28 – Superannuating related persons
A pre-June chat: superannuate mum and dad
Last year, just before 30 June, an adviser rang to discuss her parents’ position.
Tran is originally from Vietnam. Her parents arrived on a boat, worked hard, did without, put the kids through school and university and now, in their sixties, cannot stop working. Every evening they come to her office and clean and administer the practice. Its like the Penguin Parade at Philip Island. A force of nature that cannot be stopped.
Tran’s question was simple: “Could her practice trust superannuate her parents?”.
The answer was simple too: “Yes. It could. Up to their aged based limits of $35,000 each, ie $70,000 in total, and there was no reason why the contributions could not be paid to Tran’s SMSF, with her parents becoming members and trustees at the same time.”.
The $70,000 of contributions would be taxed at 15% in the SMSF’s hands. This meant the remaining 85% or $59,500 cash could be used by the SMSF to help repay the loan on Tran’s office. Her SMSF had bought the office using a non-recourse loan some years earlier, and its investment strategy focussed on rapid debt reduction: all net rents and contributions were dedicated to paying off that loan as fast as possible.
The courts’ view
Tran was concerned the ATO might be concerned the amount of $70,000 was greater than the market value of her parent’s work?
The short answer is this matter has been decided by the courts. In summary, there is no arms length rule for deducting super contributions and the full amount of the contributions paid for related persons will be deductible even if it is greater than the market value of the work performed by the related person.
This is accepted by the ATO and you can read its views on this matter here: ATO Tax Determination Ryan’s case and super contributions for related persons.
Documentation of the employment relationship
For completeness, we thought it wise to document what had previously been a somewhat loose employment relationship. Employment contracts were put in place. Everything else was done by the book too. Tran’s practice trust prepared minutes of meetings of directors where the significant contribution of Tran’s parents to the practice over the years was recorded and appreciated. There is no doubt Tran’s parents are genuine employees, and now the paper work showing this is in order too.
The reality was, like many family businesses, Tran’s parents had been under-paid in earlier years. They had frequently worked for no pay while Tran got her show up and running. Tran e-mailed her parents acknowledging this, and explaining that the super contributions were a part compensation for this, and truly well earned.
Find the cash
Tran’s practice trust did not have $70,000 available, so it used her NAB line of credit to pay the contributions. The interest will be deductible against her assessable income under the general rules of deductibility: interest on amounts borrowed by an employer to pay employee contributions is inherently deductible. Tran’s practice trust could borrow to pay the contributions: Borrowing to pay super contributions.
To complete the picture, Tran’s parents are both over age 60 so it was a no-brainer to start a pension: this means their share of the SMSF’s investment earnings is tax free and the pension income paid to them each year by the SMSF is tax free. This is explained here: Start a transition to retirement pension.
The strategy did not have Centrelink implications: Tran’s parents are not eligible for the old age pension.
Tran’s closing comment: inter-generational financial planning
As our conversation ended Tran observed that she had in effect put a very efficient gearing strategy in place. From a family financial planning point of view, where the extended family is viewed as the relevant economic unit, ie the real client, they had used a tax deductible loan to make a tax free investment, with no change to the family’s overall level of debt, and they had picked up the tax benefits connected to large super contributions, ie $21,000 cash, being $70,000 times (45% less 15%).
Tran was right. The family was $21,000 better off in cash, and would enjoy further tax savings in future years due to the interest on the $70,000 loan being deductible but the income on the SMSF investment being tax-free. The amount is about $1,500 a year every year.
This strategy is a good example of what can be done using inter-generational financial planning principles, which are discussed here Friday Reflection for 20 November 2015.
Related persons over age 65?
Tran’s parents are under age 65. But soon they will be over age 65, and when they are they will have to pass a work test. You can read a good article by Michael Dietrich in the Discover Super website here: Over 65 work test for contributions.