What is a Section 162 Bonus Plan?
A Section 162 Executive Bonus plan – sometimes called a “section 162 bonus arrangement” or “section 162 bonus agreement” is a bonus paid by an employer to an employee. The employer-paid bonus pays the premium for a cash value life insurance policy that will be owned by the executive. This is a benefit designed to attract, reward, and retain key executives until retirement.
What Types Of Insurance Policies Are Typically Used In Section 162 Executive Bonus Arrangements?
Often the life insurance policies used in Executive Bonus Arrangements are designed to accumulate cash value as opposed to providing maximum death benefit.
How Do I Determine the Amount of The Bonus?
The size of the bonus is left to the employer’s discretion, but should be “reasonable” per IRC § 162. If the goal of the bonus is executive retention, then the size of the bonus should be large enough to be meaningful and large enough to pay the premiums on a life insurance policy.
What types of companies or business entities can benefit from an Executive Bonus Arrangement?
Any business entity may benefit from an Executive Bonus Arrangement installed for executives who do not have an ownership stake in the company. A business owner may also benefit from an Executive Bonus Arrangement where the business’s form is a C-Corporation, or in some circumstances where the individual is a non-majority owner of a different business form (such as an S-Corporation or LLC). An executive who participates in an Executive Bonus Arrangement may benefit from the plan so long as the executive is interested in accumulating cash on a tax-advantaged basis or desires death benefit protection for loved ones or as part of an estate plan. Small businesses that find qualified plans too expensive and cumbersome to administer may benefit from Executive Bonus Arrangements as an alternative to qualified plans. Large businesses that are restricted as to what they can offer their executives because of qualified plan limitations may also benefit by offering selected executives Executive Bonus Arrangements as a supplement to their existing qualified plans.
Can Shareholder-Executives of Pass-through Entities Benefit from an Executive Bonus Arrangement?
Maybe. Businesses organized as pass-through entities such as S corporations, LLCs and LLPs and sole proprietorships do not pay taxes. Instead income and deductions flow through to their owners. As such, the bonus plans provide little, if any, tax leverage and are not considered to be an effective tool for majority owners but may be of some benefit to a minority owner. A bonus payment reduces the business owner’s basis in a pass-through entity. Careful consideration should be given to reducing basis if the entity expects to make future distributions to its owners, as basis shelters distributions from taxation.
Does a Section 162 Executive Bonus Arrangement Create Tax Leverage?
Yes. If the executive is in a lower marginal tax bracket than the business it may be less expensive for income to be taxed to the shareholder rather than to the corporation.
However, if the individual is in a higher marginal tax bracket than the business it may be less expensive for income to be taxed to the business and a split-dollar agreement could be a better solution.
What Are The Tax Consequences Of A Section 162 Executive Bonus Arrangement For The Employer And Executive?
Since the bonus is taxed as compensation to the executive, it is deductible by the employer in the year paid provided it qualifies as reasonable compensation to the executive. As with other life insurance policies, the death proceeds from Executive Bonus Arrangements are usually received by the executive’s designated beneficiary income tax-free under IRC Sec. 101(a).
In a single-bonus plan, the amount deducted by the employer and taxable as income to the executive is equal to the amount of the life insurance premium. In a double bonus plan, the amount deducted by the employer and taxable as income to the executive is equal to the amount of the life insurance premium plus the amount of additional cash bonus paid by the employer to the executive to cover the executive’s tax liability.
The employer selects the executives it wishes to benefit and pays tax-deductible premiums (or a cash bonus) for a policy on each executive’s life. Each executive reports the premium (or bonus) each year as taxable income. More care is required if the employer pays premiums of an executive-owned policy directly to the insurance company. In this scenario, the employer’s deduction for the premium bonus is allowed only if certain conditions are met.
What is the Difference Between A “Single-Bonus” The “Double-Bonus” Plan?
The core difference between the two plans is the amount of bonus paid by the employer to the executive. A single-bonus plan includes a bonus for an amount only to cover the premium of the life insurance policy; the executive is required to pay for the taxes which result from the bonus. A double-bonus plan includes a bonus for an amount to cover the premium but also includes an amount paid directly to the executive to cover the executive’s tax liability resulting from the two bonuses. The goal of a double-bonus plan is to reduce the executive’s after-tax outlay to zero.
Is there a quick way to calculate the amount under a double-bonus plan?
The total amount under a double-bonus plan can be calculated by dividing the amount of the premium bonus by one minus the executive’s tax bracket expressed as a decimal. Assuming a premium bonus of $80,000 and a tax bracket of 30%, the total amount under a double-bonus plan would be: $80,000 / (1 – 0.30) = $114,285.
Does the Employer Have to Include all Executives?
No. The Executive Bonus Arrangement can be completely selective in coverage. The employer is free to select the executives it wishes to benefit. A Section 162 Executive Bonus Arrangement is employer-financed life insurance that is intended to benefit select executives.
Who Owns The Life Insurance Policy?
The executive usually applies for and owns the policy, naming someone other than the employer as beneficiary. In situations where the Executive Bonus Arrangement is integrated into the executive’s estate plan, an Irrevocable Life Insurance Trust (ILIT) will apply for, own, and be the beneficiary of the policy.
How are Premiums Paid?
The employer may pay the premium directly to the insurance company, or the employer may pay a cash bonus to the executive who then pays the premium to the insurance company. The employer and executive may choose either method depending on personal preference or accounting abilities.
However, if the employer pays the premium directly to the insurance company, then greater care must be taken to meet certain conditions required to maintain the desired tax effects of the plan. In this case, the employer deduction will be allowed only if:
- The executive’s total compensation package, including the bonus, is reasonable in view of the services rendered to the employer.
- The employer is not a beneficiary of the policy, directly or indirectly.
- The salary or bonus used to pay premiums represents an ordinary and necessary business expense of the employer.
- The premium is not construed as a constructive dividend to the shareholder-executive (if the insured executive is also a shareholder in the employer).
- The employer pays its share of FICA and Medicare taxes on bonuses paid.
The cash bonus or premium is reported as additional compensation on the executive’s Form W-2 each year. In a single-bonus plan, the annual taxes on the premium bonus are paid out-of-pocket by the executive. In a double-bonus plan, the employer pays an additional cash bonus to the executive to cover the tax liability created by both bonuses.
Who Receives Death Benefits?
At the executive’s death, his/her designated beneficiary generally receives the death proceeds free of federal income taxes under IRC Section 101(a).
Are the Policy Cash Values Accessible?
It depends. If individually-owned, yes. If the policy is owned by an Irrevocable Life Insurance Trust (ILIT) for estate tax planning purposes, no. In an Executive Bonus Arrangement, the policy owner will have access to all of the policy’s values. The owner can take tax-free withdrawals to basis and/or policy loans. Policy loans or withdrawals will, of course, reduce the death benefit and may have tax consequences.
How can the Policy Owner Use The Policy’s Cash Values?
Policy owners can use the cash values as emergency funds or as a means of supplementing their retirement income.
Are there Written Agreements in a Section 162 Executive Bonus Arrangement?
Because the executive is the owner of the life insurance policy, the agreement does not have to be in writing. However, it is good practice to have the employer execute a corporate resolution authorizing payment of bonuses to fund life insurance premiums.
