most common things that occur in a family run business:
– Providing or receiving services from a related party – does your spouse/ child have a business that would complement yours? Is there any chance that they would get a favorable treatment like getting paid before other creditors or getting paid above market value?
– Employment of relatives – are you going to work in the business yourself? Are you going to pay yourself market rate for your work?
– Leasing of property – are you planning to use your property for business? If so, will you be charging commercial rates?
– Provision of fringe benefits – are you planning onto having a company car? What about something simple like a phone or a laptop?
There are so many other things to consider but the ones above are very simple to relate to by most business owners.
Where to from here?
It is safe to say that running a business in SMSF has way too many pitfalls.
If the trustees, despite the above, decide to run an SMSF business that operates in a way that doesn’t breach a specific SIS prohibition, they still need to consider the underlying reasoning behind this course of action.
Are you doing this for the sole purpose of providing retirement to your SMSF members? Or are you simply doing it for tax benefits? What would a reasonable arm’s length trustee do?
If you hesitate answering this question, you should think again.
Contravening the sole purpose test is very serious. In addition to the fund losing its concessional tax treatment, trustees could face civil and criminal penalties.
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