Executive Bonus Life Insurance: The Policy Inside the Arrangement

When an Executive Bonus Life Insurance Arrangement May Not Fit

A mismatch usually shows up in one of these facts:

• The employer wants to recover its premium outlay or hold an interest in the policy. Split-dollar life insurance is the structure usually weighed in that case.
• Total compensation, including the bonus, cannot be supported as reasonable. Treasury Regulation § 1.162-9 allows bonuses only when, "added to the stipulated salaries," they "do not exceed a reasonable compensation for the services rendered."
• The employer is directly or indirectly a beneficiary of the policy. That brings section 264(a)(1) into play.
• The employer owns the policy and is its beneficiary. That is a different structure, and the contract may be an employer-owned life insurance contract under section 101(j).
• The business wants a benefit that covers a broad group of employees, which a selective bonus is not built to do.

None of these facts decides the question alone. Each changes which rules apply.

Tax Treatment: Employer Deduction, Executive Income and the Contract

Four stages carry tax consequences: the bonus, the premium, the cash value and the death benefit.

Employer deduction. Before any deduction is considered, section 264(a)(1) bars a premium deduction when the taxpayer "is directly or indirectly a beneficiary under the policy." In a standard executive bonus arrangement, the employer is not a beneficiary, so the bar does not apply on those facts. The payment is then analyzed as compensation under section 162(a)(1). Treasury Regulation § 1.162-7(a) states that "The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services." Executive bonus deductibility and reasonableness of compensation need individual review of the contracts and facts involved by the insurers and a qualified tax professional.

Executive income. Section 61(a)(1) includes in gross income "Compensation for services, including fees, commissions, fringe benefits, and similar items." Under Treasury Regulation § 1.61-2(d)(1), when services are paid for in property, "the fair market value of the property taken in payment must be included in income as compensation." A cash bonus is compensation for services. For a premium the employer pays on the executive's behalf, 26 C.F.R. § 1.61-2(d)(2)(ii)(A) provides that, generally, "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," and for a contract the employee owns, where the payments are not split-dollar loans, it includes the employer's payments "to the extent that the employee's or independent contractor's rights to the life insurance contract are substantially vested."

Double bonus. A "double bonus" is an industry term, not a term defined in the Code or regulations. It describes an extra payment meant to cover the executive's tax on the premium bonus. The extra amount is also compensation under the same rules.

Cash value. Withdrawals, loans and surrenders from a policy can reduce its cash value and death benefit and may have tax consequences that depend on the contract.

Death benefit. Section 101(a)(1) generally excludes from gross income amounts "paid by reason of the death of the insured," subject to limits including transfer for value under section 101(a)(2). Section 101(j) caps the exclusion for an "employer-owned life insurance contract" at "the sum of the premiums and other amounts paid by the policyholder for the contract," unless a section 101(j)(2) exception applies and the written notice and consent requirements of section 101(j)(4) were met before the contract was issued. The statute defines that contract as one "owned by a person engaged in a trade or business and under which such person (or a related person described in subparagraph (B)(ii)) is directly or indirectly a beneficiary under the contract" on the life of an employee. Where the executive owns the policy and names personal beneficiaries, the employer is neither owner nor beneficiary, so the contract is generally outside that definition; the facts of each contract decide. Death-benefit taxation is covered in business life insurance tax treatment.

Potential Advantages of the Policy Structure

These features come from the rules, not from any assurance about a particular contract:

• Portability. The executive owns the policy outright, so it does not depend on continued employment.
• Cash value as a contract feature. In the basic arrangement the executive holds the right to any policy values; a restrictive endorsement can limit that access.
• Death benefit exclusion. Section 101(a)(1) generally excludes proceeds paid by reason of death from the beneficiaries' gross income, within its stated limits.
• Possible employer deduction. Section 162(a)(1) allows a deduction for reasonable compensation for services actually rendered, and the bonus is tested as compensation.
• Selectivity. The employer decides which executives participate and how much each receives.

