What Is a 'Section 162 Plan'? The Industry Term and the Actual Tax Rule

Technical Summary: What Section 162 Is and Is Not

A "section 162 plan" is an industry nickname for an executive bonus arrangement: an employer pays a selected employee extra compensation, and the employee uses it to pay premiums on a life insurance policy the employee owns. It is not a qualified retirement plan. Section 162 is a business-expense deduction rule, and it contains no plan provision.

Business owners, finance leads and owner-employees often meet the term in a proposal and reasonably assume it names a formal plan type. The business problem behind it is usually retaining a key executive, with life insurance serving as the funding mechanism for a compensation benefit.

The starting point on Business Life Insurance is the premium rule. Section 264(a)(1) of the Internal Revenue Code provides that "no deduction shall be allowed for" premiums on any life insurance policy "if the taxpayer is directly or indirectly a beneficiary under the policy." An executive bonus is structured so the employer pays compensation, not a premium on a policy it benefits from. The deduction question then runs through section 162(a)(1), which covers "a reasonable allowance for salaries or other compensation for personal services actually rendered."

Definition: What "Section 162 Plan" Actually Means

In plain terms, a section 162 plan is a compensation arrangement with a borrowed name. The phrase points to the Code section that supplies the employer's possible deduction, not to any plan the Code creates. "Section 162 plan," "executive bonus plan," "restricted executive bonus arrangement" (REBA) and "double bonus" are all industry terms. None is a term defined in the Internal Revenue Code or the Treasury Regulations, and none is a qualified plan. The site's page on executive bonus plans explains the arrangement as a whole.

The structure is simple. The employer pays a bonus to a selected employee. The employee owns a life insurance policy and pays its premium. In the structure described here, the employee, not the employer, owns the policy and names its beneficiary, and the employer holds no beneficial interest in it, so the employer is not the "directly or indirectly a beneficiary" that section 264(a)(1) addresses. The employer's payment is analyzed as compensation under section 162(a)(1).

A qualified retirement plan works differently. It carries its own plan-document, contribution-limit and nondiscrimination rules. A section 162 bonus arrangement is governed by the general compensation rules instead.

Applicable Rules: The Statutory and Regulatory Framework

Six provisions frame the tax treatment.

• 26 U.S.C. § 162(a). "There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business," including under paragraph (1) "a reasonable allowance for salaries or other compensation for personal services actually rendered."
• 26 C.F.R. § 1.162-7. "The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services."
• 26 C.F.R. § 1.162-9. Bonuses "will constitute allowable deductions" 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." It is "immaterial whether such bonuses are paid in cash or in kind."
• 26 U.S.C. § 264(a)(1). This section bars a deduction for premiums when the taxpayer is directly or indirectly a beneficiary. The executive bonus design keeps the employer out of the beneficiary position. The site's page on whether key person insurance is deductible shows the contrasting case, in which the business owns the policy and is its beneficiary.
• 26 U.S.C. § 61(a)(1). Gross income includes "compensation for services, including fees, commissions, fringe benefits, and similar items."
• 26 U.S.C. § 101(a)(1). Gross income generally excludes amounts "paid by reason of the death of the insured." The exclusion is limited by the transfer-for-value rule in § 101(a)(2) and by the employer-owned contract rule in § 101(j).

Requirements: What the Deduction Demands

Several conditions attach to the employer's deduction under the statute and the regulations. The last bullet is the employee's side of the same payment, not a condition of the deduction.

• Ordinary and necessary. Section 162(a) reaches expenses "paid or incurred during the taxable year in carrying on any trade or business."
• Reasonable in amount. Under 26 C.F.R. § 1.162-7(b)(3), the allowance "may not exceed what is reasonable under all the circumstances." The regulation states that it 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." The circumstances to be considered are those existing "at the date when the contract for services was made."
• Purely for services. Section 1.162-7(b)(1) warns that an "ostensible salary" in a corporation with few shareholders may in fact be "a distribution of earnings upon the stock," especially where excess pay tracks stockholdings.
• Good faith, additional compensation. Section 1.162-9 requires that bonuses be made "in good faith and as additional compensation for the services actually rendered."
• Paid as compensation. The payment goes to the employee, or to a premium on the employee's policy, as compensation. It is not a premium on a policy under which the employer is a beneficiary.
• Included by the employee. The bonus is compensation within § 61(a)(1).

Executive bonus deductibility and reasonableness of compensation need individual review of the facts and contracts involved by a qualified tax professional.

How the Rules Work: The Mechanics of the Arrangement

Four steps describe the typical flow, followed by two common variants.

1. The employer pays a bonus. The payment is compensation under § 162(a)(1) and is deductible only to the extent it is reasonable and purely for services under § 1.162-7.
2. The employee includes it in income. Under § 61(a)(1), the bonus is gross income.
3. The employee pays the premium. The employee is the policy owner and names the beneficiary. The employer is not a beneficiary.
4. Section 264(a)(1) is not the controlling rule. That bar reaches premiums where the taxpayer is a beneficiary. Here the employer's outlay is compensation, so the analysis turns on § 162(a)(1).

Double bonus. Under this industry label, the employer pays a second bonus to cover the employee's income tax on the first. The second bonus is also compensation, also includible under § 61(a)(1), and also counted in the reasonableness test of § 1.162-7.

Ownership. In the basic arrangement, the employee owns the policy, chooses the beneficiary and controls the cash value, which is a contract feature. The employer holds no interest unless one is added by endorsement or agreement.

REBA. In this industry-labelled variant, an endorsement or agreement restricts the employee's access to cash value. The bonus is still analyzed under § 162(a)(1). The restriction terms are set out in the endorsement or agreement.

Who This Is For: Situations Where the Arrangement Is Typically Used

An employer may use the arrangement to provide life insurance to one or a few selected key employees without building a broad benefit program. The site's overview of how business life insurance works places this arrangement among the other ownership structures.

Typical users include:

• An employer that wants to provide a selected executive or owner-employee with a life insurance benefit outside any qualified plan.
• An employer seeking a compensation deduction under § 162(a)(1), subject to reasonableness, paired with an employee who wants to own a policy outright.
• Owners who work in the business and are paid compensation for "personal services actually rendered," as § 162(a)(1) requires.

The arrangement offers no qualified-plan tax deferral. The bonus is income to the employee under § 61(a)(1).