Executive Bonus Plan Pros and Cons: Advantages and Disadvantages of a Section 162 Arrangement

When an Executive Bonus Arrangement May Not Fit

Friction usually appears in these situations:

• Control. The employer wants to control the policy or recover premiums if the executive leaves. Executive ownership gives the employer no ownership right in the policy.
• Reasonableness. Total compensation, including the bonus, cannot be supported as reasonable. Treasury Regulation § 1.162-9 allows a bonus deduction only if the payments, "when added to the stipulated salaries, do not exceed a reasonable compensation for the services rendered," so the deduction may be disallowed in whole or in part.
• Cash flow. The executive cannot or will not carry the income tax on the bonus each year.
• Business form. The business is a corporation with few shareholders, practically all of whom draw salaries. Treasury Regulation § 1.162-7(b)(1) notes that an "ostensible salary paid by a corporation may be a distribution of a dividend on stock" and that this "is likely to occur" in such a corporation.
• Restructuring. The ownership or beneficiary designation is later changed so that the business becomes a beneficiary. That change may bring the premium bar in Section 264(a)(1) into play and, if the business also owns the contract, the employer-owned contract rules of Section 101(j). The business life insurance overview covers those rules.

Tax Treatment: Deduction, Income Inclusion, and the Death Benefit

The employer's deduction is a compensation deduction, not a premium deduction. Section 162(a)(1) allows "a reasonable allowance for salaries or other compensation for personal services actually rendered." Treasury Regulation § 1.162-9 adds that bonuses are deductible "when such payments are made in good faith and as additional compensation for the services actually rendered," provided the payments, "when added to the stipulated salaries, do not exceed a reasonable compensation for the services rendered." It also states that "It is immaterial whether such bonuses are paid in cash or in kind or partly in cash and partly in kind."

The premium bar is the limit that applies. Treasury Regulation § 1.264-1(a) denies a deduction for premiums on a policy covering "any officer or employee of the taxpayer, or any person (including the taxpayer) who is financially interested in any trade or business carried on by the taxpayer, when the taxpayer is directly or indirectly a beneficiary." Under § 1.264-1(b), a taxpayer that buys a policy "for the purpose of protecting himself from loss in the event of the death of the insured" is a beneficiary. IRS Publication 334 states that premiums on "Life insurance covering your employees if you are not directly or indirectly the beneficiary under the contract" can generally be deducted. More detail is on the page on employer deductibility of the bonus.

For the executive, the bonus is gross income under Section 61(a). Where the employer pays premiums on a policy the executive owns, Treasury Regulation § 1.61-2(d)(2)(ii)(A) provides that "[g]enerally, life insurance premiums paid by an employer on the life of his employee where the proceeds of such insurance are payable to the beneficiary of such employee are part of the gross income of the employee." It adds that an employee who owns the contract must include the employer's payments in income to the extent the employee's rights to the contract are substantially vested, if the payments are not split-dollar loans. A double-bonus amount is also compensation, so it is also gross income. Income-tax withholding and employment-tax treatment depend on how the payment is made. The page on executive bonus tax treatment covers the executive's side.

Section 101(a)(1) generally excludes death proceeds from gross income. A transfer for valuable consideration under Section 101(a)(2) can cap that exclusion at the value of the consideration plus the premiums and other amounts the transferee later pays, subject to the exceptions in that paragraph. For an employer-owned contract, Section 101(j) caps it at the premiums and other amounts paid, unless a Section 101(j)(2) exception applies and written notice and consent were given before issue. Neither an exception alone nor notice and consent alone lifts the cap. Under Section 101(j)(3)(A), an employer-owned life insurance contract is one owned by a person engaged in a trade or business, under which that person (or a related person) is "directly or indirectly a beneficiary," and which covers the life of an insured who is an employee with respect to the trade or business on the date the contract is issued.

Potential Advantages of an Executive Bonus Arrangement

The advantages of an executive bonus plan fall to both parties, and each depends on the facts.

For the employer:

• A potential deduction for the bonus as reasonable compensation under Section 162(a)(1).
• Selectivity: the arrangement can cover one executive or a small group.

For the executive:

• Outright ownership of the policy, which stays with the executive if employment ends.
• The right to name a personal beneficiary, with the Section 101(a)(1) exclusion generally applying to death proceeds, subject to its limits.
• Cash value that builds within the policy as a contract feature, accessible under the policy's terms unless a REBA restriction applies.

None of these is assured. Each depends on how the arrangement is documented and on the compensation being reasonable.

