Executive Bonus / Section 162
Executive Bonus Plans for Key Employees: A Retention Benefit
Published October 9, 2026 · Updated October 9, 2026
Short Answer: What an Executive Bonus Plan Does for Key Employees
An executive bonus plan lets an employer pay a selected key employee a bonus that the employee uses to buy and own life insurance on his or her own life. The employee names the beneficiary and controls the policy. The bonus is taxable compensation to the employee, and the employer may deduct it only if total pay is reasonable.
"Executive bonus plan" and "section 162 plan" are industry terms. They are not qualified plans and are not defined in the Internal Revenue Code or Treasury Regulations. Business Life Insurance covers here the arrangement as a retention benefit for non-owner key employees; owners are treated on a separate page.
Why Key Employee Retention Matters to a Business
A key employee, in plain terms, is a person whose skills, client relationships or institutional knowledge are material to the business's operations or revenue. When such a person leaves, client relationships can follow them, projects can stall and specialized knowledge can walk out the door. The business problem is retention, and it comes first.
A selective benefit, one offered to named individuals rather than to every employee, is one response. "Key employee benefit plan" and "key employee retention life insurance" are industry labels, not statutory terms. Life insurance is one possible funding mechanism for such a benefit; it is not the only tool, and it is not the plan itself.
How Businesses Typically Structure a Key Employee Bonus Arrangement
The basic mechanics are an employer, a bonus and an employee-owned policy.
The employer and the key employee typically sign a written bonus agreement stating the bonus amount and its conditions. That agreement is a compensation agreement, not a plan document in the qualified-plan sense.
The Retention Risk This Arrangement Addresses
Voluntary departure is the central trigger: a key employee leaves for a competitor or starts a competing business. A permanent policy owned by the employee has cash value, a contract feature that can build over time under the policy's terms. That value gives the employee a financial reason to keep the benefit going while the bonus continues.
A restricted executive bonus arrangement (REBA), also an industry label rather than a regulatory term, adds a restriction on the employee's access to cash value. The restriction, and the conditions for lifting it, are contract terms the employer and employee set. A REBA creates an incentive to stay; it does not secure retention. More detail sits on the restricted executive bonus arrangements page.
How the Arrangement Works: Mechanics Step by Step
Six steps describe the standard design, summarized further on the executive bonus plan mechanics page:
- The employer and key employee enter a written bonus agreement.
- The employer pays a cash bonus to the employee or, in some structures, pays the premium to the insurer on the employee's behalf. Where the employee owns the contract and the payments are not split-dollar loans, 26 C.F.R. § 1.61-2(d)(2)(ii)(A) has the employee include the employer's payments in income "to the extent that the employee's or independent contractor's rights to the life insurance contract are substantially vested (within the meaning of § 1.83-3(b))."
- The employee applies for, owns and names the beneficiary of a policy on his or her own life.
- The employee uses the bonus to pay the premium.
- The bonus is gross income. Section 61(a) of the Internal Revenue Code includes "Compensation for services, including fees, commissions, fringe benefits, and similar items," and 26 C.F.R. § 1.61-2 lists "bonuses" as "income to the recipients unless excluded by law."
- The employer deducts the bonus as compensation, if allowed.
Before any deduction, the premium rule applies. Section 264(a)(1) provides that no deduction is allowed for "Premiums on any life insurance policy ... if the taxpayer is directly or indirectly a beneficiary under the policy." The employer is not the beneficiary here, so the item considered for deduction is the bonus. Section 162(a)(1) allows "a reasonable allowance for salaries or other compensation for personal services actually rendered."
A "double bonus," another industry term, is a second bonus to cover the employee's income tax on the first. Both bonuses are income to the employee, and both count toward the reasonableness test.
Ownership Structure: Who Owns the Policy and Why It Matters
Employee ownership is the defining feature. The key employee, not the employer, owns the policy, names a personal beneficiary, often family members, and controls the contract. That separates this arrangement from employer-owned life insurance. Section 264(a)(1) turns on whether the taxpayer is directly or indirectly a beneficiary under the policy.
Section 101(a)(1) provides that gross income "does not include amounts received ... under a life insurance contract, if such amounts are paid by reason of the death of the insured," subject to limits. One is transfer for value under section 101(a)(2). Another, section 101(j), caps the exclusion for an employer-owned contract at premiums and other amounts paid, unless a section 101(j)(2) exception applies and written notice and consent were given before issue. Section 101(j)(3)(A) defines an employer-owned life insurance contract as a contract 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 of the trade or business on the date the contract is issued. Whether a given design falls within it depends on who owns the policy and who is the beneficiary. The executive bonus tax treatment page covers the death benefit further. In a REBA, the employee still owns the policy; only access to value is restricted.
Coverage and Funding Considerations for Key Employee Arrangements
Funding starts with the bonus amount, which the employer sets. Under 26 C.F.R. § 1.162-9, bonuses are deductible when "made in good faith and as additional compensation for the services actually rendered," provided they, "when added to the stipulated salaries, do not exceed a reasonable compensation." No formula appears in the Code; 26 C.F.R. § 1.162-7 measures reasonableness by what "would ordinarily be paid for like services by like enterprises under like circumstances."
Policy type shapes the retention effect. Term coverage does not build cash value; permanent coverage does, under its own terms, and neither the employer nor the arrangement backs that growth. Premiums, charges, forms and cash-value projections vary by insurer and policy and are confirmed with the insurers involved.
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Who This Arrangement Is Typically For
This arrangement is typically considered by:
- employers wanting a selective benefit for one or more named key employees without a qualified plan;
- businesses whose key employees' departure would materially affect operations, clients or revenue;
- employers able to carry the bonus as current compensation expense;
- key employees who can use a personally owned permanent policy and who qualify under an insurer's underwriting standards, since an uninsurable employee cannot obtain the coverage; and
- businesses that want the employee to hold a portable benefit, kept after employment ends once any restriction period is over.
