Self-managed superannuation funds (SMSFs) are the fastest growing sector in Australia’s superannuation industry. The Australian Tax Office’s (ATO) most recent quarterly SMSF statistical report found the total asset value of Australian SMSFs to be approximately $701.5 billion. Considering the growing popularity of SMSFs, it is important to consider the impact bankruptcy has on these arrangements.

If a SMSF has individual trustees, each member of the fund must be a trustee and each trustee must be a member of the fund. If the members of the fund elect to use a corporate trustee, each member of the fund must be a director of the corporate trustee, and each director of the trustee must be a member of the fund.

In this way, the fund is truly “self managed”, as each member has some degree of control over the operations of the fund arising from their position as a trustee or director of the corporate trustee. Insolvency of a member of a SMSF may affect the structure of the fund and the ongoing membership of the insolvent member.

Bankrupt individuals are classified as “disqualified persons” pursuant to section 120 of the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS Act). A disqualified person cannot remain as an individual trustee of a SMSF. A bankrupt individual is also not permitted in ordinary circumstances to be a director of a company pursuant to section 201B of the Corporations Act 2001 (Cth) (Corporations Act).

Insolvency of a member therefore presents a problem for a SMSF. If a member is disqualified from being an individual trustee or director of the corporate trustee, that member can no longer fulfil the fundamental requirement for a SMSF that they be involved in the management of the fund.

If a disqualified person remains a trustee of a SMSF, they may be liable for penalties including imprisonment for up to two years. Further, there is a risk that the fund could be declared non-complying, which may jeopardise the concessional tax treatment of the SMSF and cause a higher than normal rate of tax to be paid on all earnings in the fund, including earnings to which non-insolvent members are beneficially entitled.

If a member of a SMSF becomes bankrupt, they must inform the ATO in writing immediately. Upon being notified, the ATO will allow the fund a six month “grace period” during which time the trustees must restructure the investments and membership of the SMSF ensure the fund complies with the law. This will generally, although not always, be achieved by the insolvent member of the fund transferring their superannuation balance to a retail superannuation fund and resigning as a member and trustee.

This solution assumes that the insolvent member’s entitlement to assets of the fund can be readily and conveniently separated from the assets of other members, or otherwise converted into cash within the six month restructuring period. Where this is not possible, other issues may arise.

Some difficulty in complying with the law may arise where a major asset can’t be divided or sold, and the insolvent member’s interest in that asset transferred to a retail superannuation fund within the grace period. As an example, this could occur where the major asset of the fund is a piece of real estate and there has been a downturn in the property market. In this case, the property may not readily be sold and converted into cash, and the insolvent member likely cannot transfer their part interest in real estate from the SMSF to a retail fund.

In this situation, the SMSF may apply to the Australian Prudential Regulation Authority (APRA) to appoint an acting trustee to the SMSF for the time after the expiration of the grace period until the insolvent member can extricate themselves and their superannuation balance from the SMSF. Pursuant to section 17A(3)(d) of the SIS Act, a SMSF will not fail to comply with the SIS Act where an acting trustee appointed by APRA takes control of the fund, despite the fact that causes the trustees of the fund to differ from the members of the fund.

While appointment of an acting trustee presents a solution to breach of the law where an insolvent member cannot transfer their superannuation balance within the grace period, the solution is less than ideal. An acting trustee will likely be entitled to management fees which will eat into the superannuation interest of all members of the SMSF.

Bankruptcy significantly impacts the function and effectiveness of SMSFs. If you or another member of your SMSF is verging on bankruptcy, or has been declared bankrupt, you should seek legal advice tailored to your circumstances at the earliest opportunity.