Important Considerations and Disadvantages

The disadvantages of an executive bonus plan are just as concrete as its advantages.

• Current income to the executive. The bonus is income in the year received under Section 61(a), which raises the executive's current tax liability.
• Employment taxes. As compensation, the bonus may also carry employment taxes, depending on how it is paid.
• Deduction at risk. If total compensation is found unreasonable, the Section 162(a)(1) deduction may be disallowed in whole or in part. Treasury Regulation § 1.162-7(b)(3) measures reasonableness using "those existing at the date when the contract for services was made."
• No employer ownership. The executive has full ownership rights in the policy, including the right to its values, so the employer holds no claim on cash value or proceeds.
• REBA complexity. A restriction adds retention value but also adds documents. Its terms are contractual and vary by arrangement.
• Double-bonus cost. The gross-up is itself taxable compensation. It raises the employer's cost and the executive's income.
• Product costs. Premiums, rates, fees and charges vary by insurer and are confirmed with the insurers involved.

The Section 264(a)(1) and Treasury Regulation § 1.264-1 bar turns on whether the business is directly or indirectly a beneficiary under the policy, not on ownership alone. If the business keeps a beneficial interest, the bar applies.

Tax and Legal Coordination

Reasonableness under Section 162(a)(1) is assessed on the facts, including what like enterprises ordinarily pay for like services under like circumstances (Treasury Regulation § 1.162-7(b)(3)). Treasury Regulation § 1.162-7(b)(2) adds that "The form or method of fixing compensation is not decisive as to deductibility."

Withholding and employment-tax treatment of the bonus is a point for a qualified tax professional. A REBA restriction is part of the policy contract, and its terms are typically drafted and confirmed with qualified legal and tax professionals.

Some executives' estate or business-continuity plans rely on the death benefit. In those cases, Section 101(a)(2) and Section 101(j) need individual review of the contracts involved, especially if ownership or beneficiaries change. Policy forms, free-look periods, replacement rules and suitability requirements vary by state and are confirmed with the insurers involved.

Alternatives to an Executive Bonus Arrangement

Other structures meet related goals, each with a different balance of control and tax treatment.

• Split-dollar life insurance. Employer and executive share policy costs and benefits. The tax regime, either economic benefit or loan, depends on ownership and structure. The site's split-dollar page treats this in depth.
• Nonqualified deferred compensation. The employer promises a future payment rather than paying a bonus that funds a policy the executive owns. Section 409A of the Code sets requirements for nonqualified deferred compensation plans.
• Section 412(e)(3) plan. This is a fully insured defined-benefit plan that must meet the requirements of Section 412(e)(3)(A)–(F). Among other requirements, it must be "funded exclusively by the purchase of individual insurance contracts." Contributions and benefits are subject to the Code's deduction and benefit limits. These plans were known as section 412(i) plans before the Pension Protection Act of 2006. The section 412(e)(3) plans page covers them.
• Key person insurance. The business owns the policy and is its beneficiary, so Treasury Regulation § 1.264-1 bars a premium deduction. This approach protects the business rather than benefiting the executive. The page on key person policy ownership explains it.

Hypothetical Example: Bonus, Income Inclusion, and Employer Cost

This example is hypothetical and does not represent any reader's result.

Assumptions:

• A C corporation provides the arrangement for one executive.
• The annual premium is $20,000.
• The executive owns the policy, and the corporation is not a beneficiary.
• Total compensation is assumed to be reasonable under Section 162(a)(1).
• For the double bonus, the executive's combined marginal income-tax rate is assumed to be a round 40%.

Single bonus:

1. The corporation pays a $20,000 bonus.
2. The executive includes $20,000 in gross income under Section 61(a).
3. The corporation claims $20,000 as a compensation deduction, subject to reasonableness.
4. At the assumed 40% rate, the executive's tax is $20,000 × 0.40 = $8,000, paid from the executive's own funds.

Double bonus:

1. The total bonus that leaves $20,000 after tax is $20,000 ÷ (1 − 0.40), which equals $20,000 ÷ 0.60, or about $33,333.
2. The tax at 40% is $33,333 × 0.40, about $13,333.
3. After tax, $33,333 − $13,333 = $20,000 remains for the premium.
4. The executive includes about $33,333 in gross income, and the corporation claims about $33,333 as compensation, subject to reasonableness.

The example ignores employment taxes, state income tax and the executive's actual rates. Actual figures depend on the facts of the arrangement.