Section 162 executive bonus plans: how they work and how they are taxed

A Section 162 executive bonus plan is a compensation arrangement in which the employer pays an executive a bonus, and the executive uses it to pay premiums on a life insurance policy the executive owns. The employer generally deducts the bonus as compensation under IRC 162(a)(1) if it is reasonable, and the executive reports the bonus as wages. The employer owns nothing and holds no claim on the policy.

How the arrangement works

The plan has three moving parts. The executive applies for and owns an individual life insurance policy, usually permanent coverage such as whole life or universal life. The employer pays a bonus, either to the executive or directly to the insurer on the executive's behalf, equal to the premium and sometimes grossed up for the income tax the bonus creates. The executive names the beneficiary of the death benefit.

Because the executive owns the policy, the plan does not create a deferred compensation liability on the employer's balance sheet and does not involve the funding rules of nonqualified deferred compensation and corporate-owned life insurance. The employer's cost is the bonus and the payroll taxes on it. The executive's benefit is a personal policy funded with employer dollars.

Tax treatment

• Employer: the bonus is deductible as compensation if it is reasonable for the services performed, as with any salary. Payroll taxes apply.
• Executive: the bonus is taxable wages for income and FICA purposes. The executive pays tax on the bonus even though the money goes to the premium. A common design grosses up the bonus so the net after tax covers the premium.
• Death benefit: death proceeds paid to a beneficiary are generally income-tax-free under IRC 101(a), subject to the usual exceptions such as the transfer-for-value rule.
• Cash value: growth inside the policy is tax-deferred under the life insurance definition in IRC 7702. Access to cash value through withdrawals up to basis and policy loans can be tax-free if the policy is not a modified endowment contract and stays in force. A policy that lapses with outstanding loans can create taxable income.

Compare this with split-dollar life insurance: economic benefit and loan regimes explained, where the employer shares the policy, and with an employer-owned policy under COLI and BOLI explained: corporate and bank-owned life insurance, where IRC 101(j) applies. See Employer-owned life insurance: notice and consent rules under IRC 101 for those notice-and-consent requirements, which a pure executive bonus plan avoids because the employer does not own the contract.

Why employers use it

The executive bonus plan is simple and has low administrative cost. It does not need plan documents of the kind ERISA requires for a retirement plan, although a written agreement is advisable. It lets an employer provide selective benefits to chosen executives without the nondiscrimination testing that applies to qualified plans. It can include a retention feature, such as a restrictive endorsement, a repayment agreement, or a vesting schedule. The employer can stop paying bonuses at its discretion, subject to any contract.

Retention features and their limits

A basic bonus plan gives the executive full ownership from day one. Many employers want a retention tool, so they use a "double bonus" variation and some form of restriction.

1. Double bonus: the employer pays the premium bonus plus an additional bonus to cover income tax on the first bonus.
2. Restrictive endorsement: the policy carries an endorsement that limits the executive's right to withdraw, borrow or surrender during a stated period, usually with the employer's consent. The carrier must accept this endorsement, and forms differ.
3. Repayment agreement: a signed agreement requires the executive to repay all or part of the bonus on leaving before a stated date.

A restriction can alter the tax result if it makes the arrangement look like deferred compensation or if the employer is treated as having an interest in the policy. When the employer holds rights in the contract, the arrangement may fall within the split-dollar rules of Treasury Regulation 1.61-22. Draft the terms with an attorney and a CPA.

Tax and reporting traps

• Reasonable compensation: bonuses on top of an already large salary can face scrutiny, especially in closely held corporations where the executive is also an owner. The deduction can be challenged as a disguised dividend.
• 409A: a retention bonus with a payout contingent on staying and paid later may be deferred compensation under IRC 409A. A short-term deferral generally avoids 409A when payment occurs within the short period after vesting. Check this with counsel.
• Payroll reporting: premiums paid directly to the carrier on the executive's behalf are still reported as wages on Form W-2.
• S corporation owners: compensation to a more-than-2% shareholder has additional rules for fringe benefits. Ask the CPA.

Underwriting

The executive is underwritten as an individual. Expect the standard medical history, an exam if the amount requires it, and financial underwriting based on compensation. The amount of coverage is generally limited to what the executive's income and the bonus justify. The employer's role does not change the underwriting, although the carrier will ask who pays. The general process appears in how insurers underwrite business life insurance.

Hypothetical example

Say a closely held engineering firm wants to give its chief operating officer a death and savings benefit. The COO is 48 and earns $300,000. The firm will pay a bonus of $24,000 a year toward the premium on a permanent policy the COO owns, plus an additional amount to cover the income tax on that bonus. The firm deducts the total bonus. The COO reports it as wages. The COO later borrows against the policy cash value within the policy's limits. The agreement requires repayment of the last two years of bonuses if the COO leaves within five years. The figures are invented, and the numbers a real plan would use depend on the insurer's illustration and tax advice.

Comparison with other executive benefits

Key takeaways

• An executive bonus plan is a taxable bonus used to fund a policy the executive owns; the employer deducts the bonus if it is reasonable.
• It is simple and avoids the funding and reporting rules of employer-owned and deferred compensation arrangements.
• Retention features such as repayment agreements and restrictive endorsements can change the tax analysis, so draft them with advice.
• The executive pays tax on the bonus, which is why gross-ups are common.
• Watch reasonable-compensation and 409A questions in closely held companies.