Running a business from an SMSF can have the advantages of easy access to start-up capital and lower tax on net income, but it does also come with some practical issues, writes Joel Curry.
There is a common belief among accountants and advisers that an SMSF is not allowed to run a business.
But it is it true? Is there anything in the SIS Act that prohibits it?
The answer is 'no', and even the ATO agrees. Of course, the answer is not that simple.
Why run an SMSF business?
Access to capital and concessional tax treatments stand out as the main attractions.
Having start-up capital or being able to borrow is often problematic for the upstart entrepreneur with a new business idea. The balance of the super interest is often their largest asset and could provide instant and low-cost access for immediate business commencement.
Additionally the ability to pay no more than 15 per cent tax (and possibly a nil rate) on net income would surely be attractive to any business owner. More so for those who don’t need ready access to profits before preservation age. Yearly profits would then gain access to ongoing concessions within the super environment.
This all sounds attractive, but before we get too excited, there are significant limitations and drawbacks to consider.
It may not prohibit operating a business, but the SIS Act does strictly disallow certain activities that otherwise are commonplace. Let’s look at a few examples:
Borrowing and Overdrafts: Excluding eligible LRBAs, section 67 would all but prohibit an SMSF business from entering into normal credit facilities.
Lending money: Accountants will know too well that small business operators have a habit of “borrowing money” from the business bank account. Easily dealt with in a non-SMSF environment, section 65 prohibits this for the SMSF business.
Non-arm’s length dealings with related parties: Another everyday event; let’s consider some examples that may be commonly conducted at above or below market values:
– Providing or receiving services from a related party
– Employment of relatives
– Leasing of property
– Provision of fringe benefits
Two areas of concern arise where this occurs. Firstly, Section 109 may be breached where the related party is receiving a favourable treatment. This does commonly occur where an SMSF leases a commercial property to a related entity at below market value. In the SMSF business, situations could occur where an employee is paid above award wages or receives other benefits such as private use of phones or computers. Discussed below, the Sole Purpose Test also needs to be considered in these situations.
Often overlooked, income tax consequences can arise where an SMSF business receives a favourable financial outcome from related party dealings. Section 295-550 ITAA 1997 can be triggered to apply the top marginal tax rate (even if in pension phase) to the net income of an SMSF business where non arm’s length dealings occur. Common examples could include a related party working in the business for below market wages or the SMSF leasing a property used in the business for below market lease rates.
The ATO has confirmed this treatment in relation to LRBAs and it wouldn’t be a far stretch for an SMSF business to be caught.
Giving a charge over assets: Regulation 13.14 places further restrictions on everyday business activities as it prohibits trustees from giving a charge over an asset. This would restrict entering into everyday transactions such as equipment and vehicle leasing.
Could an SMSF conduct a business within these restrictions? Yes, possibly but again… our friends at the ATO may have a close look.
Assuming business activities do not breach specific sections of the SIS Act, the trustees still have to pass the all-important but often overlooked Sole Purpose Test, which decrees:
“Thou shall not obtain personal advantage or enjoyment from the activities of the SMSF until you retire or die (at which point it becomes redundant!)”
Of course, I paraphrase and recommend a reading of the tax ruling on the subject. The sole purpose test can be hard apply to a set of facts as who is to say that the trustees run an SMSF business of breeding cattle just because they like to hang around cows!
Duties of trustees: Finally, and what may be the pertinent issue, are the trustees' duties contained in section 52.
Often overlooked, trustees must take into account the section 52 duties when making investment decisions for the SMSF.
Importantly subsection 2(b) requires trustees to “to exercise […] the same degree of care, skill and diligence as a prudent superannuation trustee would exercise in relation to an entity of which it is trustee and on behalf of the beneficiaries of which it makes investments”.
And along with Regulation 4.09, subsection 6 requires the trustees to consider a range of factors when determining whether an SMSF business would fit into the overall investment strategy of the SMSF. The key factor appears to be “the risk involved in making, holding and realising, and the likely return from, the investments covered by the strategy, having regard to the trustee's objectives in relation to the strategy and to the expected cash flow requirements in relation to the entity”.
Does running an SMSF business take the best interests of the beneficiaries into account or is there some other purpose? Is the business really just a hobby that the trustees have a side interest in?
What does this all mean?
Sufficient to say the road to running a business in an SMSF is full of potholes filled with pitfalls.
If the trustees 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.
Section 62 (sole purpose test) and Section 52 remain as hurdles to overcome.
At the end of the day, the old-fashioned “smell test” and “what would a reasonable arm’s length trustee do” clichés may very well be key questions to apply when assessing a client’s proposal to run an SMSF business.
1. Will any specific SIS provisions be breached?
2. Could income be taxed as non-arm’s length income?
3. Has the sole purpose test been considered?
4. Is the business really a hobby?
5. What would an arm’s length reasonable trustee do?
6. Smell test…
Joel Curry is the director of Newcastle based TriSuper Auditors, an independent SMSF auditing firm.
Adam Zuchetti is the editor of My Business, and has steered the publication’s editorial direction since early 2016.
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