Failing To Update A Plan Beneficiary Designation

 

Technically it is not a tax case, but it is so tax-adjacent it might as well be.

Let’s talk about beneficiaries on a retirement account – and, more specifically, an employer-sponsored retirement account.

Carl Kleinfeldt participated in the Packaging Corporation of America (PCA) Thrift Plan for Hourly Employees. In 2006 he designated his (then) wife – Dena Langdon – as his primary beneficiary.

Kleinfeldt and Langdon divorced in 2022. The divorce included a Qualified Domestic Relations Order (QDRO). A QDRO is a court order authorizing distribution to the nonparticipating (ex) spouse. The PCA Benefits Center distributed to Langdon as directed.

However, even after the QDRO there is one more step: has the ex-spouse been formally removed as beneficiary?

Kleinfeldt faxed a request to the Benefits Center to remove Langdon from both his health and life insurance as well as his retirement plan. The Benefits Center updated her status on the retirement account to “ex-spouse.” Mind you, this was not the same as removing her as a beneficiary altogether.

Why not?

There were written plan procedures to follow. Kleinfeldt’s fax was a good start but was not quite enough.

You can guess that Kleinfeldt died.

You know that Langdon wanted that retirement money.

You also know the matter went to court.

And we are in legal weeds immediately.

We are talking here about an employer-sponsored plan, which (almost always) makes the plan subject to ERISA.

ERISA in turn uses a “substantial compliance” doctrine when reviewing actions required under a plan document. It is what it sounds like: if you miss a minor clerical step, the law presumes that responsible parties know what was meant and are expected to act accordingly.

The Kleinfeldt Estate argued the substantial compliance doctrine with a white-knuckle grip.

The Court observed that substantial compliance has two steps:

1.  Was there intent to make the change?
2.  Was the attempt to make the change similar (in all material aspects) to the proper procedures required by the plan?

There was no argument about the first test: the fax was clear evidence that Kleinfeldt intended to remove Langdon as a beneficiary.

On to the second test.

The plan documents wanted Kleinfeldt to either (1) call the Benefits Center or (2) update his beneficiary designation online.

The plan documents nowhere stated that he could update beneficiaries by fax.

The Court did not consider this a minor clerical step.

Kleinfeldt did not follow the rules.

Meaning that Langdon won.

And fair had nothing to do with it.

Our case this time was Packaging Corporation of America Thrift Plan v Langdon, No 25-1859 (7^th Cir. Feb. 2, 2026)

FICA’s Special Timing Rule

 

I do not often read ERISA cases.

ERISA deals with employee retirement plans and refers to federal law: Employee Retirement and Security Act. It is old law (1974), and provides protection for individuals enrolled in private retirement and health plans. It can be as abstruse as the tax Code, and as difficult to follow. It is more in the purview of retirement specialists and not so much that of a general tax practitioner.

What made me think about it was a reference to the Henkel case from 2015.

Henkel involved a top hat plan for selected management and other highly compensated employees. The idea behind a top hat is to provide benefits in excess of those available to employees through regular plans (think 401(k), cafeteria plans and the like.) Top hats are mostly exempt from ERISA because of that select group of covered employees, You and I are unlikely to ever be enrolled in a top hat plan.

In Henkel, select employees were covered by a nonqualified deferred compensation plan. After benefits began, the company (Henkel Corporation) reduced the monthly benefits for federal tax withholding. ERISA has restrictions on reducing someone’s benefits – hence the litigation.

The federal withholding was FICA.

There is an odd rule in the tax Code for FICA taxation of deferred compensation. What sets it up is the income taxation of the deferred compensation itself.

Generally speaking, deferred compensation will include some kind of qualifying event. For example, say that an executive is entitled to 1% of his/her 2025 division profits as compensation, payable in 2028. To be entitled to the bonus, the executive must remain employed with the company through December 31, 2026.

It is that condition subsequent that makes the income taxation tick. It would be unfair to tax the executive in 2025, as he/she may never receive a dime if they are not employed through December 2026. Let’s say that they are employed through December 2026. It would still be unfair to subject the bonus to income taxation in 2026, as there is no cash until 2028. In general (and a big general at that) the tax Code will slow the income tax horses until 2028.

But this is compensation, meaning that there will also be FICA tax due.

When is that tax due?

A reasonable person would expect the FICA and income tax to lock arms and be due at the same time.

A reasonable person would be wrong.

FICA tax will be due at the later of:

The date the employee performs the services causing the deferred compensation (in our case, 2025), or

The date on which the employee is no longer subject to a substantial risk of forfeiting the deferred compensation (in our case, 2026).

Our executive would be subject to FICA tax in 2026.

What about concern for having cash to pay the tax?

It does not appear to apply to the FICA tax, only to income tax.

In practice, this is rarely as big an issue as it may first appear. FICA is divided into two parts: the old age (which is 6.2%) and Medicare (which is 1.45%). The old age (the acronym is OASDI) cuts off at a certain dollar amount. Medicare does not cut off. Odds are that someone in a top hat plan is well over the OASDI limit (meaning no old age tax), leaving only Medicare. 

