Tier One: Life Insurance & Executive Benefits: The Executive Bonus IRC §162 Plan
Attracting, compensating, and retaining key talent is an on-going challenge for companies today. Section 162 of the Internal Revenue Code establishes an easy way to accomplish these goals for executives or other key employees using a bonus arrangement. The most popular funding mechanism for a IRC §162, commonly referred to as an Executive Bonus Plan, is a whole life or universal life cash value insurance policy. These plans allow business owner and companies to provide additional benefits to employees of their choice and, by doing so, the plans can be extremely effective in attracting, retaining and retiring the chosen participants.
An employer makes a cash bonus to an employee which is used to fund a cash value life insurance policy on the life of the employee. The employee maintains all rights to the policy and can use the policy’s cash values to supplement future income while the employee is working or retired. Under most circumstances, the employee accesses a policy through loans which are tax-free as long as the policy remains in-force during the employee’s lifetime.
In addition, the employee is able to name a beneficiary of their choice to receive the policy’s income tax-free death benefit. Normally, the policy is designed to provide the minimum amount of death benefit cover permitted by regulations so that cash value growth within the policy is maximized. If the policy is large enough, the employee may wish to have an irrevocable life insurance trust (“ILIT”) own the policy so that the value of the policy’s death benefit is not included in the employee’s estate when they die. The trustee is able to make decisions regarding access to the policy for cash in the future.
From an employer’s perspective, an executive bonus plan is simple and easy to implement and administer. The bonus payments are deductible to the company and taxable to the employee just like most forms of cash compensation. In order to retain a plan participant, the employer can ask the employee to sign an agreement pertaining to certain restrictions. The employer may require a restrictive endorsement to the policy which requires the employer’s consent if the employee wants to surrender the policy or access the cash value of the policy before a certain date or period of continued employment.
Under most designs, executive bonus plans are not subject to ERISA and are typically not subject to the same complex rules of other nonqualified deferred compensation plans. Employers may discriminate which employees to include in a plan as well as the amount, timing and conditions for the bonus and the terms to any restrictions.
From an employee’s perspective, an executive bonus plan allows the employee to save more than the limits of any qualified plan. Outside of any employer restrictions for short-term access, the employee is free to access or not access the policy’s cash values whenever they would like. There is also an element of portability to a plan since the employee owns the policy. An employee may ask a future employer to continue funding the policy through another bonus arrangement.
As noted, the bonus is taxable to the employee as a wage and, as a wage, the bonus is subject to both FICA and FUCA withholding. In some executive bonus plans, the employer may elect to carry out a ‘double bonus’ and provide the employee with a bonus large enough to pay the life insurance premium as well as the income taxes incurred by the employee on the bonus. Essentially, through a double bonus, the employer eliminates any out-of-pocket expense for the employee.
Amir is a single, 34-year-old senior manager with P.J. Scooter, LLC. P.J. Scooter agrees to a IRC §162 bonus plan that provides Amir with a double bonus, or gross-up bonus, so that Amir will not have any out-of-pocket expense or tax liability by participating in the plan. Amir uses the bonus to purchase a cash value index universal life policy on his life.
P.J. Scooter is able to take a tax-deduction equal to the amount of the entire bonus.
Amir and his employer agree in writing that Amir cannot access the policy’s cash values for five years. Further, if Amir leaves the company within five years, he must repay all of the bonuses given under the plan.
At age 60, Amir retires from P.J. Scooter to work part-time for a non-profit. The index universal life policy now has $1,900,000 in cash value which Amir elects to access via tax-free policy loans to supplement his income.
Advantages of Executive Bonus Plans
The employer may selectively choose the employees they wish to include.
The bonus payments are fully tax deductible to the employer.
An executive bonus plan is simple and easy to implement.
Executive bonus plans are not subject to the limits of qualified plans.
Participants can have immediate access to the policy’s cash value unless there is a restricted or controlled arrangement with the employer.
The employee is free to name the beneficiary to the policy’s income tax-free death benefit.
Disadvantages of Executive Bonus Plans
The employee must include any bonus in their taxable income and, unless there is a double bonus arrangement, the employee is responsible for any taxes.
The employer is unable to fully recover its costs from the policy’s death benefit since the employee names the policy beneficiary.
Executive bonus plans offer an employer limited control over the policy and can only restrict or control an employee’s access to the policy’s cash values.
If the policy is owned by the employee and not in an ILIT, the policy’s death benefit will be includable in the employee’s taxable estate.
Read our companion Tier One Interview with Kathy Bolton by clicking here.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.