Executive bonus plans — also known as Section 162 plans — are the simplest of all nonqualified arrangements. The employer pays premiums on a permanent life insurance policy owned by the executive, bonusing the premium as taxable compensation. The employer receives an immediate tax deduction; the executive owns a portable, flexible policy with tax-deferred cash value growth.
Key taxation principles: premiums are ordinary income to the executive when paid; cash value grows tax-deferred; withdrawals up to basis are tax-free under FIFO treatment; loans are generally income-tax-free unless the policy lapses; death benefits are income-tax-free but may be subject to estate tax if the executive retains incidents of ownership.
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Review Questions
The employer selects an amount of income to be paid at retirement under the plan
It is more complex than the defined contribution approach
✓The cash value of the life insurance policy at retirement determines the amount of income the executive will receive
The employer must calculate the contribution amount level that will provide the promised retirement benefit
✓The premiums paid are considered contributions to a nonqualified plan and are deductible by the employer
Plan costs are reduced because the employer need not include all employees
There are generally no reporting or disclosure requirements that apply
Plan administration is very simple
Benefits under the life insurance policy stop
The employer must continue making bonused premium payments until age 65
The executive may not continue paying premiums on the policy
✓None of the above
I only
I and II only
II and III only
✓I, II and III
He must pay income tax only on this amount
He must pay Social Security tax only on this amount
✓He must pay both income tax and Social Security tax on this amount
There is no additional income tax liability
✓I only
II only
I and III only
II and III only
The $400,000 is considered taxable income, subject to capital gains tax rates
✓The $400,000 is considered taxable income, subject to ordinary income tax rates
Jeff will owe no income tax on either the $500,000 or the $400,000 loan
None of the above are true
LIFO accounting
✓FIFO accounting
Capital gains treatment
Constructive receipt doctrine
✓$180,000
$200,000
$220,000
$500,000
Long-term capital gain
✓Ordinary income
Dividend income
Modified endowment income
They must be ordinary and necessary expenses
They must be paid or incurred by the employer
They must be paid for services actually rendered
✓All of the above
I only
II only
I and II only
✓I, II, and III
$500,000
✓$1,000,000
$2,000,000
$2,500,000
A spouse
A trust
Minor children
✓The employer
10%
15%
25%
✓There is no IRS penalty associated with a withdrawal from a life insurance policy in an executive bonus plan
$300,000
$200,000
✓$175,000
Nothing
Traditional split dollar plan
Salary continuation plan
True deferred compensation plan
✓Executive bonus plan
Split dollar plans
Deferred compensation plans
Group carve-out plans
✓Executive bonus plans
✓Executive bonus plans
True deferred compensation plans
Salary continuation plans
Endorsement split dollar plans
Defined benefit pension
✓Executive bonus
Salary continuation
Profit sharing
✓The insured
The employer
The beneficiary
A trust
✓Taxable as ordinary income
Tax-free
Tax-deferred
Taxable as a dividend
Identify the plan participants by name
State that the bonus is additional compensation
Identify each participant as a member of a select group of corporate managers
✓All of the above
At retirement only
At any time permitted by the board resolution
At retirement or in the case of hardship only
✓At any time
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