It is unlikely that one is going to do a lot of tax planning for 1.45%.

This FICA trigger is called the “special timing rule.”

There is an upside to the special timing rule, and it depends on how the deferred compensation is determined.

If one can flat-out calculate the deferred compensation (in our case, 1% of division profits), the plan is referred to as an account balance plan. Granted, one can add interest or whatever to it to allow for the passage of intervening years, but one can calculate the beginning number.

If one pays FICA on an account balance plan under the special timing rule, there is no additional FICA when the plan finally pays out. This means that interest (for example) added to the beginning number is never subject to FICA.

Sweet.

Switch this over to a nonaccount balance plan and FICA can change. FICA is calculated on the actual distribution, but one is given credit for FICA previously paid under the special timing rule. In this case, one would pay FICA on the interest added to the beginning number.

There are also different ways to calculate the FICA under the special timing rule: the estimated method, the lag method, the administrative convenience method and so on.

Throw all the above in a bag, shake thoroughly, and that is how we got the Henkel case. How can the benefits go down? Take a nonaccount balance plan, with FICA being paid later rather earlier.

Is it a reduction in benefits?

Yes and no. It is technically a reduction if one was not thinking about the FICA.

It is not however a reduction for purposes of ERISA.

Our case this time was Davidson v Henkel, USDC, Eastern District of Michigan Southern Division, Case No. 12-cv-14103.

“ROB”-ing a 401(k) Plan

A CPA acquaintance from New Jersey came into town and spent a couple of days at the office. Why? Well, maybe he wanted to get away from New Jersey. Actually, he wanted to take a look at some of the policies and procedures we utilize. He only recently purchased his own practice.

He said something that surprised me, and which I thought we could discuss this week. He funded his accounting practice by using his 401(k) funds. This technique is sometimes referred to as “rollover for business startup.” The acronym is “ROBS.” Catchy, eh?

What do I think about ROBS? Frankly, I am a bit uncomfortable with them. There is the issue of concentrating your retirement monies in a venture also intended to provide current income. Should it fail both income and retirement monies vanish. I am financially conservative, as you can guess.

The second issue is technical: there are a number of ways this structure can run afoul of some very technical requirements. You have tax law, you have ERISA, you have … well, you have enough to cause concern.

Let’s give this CPA acquaintance a name. We will call him “Garry,” mostly because his name actually is Garry. Here is what Garry did:

(1)    Garry created a corporation. The corporation had no assets, no employees, no business operations, no shareholders. Accountants call this a “shell” corporation.

(2)    The corporation adopted a retirement plan. The plan allowed for participants to invest the entirety of their account in employer stock.

(3)    Garry became an employee of the corporation.

(4)    Garry rolled-over his 401(k) (or a portion thereof) to the newly-created retirement plan.

(5)    Garry had the plan purchase the employer stock.

(6)    The corporation now had cash, which …

(7)    The corporation used to purchase an accounting practice.

What can possibly go wrong? Here are several areas:

(1)    You need a solid valuation for the 401(k) purchase of the employer stock. I would not want to go into the IRS with only a rough calculation on the back of an envelope. The trustee of the plan has fiduciary responsibility. Granted Garry is both the fiduciary and beneficiary, but he still has responsibilities as trustee.

(2)    The workforce has to be able to participate in the plan.

a.       This is a qualified plan. There are nondiscrimination requirements, same as any other qualified plan.

b.      This is not a problem for a one-man shop. What will Garry do when he hires, however?

                                                               i.      Here is what he better do: amend the plan to prohibit further investment in employer stock. Future employees will not be allowed to invest in Garry’s accounting firm stock.

(3)    There is a fiduciary standard for investment diversification.

a.       You can see the problem.

                                                               i.      Maybe Garry can open a second accounting office. You know, diversify.

(4)    Garry is paying for all this. Some brokers will charge over $5,000 to set up a ROBS.

a.       Oh, there are also ongoing annual charges. The plan will have an annual Form 5500 filing requirement, for example.

b.      There may also be periodic valuations, requiring Garry to pay a valuation expert.

                                                               i.      Why? Because Garry has a difficult-to-value asset in a qualified plan. Difficult-to-value does not mean Garry gets a free pass on valuing the asset. It does mean that it is going to cost him.

(5)    These transactions have caught the attention of the IRS. This does not mean that his transaction will be audited, challenged or voided, but it does mean that he has walked into a spotlight.

a.       Garry had to gauge his IRS risk-tolerance as well as his financial diversification risk-tolerance.

Are ROBS considered “out there” tax-wise? Actually, no. There are tens of thousands of these structures and their businesses up and running. Garry is in good company. And while the IRS has scowled, that doesn’t mean that ROBS are not viable under the tax code and ERISA. It does mean that Garry should be careful, though. Professional advice is imperative.