Executive Bonus Plan Tax Treatment for the Executive: Income Inclusion and the Death Benefit

Technical Summary: How the Executive Is Taxed on a Bonus Plan

Yes, an executive bonus is generally taxable to the executive. When an employer pays the premium on a life insurance policy the executive owns, federal rules treat that premium as compensation, so it is part of the executive's gross income for the year. Under 26 U.S.C. § 101(a)(1), the death benefit later paid to the executive's beneficiary is generally excluded from income, subject to the limits in § 101(a)(2) and § 101(j).

This question usually comes from an executive or owner-employee whose company has offered to fund a personal policy, or from the finance lead designing the arrangement. Business Life Insurance treats the policy here as a funding mechanism inside a compensation plan. The underlying business problem is retaining a key person, and the policy is one way to deliver that benefit.

Several authorities set the executive's position. Under 26 U.S.C. § 61(a)(1), gross income includes "compensation for services." Under 26 C.F.R. § 1.61-2(d)(2)(ii)(A), employer-paid premiums on an employee's life insurance are generally part of the employee's gross income. In the simple case, the amount included equals the premium paid. "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 regulations. Under 26 U.S.C. § 101(a)(1), death proceeds are generally excluded from gross income, subject to the limits in § 101(a)(2) and § 101(j).

Definition: The Arrangement Whose Tax Is Described Here

An executive bonus plan is a compensation arrangement with three parties. The employer pays a bonus to a selected executive. The executive uses the bonus to pay premiums on a life insurance policy the executive owns. The executive's chosen beneficiary receives the proceeds at death.

The employer is not the policyowner and is not a beneficiary. A fuller overview appears in executive bonus plan basics.

Ownership is what sets this arrangement apart from others. In split-dollar life insurance, the premium and the benefits are split between the parties under their own tax regime. Employer-owned life insurance follows separate rules.

The employer's side is a different question, covered on the site's companion deductibility page. Section 264(a)(1) allows no deduction for life insurance premiums "if the taxpayer is directly or indirectly a beneficiary under the policy." Section 162(a)(1) allows "a reasonable allowance for salaries or other compensation."

Applicable Rules: The Statutes and Regulations That Govern the Executive's Tax

Income inclusion. Section 61(a) of the Internal Revenue Code provides that "gross income means all income from whatever source derived," including "(1) Compensation for services, including fees, commissions, fringe benefits, and similar items."

Employer-paid premiums. Treasury Regulation § 1.61-2(d)(2)(ii)(A) states: "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." The regulation adds a condition when the employee owns the contract and the payments are not split-dollar loans. In that case, the employee includes the employer's payments "to the extent that the employee's ... rights to the life insurance contract are substantially vested."

The death benefit. Section 101(a)(1) provides that "gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured."

Transfer for value. Under § 101(a)(2), a transfer of a policy for valuable consideration generally caps the exclusion at the consideration paid plus later premiums and other amounts paid by the buyer. The statute lists exceptions.

Employer-owned contracts. Under § 101(j), the exclusion for an employer-owned contract is capped at the premiums and other amounts paid. The cap is lifted only if a § 101(j)(2) exception applies, based either on the insured's status or on amounts paid to heirs, and written notice and consent were given before the contract was issued. Either condition alone is not enough. Section 101(j)(3)(A) defines an employer-owned life insurance contract as one that is 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 that covers the life of an insured who is an employee with respect to the trade or business on the date the contract is issued. An executive-owned policy will often fall outside that definition, but the answer turns on the documents.

Requirements: What Must Be True for the Standard Tax Treatment to Apply

The treatment described here depends on structure. The facts that typically decide it are the following:

• The executive owns the policy. If the employer owns it, the arrangement may instead be split-dollar or employer-owned life insurance, and different rules apply.
• The payment is compensation. The employer's payment is a bonus to the executive. It is not a premium on a policy the employer owns.
• The premium is included in income. The amount paid is included in the executive's gross income under § 61(a)(1) and § 1.61-2(d)(2)(ii)(A), to the extent the executive's rights are substantially vested.
• The death benefit meets § 101(a)(1). The proceeds are paid by reason of the insured's death under a life insurance contract, and neither § 101(a)(2) nor § 101(j) reduces the exclusion.

The employer's deduction and the reasonableness of the compensation are separate issues for the employer. Because the result depends on how the arrangement is documented, this topic needs individual review of the contracts involved, by the insurers and a qualified tax professional.

How the Rules Work: Income Inclusion, Withholding, and the Double Bonus

The basic bonus. The cycle usually runs this way. The employer pays a bonus, either to the executive or directly to the insurer on the executive's behalf. The executive owns the policy that the bonus funds. Under § 1.61-2(d)(2)(ii)(A), the premium is part of the executive's gross income. In the ordinary case, the inclusion arises in the year the employer pays.

Withholding. Because the bonus is compensation, it passes through the employer's payroll as wages. The withholding method and rate depend on the employer's federal payroll rules. This explainer states no rate.

The double bonus. Some employers pay a second cash amount intended to cover the tax on the first. That second amount is also compensation under § 61(a)(1). A gross-up is often sized with this formula: total bonus = premium ÷ (1 − assumed rate). The executive's actual after-tax cost depends on the executive's own marginal rate and full tax picture, which this explainer cannot know.

REBA. In a restricted executive bonus arrangement, a separate agreement limits the executive's access to the policy's cash value. Cash value is a contract feature, not a savings account. Whether a restriction affects the "substantially vested" condition depends on its terms. Under § 1.83-3(c)(1), whether a risk of forfeiture is substantial "depends upon the facts and circumstances," and a restriction on the transfer of property results in a substantial risk of forfeiture "only if and to the extent that the restriction is described in paragraph (j) or (k)" of that section.

Who This Is For: The Executive's Position in the Arrangement

Most readers here hold, or have been offered, the insured's seat. In that seat, the executive is the policyowner, the insured and the person who names the beneficiary. Employers typically offer these arrangements to selected key executives, owner-employees or highly compensated employees as an added benefit outside a qualified plan.

From the executive's side, the tax cost comes first: income is included as premiums are paid. What the executive receives is the policy itself. That includes its cash value, a contract feature, and the death benefit for the executive's beneficiaries.

The arrangement is not a qualified retirement plan.

Different people evaluate the arrangement for different reasons:

• Business owners and finance leads focus on deductibility and reasonableness of pay.
• HR leads focus on selection, documentation and payroll.
• Executives focus on income inclusion, withholding, ownership and the death benefit.