Restricted Executive Bonus Arrangements (REBA): What the Restriction Does

When It May Not Fit: Conditions That Limit or Complicate a REBA

A REBA may serve the parties poorly in several situations:

• The employer wants its money back. In the structure industry material describes, the executive or the executive's trust owns the policy. An employer that wants to recover premiums, or to keep a stake if the executive leaves, may look at split-dollar or collateral-assignment structures instead.
• Total pay is high relative to the work. If total compensation is not reasonable under section 162(a)(1) and Treas. Reg. § 1.162-7, the deduction may be disallowed in whole or in part.
• The executive does not want a policy. Some executives do not want or need a life insurance policy as part of their pay.
• The terms resemble deferred compensation. Some vesting terms may raise questions under section 409A, which governs "nonqualified deferred compensation plans." The statute defines "plan" to include "any agreement or arrangement, including an agreement or arrangement that includes one person."

Whether section 409A reaches a given REBA depends on how the restriction and vesting are drafted.

Tax Treatment: Section 162, Section 61 and Section 83

The tax frame has three parts. How a particular restriction bears on them depends on the contract terms.

The employer. In the structure industry material describes, the employer is neither the policy's owner nor its beneficiary, so the deduction question rests on section 162(a)(1). Treas. Reg. § 1.162-7 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." It adds that "[i]t is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances," judged by the circumstances "existing at the date when the contract for services was made." Treas. Reg. § 1.162-9 provides that bonuses are allowable deductions "when such payments are made in good faith and as additional compensation for the services actually rendered by the employees, provided such payments, when added to the stipulated salaries, do not exceed a reasonable compensation for the services rendered." Executive bonus deductibility and reasonableness of compensation need individual review by a qualified tax professional.

The executive. The bonus is gross income under section 61(a)(1). Treas. Reg. § 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." If the employee owns the contract (as defined in § 1.61-22(c)(1)) and the payments are not split-dollar loans under § 1.7872-15(b)(1), the regulation also provides that the employee must include in income the employer's payments "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))."

Section 83. Section 83 addresses "Property transferred in connection with performance of services." Treas. Reg. § 1.83-3(e) provides that, for a transferred life insurance contract, "the policy cash value and all other rights under such contract … other than current life insurance protection, are treated as property." Rev. Proc. 2005-25 gives guidance on how to determine the fair market value of a life insurance contract for purposes of applying section 83 and certain other Code provisions. Whether section 83 affects the timing or amount of income in a particular REBA depends on the contract and the restriction.

Potential Advantages: What the Structure Provides

The features below are structural. None is a promised result.

• Selectivity. The employer may offer the benefit to one executive or a few.
• Retention. The endorsement limits access to policy values until its condition is met. That creates a financial reason for the executive to stay.
• Portability. The executive owns the policy. Once the restriction ends, the policy stays with the executive regardless of future employment, subject to its terms.
• Possible deduction. The bonus may be deductible under section 162(a)(1) if it is reasonable and paid for services.
• Beneficiary control. The executive's chosen beneficiary receives the death benefit, with its income-tax treatment governed by section 101(a).

Important Considerations: Costs, Risks and Limits

The tax cost falls on the executive. The bonus is compensation under section 61(a)(1), and industry material says "The employee must pay income tax on the bonus." The restriction, as described, limits access to the policy's values. A double bonus is an additional bonus meant to cover the executive's income tax on the first bonus, but the extra bonus is also compensation under section 61(a)(1), and the executive's net position depends on actual rates and amounts.

Other points matter as well:

• A deduction depends on reasonableness under section 162(a)(1) and Treas. Reg. § 1.162-7.
• The endorsement's terms, release conditions and enforceability vary by insurer and by written agreement.
• Section 409A questions turn on how the vesting is drafted.
• Insurance rules on endorsements and policy terms vary by state.

Tax and Legal Coordination: What Needs Professional Review

Coordination usually begins with the written bonus agreement. Employers and executives can have qualified tax and legal counsel review it before the policy is issued, because the agreement and the endorsement together define the arrangement.

The issues that turn on contract-specific facts include:

• reasonableness of the bonus under section 162(a)(1) and Treas. Reg. § 1.162-7;
• how section 83, Treas. Reg. § 1.83-3(e) and Rev. Proc. 2005-25 apply to the policy and the restriction;
• whether section 409A applies, given the way the vesting and release terms are drafted;
• state insurance rules on endorsements and replacement, which vary by state; and
• the death benefit's treatment under section 101(a)(1), including transfer-for-value limits under section 101(a)(2) if the policy ever changes hands.

The section 264(a)(1) limits on deducting premiums are discussed on the site's page about business life insurance premium deductibility.

Alternatives: Other Structures That Address Similar Objectives

Several other structures address similar objectives.

• Standard executive bonus plan. This is the same bonus mechanism without the endorsement. The executive has access to the policy values from the start, so there is no retention feature.
• Split-dollar life insurance. The employer and executive share the policy's costs and benefits, and the employer typically keeps an interest in the policy.
• Nonqualified deferred compensation. The employer promises a future payment. Section 409A addresses the inclusion in gross income of deferred compensation under nonqualified deferred compensation plans.

The site's overview of types of business life insurance shows how policy types map to these strategies.

Example (Hypothetical): How a REBA Might Be Structured

Hypothetical Example. This example illustrates the mechanics only. It does not represent any reader's tax result, premium, cash value or coverage.

Assumptions: the employer is a C corporation and the executive is its chief operating officer. The annual bonus is $20,000. The combined federal and state income-tax rate is 35%, an illustrative figure and not a prediction of any reader's rate. The endorsement runs for five years.

1. The employer pays the executive a $20,000 bonus as additional compensation.
2. The executive's tax on that bonus is $20,000 × 35% = $7,000.
3. The executive uses the $20,000 bonus to pay the premium on a policy the executive owns.
4. The endorsement limits the executive's access to the policy's cash value for five years.
5. After five years, under the assumed agreement, the restriction ends and the executive has full access to the policy.

Double-bonus variation: the employer pays an additional $7,000 bonus. That bonus is also taxable, so it carries $7,000 × 35% = $2,450 of tax. In this hypothetical, the executive still bears $2,450 of tax out of pocket.