Module 3 — Executive Bonus Plans

One of the concerns that business owners often have concerning benefit plans is that they are complicated and burdensome to administer. In this module, we will consider a benefit plan that, in simplicity and ease of administration, is about as far from a qualified plan as possible. Despite that simplicity, this benefit plan meets a number of important executive and business objectives.

Executive bonus plans are often referred to as Section 162 Plans because IRC Section 162 states that an employer may deduct all ordinary and necessary business expenses, including a reasonable allowance for salaries or other compensation for personal services actually rendered.

An executive bonus plan is an arrangement under which an employer pays the premiums on a permanent, cash value life insurance policy. Although the employer pays the premiums, the executive — not the employer — owns the life insurance policy.

Upon completion of this module, you should understand:

• Executive bonus plans and the reasons companies provide them to executives
• The criteria used in setting goals for the achievement of a bonus
• How a board of directors authorizes an executive bonus plan
• Why life insurance is a suitable financial vehicle for funding executive bonus plans
• The advantages and disadvantages to both employers and executives
• Who can and should participate in an executive bonus plan
• How to design an executive bonus plan to achieve specific objectives
• The taxation issues involved for both the employer and the executive

The need for an executive bonus plan often arises out of an employer’s desire to add a certain extra incentive to its executive compensation. The executive bonus plan provides death protection for executives, gives executives an opportunity to build cash value, and gives the employer a current income tax deduction.

Although the emphasis in an executive bonus plan is on death benefits, the policy’s cash value may also provide additional retirement income for an executive — supplementing an existing qualified plan or representing the only retirement program offered by the employer.

In an executive bonus plan, the employer makes a premium payment on a permanent life insurance policy and bonuses the premium payment amount as salary to the executive. The maximum business benefit is often obtained by tying the granting of a bonus to the executive’s achievement of particular benchmarks. The bonus, if based on the meeting of some goal or objective, should be based on criteria that are achievable, stretch the individual, and are within the executive’s control.

The board of directors should pass a written authorization to establish an executive bonus plan. The authorization should:

• Identify the specific executives who will participate
• State that the bonus is intended as additional compensation to each named executive
• State that the bonus will be used to purchase individual, permanent, cash value life insurance
• Establish that each participating executive is a member of the select group of corporate management
• Define the claims procedure (written notice of claim denial and opportunity for a full hearing)

Any type of individual, permanent life insurance policy may be used as the funding vehicle. In many cases, the most desirable product is a universal life insurance policy, which more easily adapts to variations in premium deposits and provides tax-advantaged access to cash value through withdrawals.

Irrespective of the type of policy used, the executive owns the policy, names the beneficiary (which should not be the employer), and chooses the appropriate settlement option.

Selectivity. An executive bonus plan allows an employer to include a single employee or a class of employees and exclude all others. Since the employer is not required to include other employees (as in a qualified plan), plan costs are reduced. The executive bonus plan enables the employer to reward the key executive both financially and emotionally.

Current Income Tax Deduction. Employer contributions to an executive bonus plan are deductible from the employer’s income in the year in which the contribution is made. The premium paid for the executive-owned life insurance is considered current compensation to the executive, included in the executive’s W-2 statement, and taxable as ordinary income.

Ease of Communication and Administration. Communicating the operation and benefits of a basic executive bonus plan to an executive is a simple matter. There are no government reporting or disclosure requirements that apply to the typical executive bonus plan. Administration is equally simple — the bonused premium payment is treated as nothing more than additional compensation.

Post-Retirement Benefits. Unlike group health, life, and disability insurance that generally cease at retirement, executive bonus plan benefits continue at retirement. While bonused premium payments cease at retirement, the death benefits remain in effect, and the executive may continue paying premiums personally. The policy — unlike many employer-provided benefits — continues to protect the executive’s family.

Limited Cost. The cost to the executive is limited to the income and Social Security tax paid on the bonused premium. In many cases, the executive’s cost may be zero through a double bonus, by which the employer bonuses not only the premium but also the tax due on the premiums.

Corporate Dollars Used to Meet Personal Needs. The funds used to purchase the life insurance policy are employer funds. The policy values are available to the executive at all times to borrow or withdraw for family emergencies, tuition, retirement, or any other reason. Beginning at age 35 with a $10,000 annual bonus, the policy’s cash value at retirement (age 65) could be approximately $800,000 based on conservative universal life crediting. The executive could withdraw $300,000 entirely income tax-free (a recovery of basis) and continue to enjoy tax-free access through policy loans.

Portable and Flexible. The life insurance policy is portable and generally moves, in its entirety, with the executive when changing employers. A policyowner may also assign the policy and remove its death benefit from his or her estate — by gifting the policy to children or assigning it to an irrevocable life insurance trust at least three years prior to death, the proceeds can be excluded from the estate for tax purposes.

While the executive bonus plan has many advantages for both parties, there are certain disadvantages that need to be acknowledged.

For the executive, the only significant disadvantage is the required current recognition of income. Although income tax liability on cash value growth is deferred, the executive is required to recognize current income equal to the bonused premium payment each year.

