162 Executive Bonus Plan

What is a 162 Executive Bonus Plan?

An executive bonus plan (Section 162) is a way for business owners or companies to provide additional supplemental benefits to key employees or executives of their choice. The benefits usually include life insurance policy death benefits as well as cash value accumulations that can be used as a retirement income supplement.  With an executive bonus plan, the business can use tax deductible company funds to selectively provide valued benefits to key people.  An executive benefit plan, used effectively, can be a valuable tool to attract and retain key executives.

Executive bonus plans are simple in design and easy to implement. The executive bonus plan works as follows:

  • The company provides the key executive with a bonus that is taxable as income to the recipient. The bonus is generally a deductible business expense for the company.
  • The key employee may choose to use the bonus to purchase a whole life or universal life insurance policy that builds cash value that grows tax deferred.
  • The life insurance policy, if properly structured, may provide an attractive benefit to the executive in the form of cash value growth. Any cash value accumulation will grow tax deferred and may be accessed by the employee income tax-free through withdrawals and policy loans. The policy’s cash value can be used to supplement retirement income or for any other financial need.
  • If the key executive dies, in most cases, the heirs will receive the death benefit proceeds from the life insurance policy income tax free.

Variations of Executive Bonus Plans

In addition to the basic executive bonus plan, there are other common plan variations. These options include a double bonus arrangement and a restricted or controlled executive bonus plan.

With a double bonus arrangement, the company will provide the key executive with a bonus large enough to pay the life insurance premiums as well as the income taxes incurred by the key executive on the bonus.  The company can use the double bonus arrangement to eliminate any out of pocket expense for the key executive.

If the company wishes to retain some measure of control over the bonus, the controlled executive bonus design is a good choice.  With a controlled executive bonus, the company and the key executive enter into an agreement which includes a vesting schedule on the policy’s cash value growth.  The vesting schedule is a form of “Golden Handcuffs” that allows a company to limit the availability of the cash value benefits until the executive has fulfilled the terms of the agreement.  At that time, the executive is “vested”.  Once the key executive is vested, they gain full and complete access to the policy’s cash value.

Advantages of Executive Bonus Plans

Executive bonus designs using life insurance have several advantages including:

  • An executive bonus plan is simple to implement and easy to administer.
  • The business can selectively choose the key employees they wish to reward.
  • The bonus payments may be considered a fully deductible expense to the company.
  • The key employee is able to name the beneficiary of the entire death benefit of the life insurance policy.
  • In many cases, unless there is a “restricted or controlled executive bonus”, the key executive will have immediate access to policy cash value and may access that cash value without income tax through policy loans and withdrawals.
  • Executive bonus plans are not subject to “qualified plan limits”.

Disadvantages of Executive Bonuses

There are also some inherent disadvantages in using an executive bonus plans including:

  • The company is unable to fully recover its costs from the policy’s death benefit since the key executive names the policy beneficiary.
  • Executive bonus plans offer the company very little control of the policy. Even if a controlled executive bonus is utilized, it only restricts the key employee’s access to the policy’s cash value. The bonus is never recovered by the company even if the key employee leaves the company prior to vesting.
  • The key executive must include any bonus in his or her taxable income.
  • Without additional planning, the life insurance policy’s death benefit will be includable in the key executive’s taxable estate