Understanding the Sole Purpose Test for your SMSF

Why is the sole purpose test important for SMSF trustees?

It’s one of the foundational requirements for all super funds, including SMSFs.

Making sure your SMSF is used purely for your retirement sounds simple right?

And in a way it is – why else would we save in super other than to build up a retirement nest egg or protect our families?

Where it gets more complex is that we’re all expected to apply this test to absolutely everything we do when we’re making a decision about our SMSF. It pops up most often when thinking about investments – because that’s where trustees really have decisions to make that could be swayed by other factors.

Why does the sole purpose test exist?

Before we get into the detail, why do we even have the sole purpose test?

It’s because all super funds pay quite low rates of tax. From the Government’s point of view that makes sense if it’s helping you build up savings for your retirement. Having those savings at your disposal in retirement will mean you don’t cost the community as much (via age pension payments). So not surprisingly, the Government is very invested in making sure that’s really exactly what you’re doing with your SMSF – saving for your retirement, ie complying with the sole purpose test.

If it’s that important, why don’t we hear about it all the time?

As well as the sole purpose test, super law includes a whole lot of very specific rules. These cover things like what super funds can invest in, when benefits can be paid, who can make contributions, and more.

Sometimes these rules become the ‘trees’ that are hiding the ‘wood’ of the sole purpose test. Accountants, trustees and advisers tend to focus on the things super funds can and can’t do that are laid out in the specific rules and forget that the sole purpose test sits above them all. It’s the guiding principle; the specific rules are the detail.

Perhaps the easiest way to understand the sole purpose test is to think of it like this. The rest of the super rules will tell you that your SMSF can or can’t do a specific thing. The sole purpose test is all about why you’re doing it.

How might my SMSF breach the sole purpose test?

SMSFs can invest in commercial property. They can even lease the property to a member’s own business at market rates. All of these things are clear from the specific rules. But even if an SMSF followed all these rules to the letter, it would still be important to understand why the fund was leasing the property to the member’s business.

What if the SMSF got a better offer from another potential tenant (well above market rent)? If the SMSF is really all about saving for retirement, it might make more sense to take up that offer (subject to meeting any contractual obligations to an existing tenant).

Or what if the SMSF only bought the property because the member’s business was in a bind? It needed new premises, none were available to rent in the area, and the fund bought the property despite that particular investment not being sensible for the members’ retirement savings?

Both of these would be breaches of the sole purpose test despite appearing to meet all the super rules.

And in both cases, it hinged on “why” rather than “what” the super fund did.

SMSFs get special scrutiny when it comes to the sole purpose test, particularly with transactions that involve family or private companies and trusts. That’s because it can be really difficult to untangle what members want or need personally from what they would do if they were really only focused on optimising a pot of money for retirement.

A simple way to self check

Use this quick test before you act:

If I was managing someone else’s money, and trying to maximise their retirement savings, would I do this?

If the honest answer is no, because a key driver for doing it is your personal convenience, your business needs or helping someone you care about, pause and reassess.

Key takeaways for Trustees

• The sole purpose test is continuous and overlays other rules.
• Why you act determines compliance as much as what you do.
• Where it’s not obvious that a particular decision is in line with the sole purpose test, document why you made it to show it is.

You may also be interested in...

• What are my responsibilities as a trustee?
• What are the rules about investing in SMSFs?
• Investment Strategy for SMSF – why is it needed?

This article is for general information only. It does not constitute financial product advice and has been prepared without taking into account any individual's personal objectives, situation or needs. It is not intended to be a complete summary of the issues and should not be relied upon without seeking advice specific to your circumstances.