This article explores the insurance options available to SMSF trustees with a limited recourse borrowing arrangement (LRBA) and what options are no longer permitted by the Australian Taxation Office.

Limited recourse borrowing is a popular way for trustees of self-managed super funds (SMSFs) to borrow funds to purchase property inside super. To cover the repayment of the loan amount, in the event one of the SMSF members dies, most planners are likely to recommend life insurance for each of the SMSF members. However, the solution isn’t always straightforward.

This article explains the insurance options available to SMSF trustees with a limited recourse borrowing arrangement (LRBA) and what options are no longer permitted by the Australian Taxation Office (ATO).

Available LRBA insurance options

SMSF owned and member-insured strategy

This strategy involves the trustee of an SMSF taking out life insurance for a member. The insurance premium is funded from the member’s super account and, if they die, the insurance proceeds are credited to the deceased member’s super account.

As the insurance proceeds increase the deceased member’s super account, this has the effect of increasing the death benefit payable, and doesn’t automatically result in the loan being paid off. In some circumstances, such as members of a couple, this strategy may be appropriate.

Case study 1: Married couple

Jack and Jill are married, and are trustees of their own SMSF. The fund purchased a property for $1.5 million with an LRBA that has a loan amount of $1 million. The fund has a $1 million life insurance policy on each member’s life to cover this debt.

Assuming the only asset of the fund is the property, the equity in the fund is $500,000. Let’s assume that Jack has an accumulation interest of $300,000 and Jill has an accumulation interest of $200,000.

Upon Jack’s death, life insurance of $1 million is paid to the fund, and the trustee allocates the proceeds to his interest, increasing his member interest to $1.3 million ($1 million + $300,000). Jill can elect to receive a death benefit pension and use the proceeds to pay off the debt.

Table 1 is a detailed breakdown of this case study.

Table 1

Assets and liabilities of the fund:
Property	$1,500,000
Loan	$1,000,000
Total net assets	$500,000

 

Member equity interests:
Jack (accumulation)	$300,000
Jill (accumulation)	$200,000
Total member equity	$500,000

Please note that the net assets equal the sum of the member equity of the fund.

When Jack dies, insurance of $1 million is paid to the fund and allocated to Jack’s account, forming part of his death benefit. See Table 2.

Table 2

Assets and liabilities of the fund:
Property	$1,500,000
Loan	$1,000,000
Cash account	$1,000,000 (proceeds from insurance)
Total net assets	$1,500,000

 

Member equity interests:
Jack (Death benefit)	$1,300,000
Jill (accumulation)	$200,000
Total member equity	$1,500,000

The sum of the member equity interest of $1,500,000 equals the sum of the equity of the fund of $1,500,000.

The trustees of the SMSF decide to pay a death benefit account-based pension to Jill. Proceeds from the cash account are used to pay off the loan. See Table 3.

Table 3

Assets and liabilities of the fund:
Property	$1,500,000
Total net assets	$1,500,000

 

Member equity interests:
Jill (Death benefit pension)	$1,300,000
Jill (accumulation)	$200,000
Total member equity	$1,500,000

This example shows how a death benefit of $1.3 million is generated, with which Jill could commence a death benefit pension that could pay off the loan. This example demonstrates how this strategy can be successful in covering the loan amount for members of a couple.

However, the strategy may not be an appropriate solution for everyone. Planners need to consider the beneficiary’s transfer balance cap and how it may limit the commencement value of the death benefit pension. Likewise, planners need to consider the cash flow required by the SMSF to meet at least the minimum pension payments of the account-based pension. For others, a death benefit pension may not be an option.

Case study 2: Brothers

Bill and Ben are brothers who run a business together. They are also trustees of their SMSF. The fund purchased a property for $800,000 with an LRBA that has a loan amount of $500,000. The fund has a $500,000 life insurance policy on each member’s life.

