What Is a Group Carve-Out Plan? Key Benefits and Limitations

Companies offer employee benefits to attract and retain talent, but not all benefit plans are structured the same way. A group carve-out plan separates high-earning employees from standard group coverage, providing them with enhanced benefits tailored to their financial needs. This approach can improve tax efficiency and offer better coverage, but it also comes with regulatory considerations that employers must evaluate carefully.

Key Components

A group carve-out plan provides select employees with benefits beyond those available in a standard group policy. This typically involves removing high-income employees from the employer’s basic group life insurance plan and replacing their coverage with an individual policy, such as a permanent life insurance plan. This allows companies to offer more competitive benefits while managing costs.

A key feature of these plans is the use of permanent life insurance, such as whole or universal life policies, instead of traditional group term life insurance. Unlike term policies, which expire after a set period, permanent life insurance accumulates cash value over time. Employees can borrow against this value or use it for retirement planning. Some plans also include supplemental benefits, such as disability income riders or long-term care provisions.

Employers fund these plans in different ways. Some pay the premiums for individual policies, while others use split-dollar arrangements, where costs and benefits are shared between employer and employee. Another option is an executive bonus plan, where the employer provides a cash bonus to cover the premium, which is then taxed as income to the employee. The chosen funding method affects both financial reporting and long-term financial planning.

Eligibility Requirements

Eligibility for a group carve-out plan is typically based on compensation and job classification. These plans are designed for executives or other high earners whose financial needs exceed the coverage limits of standard group policies. Employers often set a minimum salary threshold, usually aligned with IRS compensation limits for highly compensated employees. In 2024, this threshold is $150,000 under Section 414(q) of the Internal Revenue Code.

Beyond salary, job classification plays a role. Many companies extend carve-out benefits to C-suite executives, senior management, or other leadership positions. This selective approach helps businesses provide tailored benefits without significantly increasing costs. However, employers must ensure the plan does not create discrimination issues under the Employee Retirement Income Security Act (ERISA) or violate nondiscrimination rules under certain tax laws.

State insurance regulations also impact eligibility and plan structure. Some states impose restrictions on modifying group policies or replacing them with individual coverage. Businesses with employees in multiple states must navigate varying compliance requirements, which can affect plan design.

Tax Treatment

The tax implications of a group carve-out plan depend on its structure and the type of life insurance policy used. Under IRS rules, employer-provided group term life insurance coverage up to $50,000 is tax-free for employees under Section 79 of the Internal Revenue Code. However, when high earners are removed from the group plan and provided with an individual policy, different tax rules apply.

If the employer owns and pays for the policy, the premiums may be considered a taxable fringe benefit, increasing the employee’s taxable wages. If the employer provides a bonus to cover the premium—structured as an executive bonus plan—the bonus is taxed as ordinary income, but the employee gains full ownership of the policy. This allows the employee to access the policy’s cash value and death benefit without employer restrictions, though it results in an immediate tax liability.

For employers, the tax deductibility of premiums depends on the funding method. Premiums paid directly by the company for a policy it owns are generally not tax-deductible. However, if the employer provides a cash bonus for the employee to purchase the policy, the bonus is considered compensation and is deductible as a business expense under Section 162 of the Internal Revenue Code. Some companies use a double bonus arrangement, providing additional funds to cover the employee’s tax liability, ensuring the full premium cost is covered.

Financial Statement Reporting

Accounting for a group carve-out plan requires careful classification and disclosure. When a company funds individual life insurance policies for select employees, the treatment of premium payments depends on whether the employer retains any ownership interest. If the business maintains control over the policy or retains a collateral assignment, these policies must be recorded as assets on the balance sheet under “Cash Surrender Value of Life Insurance.” Any increase in cash surrender value over time must be recognized as investment income, impacting earnings before interest and taxes (EBIT).

If the company does not retain ownership and instead provides funds as a compensation expense, the premiums are recorded as part of employee benefits expense on the income statement. This increases total compensation costs, which can affect financial ratios such as the operating margin and EBITDA margin. Transparent footnote disclosures in financial statements help clarify the nature and scope of carve-out benefits, ensuring compliance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).

Regulatory Framework

Employers must navigate federal and state laws governing employee benefits and insurance policies when implementing a group carve-out plan. The Employee Retirement Income Security Act (ERISA) sets standards for employer-sponsored benefit plans. While traditional group term life insurance policies often fall under ERISA’s jurisdiction, carve-out plans that replace group coverage with individual policies may be exempt, depending on their structure. Employers must determine whether their plan qualifies for an ERISA exemption, as compliance requirements can affect administrative costs and reporting obligations.

State insurance regulations add complexity, as each state has its own rules regarding the issuance and replacement of life insurance policies. Some states impose restrictions on replacing group coverage with individual policies, requiring disclosures to employees or specific approval processes. Additionally, companies offering carve-out plans must comply with nondiscrimination rules under the Internal Revenue Code, particularly Sections 105(h) and 125, which govern tax-favored benefits. Failure to comply can result in penalties, loss of tax advantages, or legal challenges from employees. Employers should work closely with legal and tax advisors to structure their plans in a way that aligns with both federal and state requirements while maximizing benefits for eligible employees.