Attracting and retaining key employees can be a significant challenge for closely held businesses. Salary, cash bonuses, equity incentives, and qualified retirement plans can all play a role, but business owners may also want additional flexibility when designing benefits for selected executives.
An Executive Bonus Plan with life insurance is one approach. Under this type of arrangement, an employer provides additional taxable compensation to an executive that can be used to fund a personally owned life insurance policy.
The structure can provide the executive with life insurance protection and, when permanent insurance is used, the potential to accumulate policy cash value. For the employer, it can provide a relatively straightforward way to offer a selective benefit without transferring ownership of the business.
Executive Bonus Plans are not appropriate for every business or executive. The compensation arrangement, policy design, tax treatment, retention objectives, and long-term funding commitment should be evaluated together.
An Executive Bonus Plan Is a Compensation Strategy, Not an Insurance Product
The employer provides taxable compensation to the executive. The executive generally owns the policy, and the life insurance should be selected and designed around the executive's insurance needs and the objectives of the compensation arrangement.
What Is an Executive Bonus Plan?
An Executive Bonus Plan, sometimes referred to as a Section 162 bonus arrangement, is a nonqualified compensation strategy in which an employer pays additional compensation to a selected employee. The employee can use that compensation to pay premiums on a life insurance policy that the employee owns.
A typical arrangement works as follows:
Employer Pays the Bonus
The employer provides additional compensation to the executive, either directly or through premium payments made on the executive's behalf.
Executive Recognizes Compensation
The bonus is generally treated as taxable compensation to the executive.
Executive Owns the Policy
The executive generally owns the life insurance policy and designates the beneficiaries, subject to any separately established restrictions.
Policy Provides Benefits
The policy provides life insurance protection and, when permanent insurance is used, may accumulate cash value based on the terms and performance of the contract.
The employer may generally deduct compensation that satisfies applicable federal tax requirements, including the requirement that total compensation be reasonable. Business owners should coordinate the arrangement with their tax and legal advisors rather than assuming every premium-related bonus will automatically be deductible.
Why Use Life Insurance in an Executive Bonus Plan?
Life insurance can serve two purposes within an Executive Bonus Plan: providing death benefit protection and, when permanent insurance is appropriate, creating the potential to accumulate policy cash value over time.
Depending on the executive's objectives and the policy selected, potential benefits may include:
- Death benefit protection for the executive's beneficiaries
- Tax-deferred accumulation of policy cash value in permanent life insurance
- Flexible policy design based on the executive's insurance needs, funding objectives, and risk tolerance
- Employee ownership of an individually owned asset that may remain in place after employment ends
Because the executive generally owns the policy, the employer does not control the policy in the same manner it would with employer-owned life insurance. The executive typically controls beneficiary designations and, subject to the policy terms and any separate agreement, access to policy values.
The type of life insurance should be selected based on the objectives of the arrangement rather than simply because a particular product accumulates cash value. Permanent policies may be appropriate when long-term death benefit protection and cash value are important, while other circumstances may call for a different policy design.
Policy cash values are not the same as a traditional investment or retirement account. Access through withdrawals or policy loans can reduce cash value and the death benefit, may require interest payments, and can create adverse tax consequences if a policy lapses or is surrendered with an outstanding loan. Policy performance and funding should therefore be reviewed periodically.
Executive Bonus Plans vs. Other Incentive Strategies
Executive Bonus Plans serve a different purpose than equity incentives and qualified retirement plans. The following comparison highlights some of the structural differences among these approaches:
| Strategy | Employee Ownership | Equity Required | Selective Benefit |
|---|---|---|---|
| Executive Bonus Plan | Executive generally owns the life insurance policy | No | Yes |
| Stock Options | May provide an opportunity to acquire company shares | Yes | Generally yes |
| Phantom Stock | No actual company shares are transferred | No | Generally yes |
| Qualified Retirement Plan | Participant has an interest in the retirement-plan benefit | No | Generally subject to broader participation rules |
Adding Retention Incentives With a Restricted Executive Bonus Arrangement
A traditional Executive Bonus Plan gives the executive ownership of the life insurance policy, which provides flexibility but may offer the employer relatively little leverage to encourage long-term retention.
