How Do Carve-Out Plans Work?

The Nature of Carve-Out Plans

Carve-out retirement plans help small business owners create plans that slant the contributions to key employees.

How Do Carve-Out Plans Work?

The strategy of the design limits the employer’s contribution to a select group of employees (the “carved-out” group). This group generally includes a limited number of highly compensated (HCE’s) and non-highly compensated employees (NHCE’s). Among other Tax Code regulations, these plans must satisfy certain minimum coverage requirements. Understanding the minimum coverage requirements of IRC §410(b) is essential to knowing when a design that favors the HCE’s will work.

The “Carve-Out” Concept

Most retirement plans include all full-time employees who meet prescribed service and age requirements. However, it is possible to design a plan which “carves out” a subgroup of employees for inclusion in the plan while excluding others. This is commonly known as the “Carve-out” concept, and this is how the technique works:

Highly Compensated Employees (HCE) are specifically defined (by IRC 414(q)) as:

  1. Those employees who have greater than five percent ownership in the business, including spouses of owners, children, grandchildren, parents and grandparents through attribution rules.
  2. Employees who earned more than $120,000 in the preceding plan year (i.e., 2016).

All other employees are considered Non-Highly Compensated Employees (NHCE).

A plan may not discriminate in favor of HCEs, but it may limit or even exclude benefits for HCEs. To qualify, a plan must meet two general tests:

  1. The first test applies to all plans and determines the necessary mix of HCEs and NHCEs.
    1. Generally, at least 70% of the NHCEs must be included to qualify.
    2. However, if less than 100% of the HCEs are included, the 70% requirement is reduced accordingly (per 410(b)).
    For example, if a plan only includes half of the HCEs, the plan need only include 35% (50% times 70%) of the NHCEs.
  2. The second test applies only to Defined Benefit (DB) Benefit (DB) and Cash Balance (CB) plans and determines how many total employees must participate in the plan (per 401(a)(26)). Each plan must include the lesser of:
    1. 40% of otherwise eligible employees, or
    2. 50 employees.

DB/CB plan must meet BOTH tests to meet IRS coverage requirements and the test must be passed every year to maintain qualification. All other plans (generally 401k and Profit SharingProfit Sharing plans) must meet the 70% coverage test.
Several criteria are allowable (by Treas. Reg. 1.410(a)-3(d)) in determining which employees are selected for inclusion in the plan including, but not limited to:

  1. Compensation (per 410(b))
  2. Hourly versus salary (per 410(a)(4)& ERISA 202(a)(4))
  3. Job class (per 401(a)(5))
  4. Job title (per 401(a)(5))

Almost any method may be used providing it does not discriminate by age, sex, creed or race. The “Carve-out” design technique is useful in providing key employees with a higher percentage of the overall contribution.

Employee morale is important in all companies and ‘carve-out’ plans can certainly create issues. A separate 401(k) plan that covers at least the NHCE’s is a good way to provide benefits to those employees who are excluded from the carve-out plan(s).

The “Carve-out” concept enables an employer to put a plan in place which allows the owners to maximize their share of contributions. The optional bonus program provides a flexible method to reward the most important employees based on their importance to the company.