DBA Lawyers in Asset magazine — The tax trap for super death benefits paid to a deceased estate

This article originally appeared in the March 2014 edition of Asset Magazine (Financial Review).

If superannuation death benefits are paid to the estate, a quirk in the law can mean higher tax and increased administration costs. Advisers are well-placed to add value by alerting clients and lawyers to this possible tax trap.

Where does a problem arise?

Consider the situation of a client dying with their binding death benefit nomination directing all super to the estate. A commonly drafted will might state the following:

The executor collects $100,000 from the deceased’s term deposit and $500,000 (all from the taxable component) is paid to the executor from the deceased’s super. The executor then uses $30,000 to discharge the deceased’s various debts, pay the funeral bill of $10,000 and $10,000 in other estate administration costs. The question is then what taxes are payable by the executor as a result of the $500,000 received from super. The balance will be paid to the deceased’s wife, as directed by the will.

Traditionally, one might think there is no tax in this situation. However, the tax law in s 302-10 of the Income Tax Assessment Act 1997 (Cth) applies to the executor of a deceased estate who receives a superannuation death benefit. The law says that to the extent that tax dependants may be expected to benefit, the executor pays tax as if the benefit had been paid directly to a tax dependant. In the present example, the part that does not benefit tax dependants would be subject to tax.

Due to the way the will is drafted, the amount that remains in the estate after tax would be paid to the deceased’s wife (a tax dependant). However, as discussed above, the actual tax amount is calculated by asking: to what extent is the wife expected to benefit? This calculation is impossibly circular. Accordingly, the only reasonable way to proceed is to engage an actuary to calculate the extent that tax dependants are expected to benefit.

A further problem arises because expenses are often paid out of an undifferentiated ‘pool’ of money, which includes money from super. It is then impossible to say whether, for example, the funeral bill was paid out of the money received from super or from the deceased’s other money. The question is important because if the money from super is being ‘eroded’ to pay expenses, rationally, the amount that tax dependants later stand to receive is decreasing. The law does not specifically say how to deal with this scenario. There are a few possibilities, including the following.

• If all money was pooled in one bank account, the rule in Devaynes v Noble (1816) 35 ER 781 (often referred to as Clayton’s case) could apply to argue that the first sum paid in is also the first sum drawn out. Accordingly, it could be argued that, if the superannuation money was received after the term deposit, the various expenses were paid out of non-super money, and all super monies ended up being paid to the deceased’s wife. However the specific order of payments in each case will produce a different result. Also, it seems to be a complicated method to use (and again, it is not specifically sanctioned by the tax law).
• The expenses could be argued to have been paid proportionately out of super monies and other money in the ratio of 5:1 (since the money from super was $500,000 and other monies were $100,000).
• It could be argued that the tax law does not specify a method and therefore gives ‘freedom’ to decide that the expenses were (notionally) paid from non-super monies.

Unfortunately, none of the above methods are specifically sanctioned. What is clear then is that it would have been better to sidestep this issue in the first place.

What avenues exist to avoid this problem?

Tax considerations are only secondary to the primary consideration of whether the ‘right’ people have received the right benefit. Nevertheless, this article now discusses in brief some options to overcome the problem described above.

If a will is drafted with superannuation and tax in mind, superannuation benefits received by the executor can be quarantined as a first step (before any expense payments, etc). It can then be made clear that only tax dependants are to benefit from them. One must be careful if a testamentary trust is used where it is possible that somebody other than a tax dependant could benefit from the trust. This would then mean that the death benefit would be partly taxed as if received by a non-tax dependant.

Alternatively, super benefits can be paid directly to tax dependants rather than being directed to the estate.

Lastly, withdrawing superannuation money before death can be tax efficient (but of course it is difficult to calculate the appropriate time).

Conclusion

While clients and their lawyers may not be fully aware of the pitfalls described, clients stand to benefit greatly from the foresight of advisers on the cutting edge of succession and tax planning.

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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.