A Restricted Executive Bonus Arrangement (REBA) can add a retention component while allowing the executive to remain the policy owner. Under this approach, the employer and executive enter into a separate agreement that may restrict certain policy rights for a specified period.
For example, the agreement may limit the executive's ability to access policy cash values through withdrawals, loans, surrender, or other transactions until specified conditions have been satisfied. The restrictions and the circumstances under which they are released should be clearly defined in the agreement.
This can create an additional incentive for the executive to remain with the business while preserving the basic structure of an employee-owned life insurance arrangement.
Because the legal, tax, and employment consequences depend on how the restrictions are structured, a REBA should be designed in coordination with the business's legal and tax advisors.
Example: Using an Executive Bonus Plan to Support Retention
Consider a closely held business that wants to provide an additional benefit to a key operations executive. The executive is important to the company's long-term growth, and the owners would like to create an incentive that provides meaningful personal value without transferring equity.
After evaluating the executive's compensation, insurance needs, and long-term objectives, the company establishes an Executive Bonus Plan. The company provides a $50,000 annual bonus that the executive uses to fund a personally owned permanent life insurance policy.
Under the arrangement:
- The $50,000 is generally treated as taxable compensation to the executive.
- The executive owns the policy and designates the beneficiaries.
- The policy provides life insurance protection and has the potential to accumulate cash value over time.
- The employer may generally deduct the bonus as compensation when applicable tax requirements, including reasonable compensation standards, are satisfied.
To add a retention component, the employer and executive also enter into a Restricted Executive Bonus Arrangement. For example, the agreement might restrict the executive's ability to access policy cash values for five years, with the restrictions being released according to the terms of the agreement.
The result is a compensation arrangement designed to provide the executive with a personally owned benefit while giving the employer an additional tool to support long-term retention.
The actual life insurance policy, premium level, death benefit, funding period, and restrictions should be designed around the circumstances of the business and executive rather than predetermined as part of the Executive Bonus Plan structure.
Tax Considerations for Executive Bonus Plans
The tax treatment of an Executive Bonus Plan is generally based on the compensation relationship between the employer and executive.
- Employer: The bonus may generally be deductible as compensation when applicable requirements are satisfied, including reasonable compensation standards.
- Executive: The bonus is generally treated as taxable compensation and reported as income to the executive.
Some employers use a double bonus arrangement, providing an additional bonus intended to help offset the executive's income tax liability associated with the amount used to fund the policy. The additional bonus is itself taxable compensation, so the total amount should be calculated with the executive's individual tax circumstances in mind.
When permanent life insurance is used, policy cash value generally accumulates on a tax-deferred basis. Life insurance death benefits are also generally received by beneficiaries free of federal income tax, subject to applicable tax rules and exceptions.
Access to policy cash value requires additional consideration. Withdrawals and policy loans can affect the policy's cash value and death benefit, and loans accrue interest. Depending on the policy's tax status and how it is managed, distributions or a later lapse or surrender can also create taxable income.
Because the compensation arrangement and life insurance policy have separate tax considerations, business owners and executives should coordinate the plan with their tax and legal advisors and periodically review the policy's performance and funding.
Customization and Flexibility
One of the advantages of an Executive Bonus Plan is the flexibility to design the arrangement around the needs of the business and individual executive. Unlike qualified retirement plans that generally must follow broader participation and nondiscrimination requirements, an Executive Bonus Plan can typically be offered selectively to key employees.
