When some people look at their superannuation, they see it as a cash cow to help finance their small business and will use an SMSF with that intention in mind.
However, there are two ways of looking at these types of ideas - the first is that establishing an SMSF retirement saving could be improved in the long-term and, at the same time, help expand the business. The second is that by concentrating high levels of retirement savings in the business, rather than diversifying investment risk, there may be little left over should the business go pear-shaped. Also, whether the SMSF is being used solely for superannuation purposes is questionable.
By way of background, the current superannuation legislation limits the types of investments, loans or leases that can be made related to parties such as members, trustees and other parties related to the fund. These limits act as an insurance policy for the fund and ensure the SMSF does not put all its eggs in one basket to expose the fund investment to high levels of risk.
If we look at how superannuation can be used to expand a small business, then in practice, it is possible only by using an SMSF. The reason is that SMSFs are in a unique position and can rent a commercial property it owns on an arm’s length basis to a related party such as a member’s business. The larger superannuation funds invest in massive investments and are not interested in small businesses as the investments are much smaller.
Therefore, it is possible for an SMSF to provide some capital to grow the business if the tax and superannuation legislation allows.
When considering the superannuation legislation, it is crucial to understand how an SMSF can assist the business and still stay within the law. Whether the SMSF could help expand the business depends on the type of structure that is in place to conduct the business.
For example, the small business may be operating as a sole trader, in partnership with others, in a trust or via a private company.
Suppose a member operates the business as a sole trader or in partnership with others. In that case, the superannuation legislation does not allow the SMSF to make loans or provide capital to the business. The reason is that the legislation prohibits making loans to members or relatives or any business where they are sole traders or in partnership.
However, suppose the business operates via a trust or company. In that case, it could be possible for the SMSF to lend to or hold units in the unit trust or shares in the company, which can provide capital to help with any business expansion. The amount that can be invested or lent may be restricted as it will depend on whether related parties, which includes the SMSF, have ‘control’ over the company or unit trust. These investments are referred to as in-house assets, and limits apply to the amount invested, lent or value of fund assets leased to the trust or company.
Suppose it is considered that related parties control the trust or company. In that case, the SMSF will be limited to investing, lending or leasing no more than a total of 5% of the market value of its assets in all related party investments. As a general rule, control is where related parties own more than 50% of shares in a company or have a right to receive more than 50% of the income or capital of the unit trust. However, if related parties do not control the trust or company, it may be possible for the fund to have a greater amount invested, lent or leased to the business.
Rather than directly investing SMSF money in the business, it is possible for the SMSF to purchase a commercial property outright or borrow to purchase the property by using a limited recourse borrowing arrangement. This feature is unique to SMSFs. If the property owned in this way is used wholly and exclusively by the business on full arm’s length commercial terms, then the business will be required to pay rent on commercial terms to the SMSF. It is possible that the business could claim a tax deduction for the rent paid.
To illustrate how this works, take for example, a small business manufacturer or a tradesperson. It could be possible for the SMSF to purchase a workshop in which goods are manufactured or the tradesperson carries on their business. If the SMSF had sufficient capital to purchase the workshop outright without mortgaging it then the business could lease the workshop directly from the SMSF.
However, suppose the SMSF did not have sufficient capital to purchase the property. In that case, it is possible for the fund to purchase the property and mortgage it by using a limited recourse borrowing arrangement. This involves the SMSF borrowing to purchase the property, which is held under a special trust for the SMSF until the amount borrowed has been paid out. The business can lease the property from the special trust and is required to pay rent on arm’s length commercial terms.
While there may be value in using an SMSF to expand a small business, the risk associated with the investment should be considered. Maybe some of the retirement savings in the SMSF could be used in the business, and the remainder invested arm’s length in helping diversify the fund’s investment portfolio.