For the employer, the disadvantages are more significant:

• Loss of control over the policy. Since the executive is the policyowner, the employer’s control is limited to the premium payment. The employer may reduce or stop the bonus, but the life insurance policy and its values — paid for by previous bonuses — are entirely under the control of the executive. An executive bonus plan offers only the carrot of possible future contributions without the stick of benefit loss upon termination.
• No employer cost recovery. Unlike split-dollar and deferred compensation plans, an executive bonus plan does not provide for employer cost recovery.
• Tax inappropriateness for sole proprietors and S corporation owners. Since in both of these organizations there is no distinction between the owner’s income tax bracket and the employer’s bracket, there is no tax benefit from the bracket differential. Executive bonus plans may still be used in these organizations for non-owner executives.

An executive bonus plan is considered an employee welfare benefit plan under ERISA since it provides death benefits. If the plan includes only highly compensated employees or applies only to a select group of management employees, it is exempt from all ERISA reporting and disclosure requirements. The plan must be prepared to provide copies of the plan document to the Secretary of Labor if asked.

An executive bonus plan is also exempt from all participation, funding, and vesting requirements of ERISA. The plan document can be as liberal or as restrictive as the employer desires.

Smaller organizations may choose initially to provide the plan only to the owner, adding additional executives as the business grows. Some S corporations and partnerships may choose not to establish a Section 162 plan because the tax advantages available to C corporations — specifically, the employer tax deduction and tax bracket differential — are not available for owner-participants.

If an employer considers providing a benefit for all employees under an executive bonus plan, ERISA reporting and disclosure requirements would apply, and the relative benefits of a qualified retirement plan would need to be considered. The financial professional should help the client understand that an executive bonus plan can be established as a supplemental plan to all other employee benefit plans — it need not be an alternative to a qualified plan.

Some employers use a formula approach in determining contributions to an executive bonus plan. Yearly retirement benefits could equal a percentage of final compensation (e.g., 30–40%), with the annual bonus equal to the premium needed to generate the agreed retirement income. Another common formula ties the retirement benefit to Social Security benefits.

The most effective formula approach connects the bonus amount to predetermined performance goals:

The flat amount method is commonly used when there are only a few participants or when benefit equity is desired. There are two basic variations:

• Defined Contribution Approach: A flat bonus amount is determined for all years (same for all participants, same percentage of base compensation, etc.). The policy cash value at retirement determines the income the executive may receive. This is the simpler of the two variations.
• Defined Benefit Approach: The employer selects a specific retirement income amount (e.g., $50,000/year for 10 years). A calculation must be made to determine the annual bonus needed to provide the promised benefit. This approach adds substantial complexity and is often avoided by employers.

Since the executive owns the life insurance policy, vesting in the qualified plan sense is generally not applicable. However, an employer may restrict the executive’s rights to the policy by allowing access to cash value only after a specified period of time.

If the life insurance purchased is participating, any and all policy dividends are payable to the executive. The executive may choose any dividend option, including cash as a means of offsetting the end-of-year income tax liability caused by the bonus.

Any form of permanent, cash value life insurance may be used. Universal life insurance is generally preferred when the bonus amount may vary from year to year, due to its premium flexibility and ease of accessing policy cash values through withdrawals. Annuity contracts may also be used — they can be issued regardless of the executive’s health and may produce greater cash values at certain durations, though they lack the preretirement death benefit and FIFO tax treatment of life insurance.

Three requirements must be met for a bonus to be deductible by the employer:

• Ordinary and Necessary: The expense must occur in the usual course of business and be necessary or helpful in furtherance of the goals of the business, including a reasonableness-of-compensation test.
• Paid or Incurred: The bonus must be actually paid or incurred in the year in which it is deducted.
• Services Actually Rendered: The bonus must be in payment for services actually rendered in a trade or business. An employment relationship is necessary. A non-employee shareholder who receives a bonus would be deemed to have received a dividend — not deductible by the corporation and taxable as a dividend to the recipient.

Whether the employer pays the life insurance premiums on a policy owned by the executive or pays the executive a cash bonus is immaterial — the amount of the bonus is includable in the executive’s gross income as compensation, taxable at ordinary income rates. The premium payments then grow inside the life insurance policy on a tax-deferred basis.

There are three methods of accessing policy cash values, each with different tax treatment:

1. Surrendering the Policy for Cash: If the executive surrenders the policy for cash, the entire proceeds constitute taxable income to the extent they exceed the executive’s cost basis. The gain is taxed at ordinary income rates.

2. Taking Policy Withdrawals (FIFO Treatment): As long as the policy is not a modified endowment contract (MEC), the executive can withdraw an amount equal to cost basis entirely income tax-free under FIFO (first-in, first-out) tax treatment. Once withdrawals exceed basis, subsequent withdrawals are fully taxable as ordinary income.

The tax-efficient strategy combines withdrawals up to basis followed by policy loans for the remaining gain. Since policy loans are not considered distributions (except in an MEC), the executive may access remaining values without income tax — as long as the policy is never surrendered or allowed to lapse. If the policy lapses after loans exceed basis, the entire gain becomes taxable with no remaining proceeds to pay the tax.

3. Taking Periodic Income Payments: The executive may surrender the policy and choose a settlement option. Under the annuity rule, the portion of each installment representing premiums paid less any dividends withdrawn is received income tax-free as a return of investment. The balance is taxable as ordinary income.

Death benefits payable to a named beneficiary are income tax-free. However, if the executive owns the policy or has any incidents of ownership at death, the policy will be included in the estate for estate tax purposes. To remove the death benefit from the estate, the executive may assign the policy to an irrevocable life insurance trust or gift it to children, provided the transfer is made at least three years prior to death.