Assuming the sole asset of the fund is the property, the equity in the fund is $300,000. Bill has an accumulation interest of $200,000 and Ben has an accumulation interest of $100,000. Neither Bill nor Ben has a spouse, child or any other dependants.

Upon Bill’s death, life insurance of $500,000 is paid to the fund, and the trustee allocates the proceeds to his accumulation interest, which increases the death benefit amount to $700,000 ($200,000 accumulation plus $500,000 life insurance). As Bill doesn’t have any SIS dependants, the trustee can only make a death benefit lump sum payment to his estate.

This creates a liquidity problem, as the fund is required to pay out a death benefit lump sum of $700,000 but only has $500,000 in cash. The likely outcome is that the fund will be required to sell the property to provide liquidity to pay the death benefit lump sum.

Insurance outside super and then make a personal contribution to the SMSF

This strategy involves holding an amount of insurance outside the SMSF and, if a member dies, the other members use the life insurance proceeds to make a personal contribution to super. The benefit of this strategy is that the surviving member’s account is increased and the proceeds can be used to reduce or pay off the debt.

The downside of this strategy is the cap that applies to non-concessional contributions. Based upon the current rules, the individual is limited to a maximum non-concessional contribution of $300,000 under the bring forward rule. However, not everyone is eligible to bring forward future non-concessional contributions. You need to consider a person’s age and their total super balance to determine how much they can contribute.

Case study 3: Business partners

Mark and Matthew are business partners and are trustees of an SMSF. The SMSF owns a $500,000 property that is leased to their company. An LRBA was used to purchase the property inside the SMSF and has an outstanding loan amount of $200,000.

Their strategy is to hold a $200,000 life insurance policy on each other’s life, outside of superannuation. Note that the insurance premiums are not tax deductible, likewise, the proceeds are not taxable.

When Mark dies, Matthew receives $200,000 from the life insurance policy. Matthew makes a non-concessional contribution to superannuation, which increases his member balance by $200,000 (assuming a total superannuation balance under $1.5 million as at 30 June of the previous financial year). The SMSF uses the proceeds to pay off the LRBA. See Tables 4 and 5.

Table 4: Position before Mark’s death

Assets and liabilities of the fund:
Bank account	$100,000
Managed funds	$100,000
Equity in property	$300,000 ($500,000 less loan of $200,000)
Total equity in SMSF	$500,000

 

Member equity interests:
Mark’s accumulation interest	$200,000
Matthew’s accumulation interest	$300,000

 

Table 5: Position after Mark’s death

Mathew receives the insurance proceeds and makes a $200,000 non-concessional contribution to the SMSF.

Assets and liabilities of the fund:
Bank account	$100,000
Managed funds	$100,000
Equity in property	$500,000 (loan has been extinguished)
Total equity in SMSF	$700,000

 

Member equity interests:
Mark’s death benefit interest	$200,000
Matthew’s accumulation interest	$500,000

If the SMSF pays a lump sum death benefit, it would be required to sell the managed funds and use the proceeds in the bank account to pay Mark’s death benefit of $200,000. While this case study has been structured to illustrate how this operates, in practice, the fund may continue to have liquidity problems and may incur capital gains tax on the disposal of the managed funds.

Re-financing the loan

This strategy involves the surviving individual using the proceeds of life insurance outside of super to re-finance the loan. One of the challenges of dealing with the death of a member where there is an LRBA is that the financial institution providing the loan may require a repayment of the loan. The solution to this problem is to use a related party loan.

The use of a related party loan became more difficult in 2016, as the loan would need to meet the safe harbour provisions or be subject to additional scrutiny by the ATO.

Please note that the fund may continue to have liquidity issues when dealing with the deceased member’s death benefit, particularly where a death benefit lump sum is paid.

LRBA insurance options which are no longer permitted

Reserving strategy

This strategy involves taking out insurance on each member’s life and funding the premiums from a reserve account. In addition, it involves the payment of any insurance proceeds to the reserve account.