Depending on the objectives of the arrangement, a business may be able to:
- Select which executives participate
- Establish different bonus amounts for different executives
- Coordinate bonuses with compensation or performance objectives
- Add separately documented restrictions designed to support retention
- Design the life insurance policy around the executive's insurance needs and long-term objectives
This flexibility can make an Executive Bonus Plan useful for closely held businesses that want to provide additional benefits to selected executives without transferring equity or establishing a benefit for the entire workforce.
Who May Benefit From an Executive Bonus Plan?
An Executive Bonus Plan may be worth considering when a business wants to provide additional compensation or benefits to one or more key employees while allowing those employees to own their life insurance policies.
Potential applications include:
- Closely held businesses seeking to reward or retain key executives
- Professional practices with a small group of highly compensated employees
- Businesses that want to provide selective benefits without transferring ownership interests
- Companies looking for an alternative or complement to other executive compensation strategies
The arrangement is most useful when the executive has a legitimate need for life insurance and the policy is designed to support that need as part of the broader compensation strategy. The business should also consider the executive's total compensation, the expected duration of the arrangement, and whether a retention component is necessary.
Frequently Asked Questions
What type of life insurance can be used in an Executive Bonus Plan?
Different types of life insurance may be used depending on the executive's insurance needs and the objectives of the arrangement. Permanent life insurance is often considered when long-term death benefit protection and the potential accumulation of cash value are important. The appropriate policy type and design should be determined based on the executive's circumstances rather than treating any particular product as the default choice.
Can a business owner participate in an Executive Bonus Plan?
Potentially. The tax and planning considerations depend on the business's entity structure, the owner's compensation, and other circumstances. For example, compensation paid by a corporation must satisfy applicable requirements, including reasonable compensation standards, for the business to claim a compensation deduction. Owner participation should therefore be reviewed with the business's tax and legal advisors.
What is the difference between an Executive Bonus Plan and a Restricted Executive Bonus Arrangement?
Under a traditional Executive Bonus Plan, the executive generally owns and controls the life insurance policy. A Restricted Executive Bonus Arrangement adds a separate agreement that may temporarily restrict certain policy rights, such as access to cash value, until specified conditions have been satisfied. This can add a retention component without requiring the employer to own the policy.
Can an executive access the policy's cash value?
If permanent life insurance is used, the executive may be able to access available policy cash value through withdrawals or policy loans, subject to the terms of the contract and any restrictions established under a separate agreement. Withdrawals and loans can reduce policy values and the death benefit, loans accrue interest, and improper management can create adverse tax consequences.
Are Executive Bonus Plans guaranteed to be tax deductible to the employer?
No. Executive Bonus Plans are commonly structured so that employer payments are treated as compensation, but deductibility depends on the applicable tax requirements and the facts of the arrangement. Among other considerations, compensation generally must be reasonable in amount. Businesses should have their tax advisors evaluate the treatment of the bonus rather than assuming a deduction is automatic.
Is an Executive Bonus Plan Right for Your Business?
An Executive Bonus Plan can provide closely held businesses with a flexible way to reward selected executives while providing life insurance protection and, when appropriate, the potential benefits of permanent life insurance.
The value of the strategy depends on more than simply paying life insurance premiums as a bonus. The executive's insurance needs, total compensation, policy design, tax treatment, retention objectives, and the employer's long-term commitment should all be considered when designing the arrangement.
For businesses that want to provide an additional benefit without transferring equity, an Executive Bonus Plan may be one option to consider alongside other executive compensation and retention strategies.
When the primary objective is protecting the business against the financial consequences of losing an important employee or owner, key person life insurance serves a different purpose. In that structure, the business generally owns the coverage and is the beneficiary rather than providing a personally owned benefit to the executive.
This article is provided for general informational and educational purposes and is not intended as legal, tax, accounting, or investment advice. The tax treatment of executive compensation arrangements and life insurance depends on the specific facts and circumstances.
Business owners and executives should consult their legal, tax, and other professional advisors before implementing or modifying a strategy.