Whether any of these features matters to a given business depends on its facts and on the policy actually issued.

Important Considerations for the Policy and the Arrangement

Reasonableness is never automatic. It is judged on facts and circumstances, so a deduction under section 162(a)(1) turns on the executive's role, the business's size and the total pay package.

Income arrives with the payment. The executive includes the bonus in gross income as compensation, and for a contract the executive owns, 26 C.F.R. § 1.61-2(d)(2)(ii)(A) includes the employer's payments "during any year to the extent that the employee's or independent contractor's rights to the life insurance contract are substantially vested," whether or not the executive ever touches the cash value.

A REBA restriction is an obligation created by agreement. Its enforceability and its tax effect depend on how the agreement and any endorsement are drafted.

Contract qualification also matters. A contract that does not meet section 7702(a) is not a "life insurance contract" for federal tax purposes, and its treatment then departs from the rules above.

Structure can drift. A collateral assignment or a beneficiary change that gives the employer an interest can bring section 264(a)(1), and possibly section 101(j), into play. Any change of that kind needs individual review before it is made.

State insurance rules on free-look periods, replacement and suitability vary by state.

Tax and Legal Coordination: Where the Facts Decide

Several questions cannot be answered from the rules alone.

• Reasonableness of total pay. Salary plus bonus is tested under section 162(a)(1) and Treasury Regulations §§ 1.162-7 and 1.162-9. A qualified tax professional evaluates it for the specific employer and executive.
• REBA drafting. The agreement's terms, enforceability and tax treatment are legal questions for the attorney who drafts the documents.
• Contract qualification. Whether a contract meets section 7702(a) depends on its terms. The insurer and a qualified tax professional are the ones who confirm it.
• Entity form. In a C corporation, an S corporation, a partnership or a professional practice, the form of the business and the executive's ownership stake can change how the payment is characterized and reported. Owner-employees in closely held corporations face the dividend characterization concern in § 1.162-7(b)(1).

Structure, ownership and tax treatment are confirmed with qualified tax, legal and insurance professionals before an arrangement is adopted or changed.

Alternatives to an Executive-Owned Policy

Other structures address the same retention problem in different ways:

• Split-dollar life insurance. The employer keeps an interest in the policy, and the arrangement is taxed under either an economic benefit regime or a loan regime depending on ownership and structure.
• Nonqualified deferred compensation. The employer promises a future payment. The executive does not own a policy.
• Group-term life insurance. The employer provides group coverage rather than an individually owned policy, under its own federal tax rules.

How the bonus arrangement compares with split-dollar is covered on the executive bonus overview and the split-dollar pages of Business Life Insurance.

Hypothetical Example: How the Numbers Move

This example is hypothetical. It uses round figures and an assumed tax rate, and it does not represent any reader's result.

Assumptions: The employer pays a $20,000 annual bonus that covers the premium on a policy the executive owns. The executive's assumed combined marginal income-tax rate is 40 percent. Total compensation is assumed to be reasonable. Payroll taxes are ignored.

Single bonus:

1. The employer pays $20,000 and treats it as compensation under section 162(a)(1).
2. The executive includes $20,000 in gross income under § 1.61-2.
3. Tax at the assumed rate: $20,000 × 40% = $8,000.
4. The executive's out-of-pocket cost for $20,000 of premium is $8,000.

Double bonus (full gross-up):

1. The goal is $20,000 left after tax. At 40 percent, the executive keeps 60 percent of each dollar.
2. Total bonus: $20,000 ÷ 0.60 ≈ $33,333.
3. Tax: $33,333 × 40% ≈ $13,333.
4. After tax: $33,333 − $13,333 = $20,000, which covers the premium.
5. The employer's compensation expense is about $33,333, all tested for reasonableness.

Actual tax depends on the executive's real rates, payroll taxes and the facts of the business.