Up until recently, this strategy was used as a solution. In March 2018, however, the ATO issued a regulator bulletin (SMSFRB 2018/1), which explains the use of this strategy is inconsistent with the sole purpose test. Specifically, the ATO identified the problem with the strategy is that the insurance benefits are not being used for the benefit of the insured member.

Cross insurance strategy

A cross insurance strategy involves the fund taking out insurance on the other member’s life, where the proceeds are paid into the surviving members account. The proceeds were then paid into the outstanding balance of the loan.

There was debate in the industry as to whether this strategy was or was not permitted. The ATO decided that this strategy is inconsistent with the regulations and is not permitted. On 17 November 2014, the ATO announced:

“Regulations that came into operation on 1 July 2014 do not permit cross-insurance on any new insurance products. These types of insurance arrangements are not permitted because the insured benefit will not be consistent with a condition of release in respect of the member receiving the benefit.”

Summary

Limited recourse borrowing inside an SMSF is popular, but it can be complicated, especially when it comes to considering insurance strategies to cover the loan. A limited number of strategies are permitted and planners should make sure the strategy is viable and meets their clients’ needs and objectives. If you put a strategy in place several years ago, you should revisit it to check whether it continues to be a viable solution.

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QUESTIONS

Take the quiz here.

Q1. Steve and Sarah are a married couple. They are trustees of an SMSF with a LRBA, with borrowing inside the SMSF of $500,000. Steve and Sarah intend to take out insurance on each others life of $500,000 to cover the debt.

Upon Steve’s death, Sarah will receive an insurance payment of $500,000. Which following statement is correct?

a. Sarah can use the proceeds to make a non-concessional contribution to extinguish the debt of $500,000.

b. Sarah can use the proceeds to make a non-concessional contribution of $300,000 to partially extinguish the debt.

c. Sarah can use the proceeds to make a non-concessional contribution of $300,000 and make a member contribution into Steve’s account of $200,000.

d Sarah can use the proceeds to make a non-concessional contribution of $300,000 and make a spouse contribution into Steve’s account of $200,000.

Q2: An insurance reserving strategy operates by taking out insurance on each member’s life and funding the premiums from a reserve account. In addition, it involves the payment of any insurance proceeds to the reserve account. Presently, trustees of SMSFs can start an insurance reserving strategy. True or false?

a. True

b. False

Q3: On what date did regulations come into operation which do not permit cross-insurance on any new insurance products?

a. 1 July 2014.

b. 1 July 2015.

c. 1 July 2017.

d. 1 July 2019.

Q4. Kim and Kimba are a married couple and are trustees of their SMSF. The fund purchased a property for $900,000 with an LRBA that has a loan amount of $400,000. The fund has a $400,000 life insurance policy on each member’s life. The only asset of the fund is the property. Kim has an accumulation interest of $300,000 and Kimba has an accumulation interest of $200,000.

Upon Kim’s death, life insurance of $400,000 is paid to the fund, and the trustee allocates the proceeds to his accumulation interest, which increases his member interest to $700,000 ($400,000 + $300,000). Kimba elects to receive a death benefit pension, and the proceeds are used to pay off the debt. Calculate the interests.

a. Kimba’s accumulation interest is $900,000.

b. Death benefit pension is $900,000.

c. Death benefit pension is $700,000 and Kimba’s accumulation interest is $200,000.

d. Death benefit pension is $600,000 and Kimba’s accumulation interest is $300,000.

Q5: Stuart (52) and Jenny (49) are trustees of their SMSF. They have been married for 12 years and have two children, who are both at school. Their SMSF has an investment property valued at $800,000 with an outstanding LRBA of $500,000. They have decided to use insurance to cover the outstanding debt of $500,000 of the LRBA. Which of the following is the most appropriate strategy?

a. Reserving strategy.

b. SMSF owned and cross insurance strategy.

c. SMSF owned and member-insured strategy.

d. Hold insurance outside of the SMSF and make a personal contribution to the fund.