It’s tempting to want to dip into your SMSF honey pot if you, your business, or someone you know is struggling for cash. But there’s a very fine line between what you can and can’t do when lending with your retirement savings, and with the Australian Tax Office currently targeting those that break the lending rules, it’s crucial you make sure your transactions are done properly.

First things first, SMSFs can lend money (read, How you can be the bank). Whether or not you’re breaking the law largely comes down to whom you lend the money to.

One of the country’s leading SMSF legal experts, Dan Butler from DBA Lawyers, says many trustees fall prey to a false sense of security when lending money from their SMSF because if they break the law, they are often not caught out until their next financial audit.

Lending to a friend

To lend from your SMSF, you must make sure that the person or business receiving the money is not a ‘related party’. That means you, your spouse, defacto partner, your children, business partners, and in some cases, even a friend.

“If the loan’s to a friend, as long as there’s no relationship – business relationship, personal relationship, love relationship – it should be OK – as long as it’s done at ‘arm’s length’,” Butler says. “To do it at arm’s length means they should get it documented, they should have ‘arm’s length’ terms, and they should benchmark it to what the bank’s charging.”

But, even though you can lend to a friend, the situation is tricky because the reason behind the loan may be taken into account. Butler points to a recent case where a trustee wanted to lend to a friend whose loan requests had been rejected by the banks.

“Now why is the super fund standing in? Is it because it’s the best investment in town? Or is because they’re wanting to help a friend? If they’re doing it because they want to help a friend, they’re in breach of the law. If they’re doing it because it’s the best deal in town, and they’re willing to take a punt, then that’s OK.”

Lending to a related party

Your SMSF can lend to a related party, as long as the loan is limited to 5% of the value of the SMSF’s assets (be careful here, because, as you know, the value of assets fluctuates and this could push you over the 5% limit). If you breach the 5% cap, you will have broken the ‘in-house asset test’.

Lending to a third party

Butler says the majority of lending is to third parties, and there is quite an active secondary market where sophisticated investors (generally, high net-worth individuals with years of experience in business) network to lend.

Some trustees who have wanted to borrow from their fund have tried to side-step the 5% rule by lending money to a third party, then borrowing that same money from the third party. Butler says this is illegal and the ATO won’t go lightly on you if you’re found out.

Lending to a private business

SMSFs can lend to private businesses, but once again, the loans must be made at arm’s length.Butler says legal and accounting advice is very important before investing in a private business.

In some cases, SMSFs can lend to the business of a related party, but this immediately throws out warning bells because the transaction may be viewed as an in-house asset.

“If there’s any relationship there between the business and the self-managed super fund members, we’ve got to be very, very careful that everything the super fund does stacks up at arm’s length,” he says.

If you own the company outright, you can’t lend it more than 5% of your SMSF’s value. The SMSF could potentially lend more if your interest in the company is less than 50%, but you should seek legal advice to determine how much ‘significant influence’ you have in the company. Tread carefully if your SMSF lends to a company that you partly own with someone that you have other investments with. This is considered to be a tax-law partnership and your shares in the company will likely be counted as one.

The consequences

Butler says contraventions of the law can add up quickly, and in one recent case where two trustees were lending their SMSF’s money to four of their struggling businesses, the trustees were found to have broken the law 60 times.

“Merely not having a loan documented is one contravention. Merely failing to collect interest on a loan is another contravention,” he says.

The ATO had previously issued a warning to the trustees, but they failed to listen.

“In this case, the fund was rendered non-complying, the trustees were disqualified from ever becoming trustees of a self-managed super fund, therefore they can’t be members of a self-managed fund ever again. They’re members assessments were hit at $150,000, they got a $50,000 penalty split $35,000 to dad, $15,000 to mum, and they had to pick up the ATO’s costs as well as their own costs,” says Butler.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Also in the Switzer Super Report

• Charlie Aitken: Bank stocks, rate cuts and a Greek tragedy
• JP Goldman: How Europe will affect us
• Tony Negline: How to bring foreign retirement savings home