Income tax considerations on death benefit payments

The tax profile of members’ death benefits is an important consideration in succession planning.

The starting point is that a death benefit lump sum paid to a ‘tax dependant’ (ie, a death benefits dependant under s 302-195 of the Income Tax Assessment Act 1997 (Cth)) will be tax free (ie, as non-assessable non-exempt income) in the hands of the recipient. A dependant for tax purposes means (in respect of a deceased member):

· a spouse or former spouse;

· a child under 18;

· any person in an interdependency relationship with the deceased; or

· anyone who was financially dependent on the deceased.

As a result, adult independent children typically do not qualify as tax dependants. The taxable component of any death benefit payment they receive (usually when there is no surviving spouse) will be subject to a ‘death tax’—typically 15%, plus the 2% Medicare levy. Only the tax-free component is exempt from tax.

Summarising the tax applicable on a lump sum payment of death benefits

The below table summarises the tax treatment for lump sum death benefit payments:

Note: The above rates do not include the Medicare levy, currently 2%.

Generally, there is no element untaxed in an SMSF unless the fund has previously claimed deductions for insurance premiums in respect of members. Further, there is generally no practical effect in relation to the element untaxed where the benefit is paid to a tax dependant or where the deceased was aged 65 or over at the time of their death.

Other tax aspects

While this article primarily focuses on income tax, it’s important to note that other relevant tax aspects should be considered, including:

· Fund-level capital gains tax (CGT), eg, if CGT assets are transferred or sold; and

· stamp duty and other indirect taxes (including changes in the level of land tax levied).

Planning for an exit

To mitigate the ‘death tax’ that arises where death benefits are paid to non-tax dependants, some members may wish to plan in advance to withdraw their superannuation benefits before their death (ie, assuming that the member is over age 60 and has met a relevant condition of release).

Naturally, this is an option that should not be contemplated lightly as the relevant entitlements will leave the super environment and there may be limited opportunities to make further contributions, subject to the member’s age and other factors. Furthermore, any earnings on the withdrawn funds will be subject to standard tax rates once outside the superannuation environment, potentially diminishing the tax effectiveness of this strategy, especially if the member survives for many years after withdrawal.

In any event, if the option is being seriously contemplated, SMSF members must carefully plan how to execute the withdrawal, eg, by paying:

· ordinary pension payments for any pensions that may be in place; and/or

· lump sum payments for the member’s accumulation entitlements and amounts arising on commutation of a pension.

Superannuation benefits can be withdrawn by drawing down on a pension account (assuming the pension is an account-based pension with no payment restrictions in place). However, pension payments must be made in cash, meaning assets may need to be liquidated, which can be problematic when the fund holds illiquid investments. Additionally, pension payments will not address any balance in the member’s accumulation account.

To expedite the withdrawal process, an SMSF member seeking a timely exit may opt to transfer fund assets on an in-specie/in-kind basis (ie, as a lump sum payment).

Lump sum payments in specie

Transferring legal title to relevant fund assets from the SMSF trustee to the member (as part of a lump sum payment in kind) is generally considered the most conventional way to achieve a speedy withdrawal of non-cash assets from an SMSF.

However, the process of transferring legal title can still take days, weeks, or longer, depending on the assets involved, such as:

· real estate;

· assets that cannot be readily realised or transferred for various reasons; or

· securities (eg, shares or units) that are subject to specific transfer requirements or formalities in the governing rules of the trust or company.

What if there is little time to act?

If the member dies and the relevant assets remain with the SMSF trustee, a mere request to cash the fund assets as a lump sum will generally not be accepted by the ATO as a valid basis for treating the benefits as having been paid to the member (for legal, tax, and accounting purposes).

SMSF members, trustees, and advisers need to be aware of the ATO's current position on this matter, which has become more stringent in recent years — see the ATO’s webpage here for relevant commentary QC 45254).

Therefore, if time is critical in executing a withdrawal of benefits, it is vital to obtain expert advice to confirm legally sound options for expediting the process.

Conclusions

A robust and effective SMSF succession plan should be informed by comprehensive tax analysis. Additionally, if an exit strategy is being considered, it is crucial for SMSF members to seek expert advice to ensure their plans are both tax-efficient and legally sound, particularly in time-sensitive situations. Proper planning and professional guidance are crucial for achieving the desired outcomes and avoiding potential pitfalls in managing SMSF death benefits.