When an Executive Bonus Plan May Fit a Key Employee Situation
Fit usually turns on the employer's objectives and the employee's circumstances. The arrangement is commonly considered when:
- the benefit is meant to be selective rather than offered to all employees;
- the employer prefers a current compensation expense to a deferred obligation;
- the key employee values a portable, personally owned policy;
- the employer does not want to own the policy or be its beneficiary;
- the business has cash flow to pay the bonus when due;
- the employee is insurable; and
- a REBA structure is considered when the employer wants a restriction added to strengthen the retention element.
When an Executive Bonus Plan May Not Fit
Some objectives point away from this design:
- the employer wants to own or control the policy, which leads to split-dollar or employer-owned structures; the executive bonus vs split-dollar comparison covers that question;
- the employer wants to recover its outlay if the employee leaves early;
- the key employee is not insurable;
- the employee's total pay is already near what would be reasonable, leaving little room for an additional deductible bonus;
- the employer wants deferral rather than a current-year expense; or
- cash flow cannot sustain annual bonuses.
Whether any of these applies depends on facts specific to the business and the employee.
Potential Advantages of This Approach for Key Employee Retention
Selectivity comes first: the employer names the key employees who take part. Second, section 162(a)(1) may allow the bonus as compensation, subject to reasonableness; deduction details appear on the executive bonus tax deductibility page. Third, the employee owns the policy and may keep it after leaving, subject to any REBA terms.
Fourth, the death benefit goes to the employee's beneficiary, and section 101(a)(1) excludes amounts paid by reason of the insured's death from gross income, subject to its stated exceptions. Whether federal benefit-plan rules reach a particular bonus design is a legal question for counsel.
Important Considerations and Risks
Tax falls on the employee first. Under section 61(a) and 26 C.F.R. § 1.61-2, the bonus is income to the employee. The employer's deduction depends on reasonableness; 26 C.F.R. § 1.162-9 says amounts "in excess of reasonable compensation for services, are not deductible."
REBA drafting carries its own issues. Section 409A governs nonqualified deferred compensation, and section 409A(d)(3) provides that "plan" includes "any agreement or arrangement, including an agreement or arrangement that includes one person." Under 26 C.F.R. § 1.83-3(c)(1), whether a forfeiture risk is substantial "depends upon the facts and circumstances." Bonus deductibility, reasonableness of compensation and REBA restriction design all need individual review with a qualified tax professional and the insurers involved.
The arrangement creates an incentive, not an assurance that anyone stays, and policy values depend on the contract's terms. State insurance rules on policy forms, replacement and suitability vary by state.
Alternatives to an Executive Bonus Plan for Key Employee Benefits
Several other arrangements address related goals, each with different ownership, tax and retention traits:
- Split-dollar life insurance: employer and employee share a policy's costs and benefits under either the economic benefit regime or the loan regime, depending on ownership and structure.
- Nonqualified deferred compensation: the employer promises a future payment, subject to section 409A; life insurance may serve as informal funding, but the employee does not own the policy.
- Key person insurance: the employer owns the policy and is the beneficiary, protecting the business against the employee's death rather than providing a benefit to the employee.
The choice depends on the employer's objectives and the facts.
Planning Example (Hypothetical)
This hypothetical uses round figures and illustrates bonus mechanics only, not policy cost. Assumptions: a C corporation; a non-owner operations director; a $20,000 bonus; a 30% marginal income tax rate, assumed for illustration; total pay assumed reasonable; employment taxes ignored.
Single bonus
- The employer pays a $20,000 bonus.
- Gross income to the employee: $20,000.
- Assumed tax: $20,000 × 30% = $6,000.
- Net bonus left for the employee: $20,000 − $6,000 = $14,000.
- Amount the employer may claim as compensation, if reasonable: $20,000.
Double bonus
- The employer adds a $6,000 bonus to cover the assumed tax.
- Total bonuses: $20,000 + $6,000 = $26,000.
- Assumed tax: $26,000 × 30% = $7,800.
- Net to the employee: $26,000 − $7,800 = $18,200, because the second bonus is also taxed.
- Amount the employer may claim, if reasonable: $26,000.
Actual rates, policy costs and results vary; this is neither a coverage recommendation nor any reader's tax result.
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Frequently Asked Questions
Is the bonus taxable to the key employee?
Yes. Section 61(a) includes compensation for services in gross income, and 26 C.F.R. § 1.61-2 lists bonuses as income to recipients unless excluded by law.
Can the employer deduct the bonus paid under an executive bonus plan?
The employer may deduct it under section 162(a)(1) if it is part of "a reasonable allowance for salaries or other compensation." Reasonableness is judged on the facts and circumstances, as 26 C.F.R. § 1.162-7 describes, and depends on the employee's total pay.
What is a restricted executive bonus arrangement (REBA)?
A REBA is an industry label for an executive bonus arrangement that restricts the employee's access to policy cash value for a stated period. The employee still owns the policy. Its design and tax effects, including any section 409A question, turn on how the restriction is drafted.
Who owns the life insurance policy in an executive bonus plan?
The key employee owns the policy, applies for coverage, names the beneficiary and controls the contract. That ownership distinguishes the arrangement from employer-owned life insurance and keeps the employer from being the beneficiary.
What happens to the policy if the key employee leaves the company?
The employee generally keeps the policy, because the employee owns it. If a REBA restriction is in place, the agreement's terms govern access to policy values during the restriction period. The outcome depends on those terms.
Educational information only. Not legal, tax, investment or insurance advice. Product availability and outcomes depend on individual circumstances.