GROUP TERM CARVE-OUTS : Bonus Plans, Determining the Best Plan

GROUP TERM CARVE-OUTS
Prior to 1984, employees had no taxable income if they were provided with postretirement coverage under a group term life insurance plan. After that time, coverage in excess of $50,000 became subject to the imputed income rules of Section 79, based on Table I cost, which are relatively high at older ages. As a result, employers increasingly turned to group term carve-outs. While carve-outs can be used for any employee with more than $50,000 of group term coverage, they typically apply only to shareholders and key executives.

Bonus Plans
In the simplest sense, a carve-out works like this: The employer decides which employees are to be covered under the carve-out plan and limits coverage for these employees under its group term plan to the $50,000 that can be received tax free. The employer then gives any premium savings to each "carved-out" employee in the form of a bonus, which is fully deductible to the employer as long as the employee's overall compensation is reasonable. The bonus amounts are either paid directly to an insurance company for individual coverage on the lives of the participants in the carve-out plan or, in some cases, provided to the employees as compensation to pay life insurance premiums. In most cases, the coverage purchased under the carve-out plan is some form of permanent life insurance protection that provides paid-up coverage at retirement. Traditional whole life insurance, universal life insurance, variable universal life insurance, and variable life insurance are all viable alternatives. At retirement, the employee can either keep the coverage in force (possibly at a reduced paid-up amount) or surrender the policy for its cash value.

The popularity of carve-out plans lies in the fact that a comparable or greater amount of life insurance coverage can often be provided to participants at a lower cost than if the participants had received all their coverage under the group term life insurance plan. Because the carve-out plan does not qualify as a plan of insurance under Section 79, each participant has taxable income in the amount of the bonus. However, this income is offset by the absence of any imputed income from Table I.

In reality, carve-out plans are more complex. In many cases, the cost of permanent coverage for an employee may actually be greater than the cost of group term coverage during the working years. However, this high cost is often more than compensated for by the cash value at retirement and the absence of imputed income after retirement. Under some carve-out plans, participants must pay this increased premium cost with after-tax dollars. Under other plans, the employer increases the bonus amount. In effect, the employer is now paying more than if the carve-out plan did not exist, but this arrangement is often acceptable to the employer as a way of providing shareholders and key executives with a benefit that is not available to other employees. In many plans, the bonus is also increased to compensate the employee for any additional income taxes that must be paid because of the carve-out plan. Such an arrangement is commonly referred to as a zero-tax approach.

A carve-out plan can pose a potential problem if there are rated or uninsurable employees, but the problem is ameliorated if the plan has enough participants that the insurance company will use simplified underwriting or grant concessions on impaired risks. Any employee who is still uninsurable can be continued in the group term plan.

Other Types of Carve-Out Plans
While a bonus arrangement is the most common type of carve-out plan, other alternatives are available. Some carve-out plans are designed as death-benefit-only plans, under which the employer agrees only to pay a death benefit to the employee's beneficiary out of corporate assets. The employer often funds the plan with corporate-owned life insurance on the employee's life. With this approach, the employee has no taxable income, but death benefits will result in taxable income to the beneficiary. In addition, the employer is unable to deduct the premiums as a business expense but does receive the death proceeds tax free.

Some firms also use split-dollar life insurance in carve-out plans. The most common approach is to use a collateral assignment arrangement, under which the employer pays most of the premium and the employee collaterally assigns a portion of the cash value and death benefit to the employer equal to the employer's premium payments. At retirement (or any other predetermined time), the employee withdraws the cash value necessary to repay the employer, who then removes the collateral assignment. At that time, the employee has full control of the policy, and the remaining cash value can be used to keep coverage in force. Many split-dollar arrangements are also used to provide nonqualified retirement benefits to key employees as a supplement to the benefits under the employer's qualified retirement plan.

Determining the Best Plan
In many instances, carve-out plans are the most cost-effective approach for providing benefits to key employees. The best plan depends on the overall benefit objectives of employer. A proper analysis of alternatives involves a complex consideration of many factors, including the employer's tax bracket, the effect on the employer's financial statements, the employee's tax bracket, premium costs, and the time value of money.