What is an Executive Bonus Arrangement?
An Executive Bonus Arrangement, under Internal Revenue Code Section 162, is a bonus paid to an executive in the form of a life insurance premium. In this type of plan, the employer and executive enter into an agreement in which the employer pays the premium on the insurance policy via a cash bonus for the executive as long as he or she remains employed by the employer. The employer receives a current income tax deduction for the bonus paid to the executive. The employee recognizes the amount of the bonus as taxable income. An Executive Bonus Arrangement may also be designed so that the executive’s net after-tax outlay is zero.
An Executive Bonus Arrangement is not governed by the restrictive rules and onerous non-compliance penalties of IRC Sec. 409A, and is typically not subject to ERISA. Thus, an Executive Bonus Arrangement is less costly to implement and administer than most employee benefit plans. It can also be an excellent split dollar alternative and a way to help executives save for retirement or purchase life insurance benefits for their families or estate planning needs. An Executive Bonus Arrangement is a simple way to supplement other employee benefits, is easy to implement, and can be customized based on an executive’s particular financial situation or need.
Executive Bonus Arrangements offer the employer an immediate deduction for the costs of the plans as wages paid. An employer deduction will be allowed for premiums paid on a policy owned by an employee where:
- (a) the premiums constitute compensation to the employee;
- (b) the total amount of the compensation paid to the employee is not unreasonable;
- (c) the bonus represents an ordinary and necessary business expense;
- (d) the employer is not a beneficiary of the policy either directly or indirectly; and
- (e) the employer pays its share of the FICA and Medicare taxes on bonus amounts each year.
The executive receives life insurance protection for little or no cost, depending on the plan design. The executive controls the policy, therefore he or she has control over the beneficiary selection. The policy is portable upon separation from the employer’s service. Though, if the employer stops contributing premiums, the executive will be responsible for future premium payments, if needed.
Additionally, the policy’s cash value grows on an income-tax deferred basis. The executive may access the cash value for any purpose, such as an emergency, meeting annual income tax liabilities, or supplementing retirement income. Provided certain other steps are taken, the executive may also integrate his or her estate planning objectives into the plan by allowing a third-party, such as an irrevocable life insurance trust (ILIT), to own and be the beneficiary of the policy. Finally, the death benefit is received income-tax free to by the named beneficiary.
- The employer and executive enter into an agreement under which the employer agrees to pay the executive an annual bonus. For a single-bonus plan, the bonus amount is equal to the premium on a life insurance policy. For a double-bonus plan, the bonus amount is equal to the premium on a life insurance policy plus the amount required to pay the executive’s income taxes, based on the combined amount of the bonuses. The life insurance policy is purchased and owned by the executive or a third party, such as an irrevocable life insurance trust (ILIT)
- The bonus paid should be deductible to the employer so long as it is “reasonable” compensation. The deductibility of the bonus is not dependent on whether it a part of a single-bonus or double-bonus plan; the only difference between the plans is the amount of the bonus, and therefore the amount of the deduction. The portion of the bonus equal to the life insurance premium may either be paid to the executive or directly to the insurance company. The executive recognizes the amount of the total bonus as taxable income, including any amounts in addition to the insurance premium under a double-bonus plan. Any bonus amounts in addition to the insurance premium are paid directly to the executive, if applicable.
- The executive is typically the insured, but in some circumstances it may be appropriate to insure the life of a person other than the executive. Regardless of who is the insured, the executive will control the ownership of the policy, and will often own it personally. Alternatively, if the executive prefers to use the policy in his or her estate plan, he or she may gift the bonus to an ILIT and the ILIT’s trustee can purchase the policy.
- Access of the policy’s cash value is best accomplished when the executive owns the policy personally, and not in an ILIT. If properly structured, the policy withdrawals and loans are received by the executive income tax free. Care should be exercised so that the policy does not lapse, as a policy lapse will likely trigger a sizable taxable event for the policy owner (executive). The executive might also be able to access the policy’s cash value before retirement, perhaps to pay the income taxes due under a single-bonus plan.
- Care should be taken when the owner of policy is not the executive or if the person insured under the policy is someone other than the executive. The death proceeds may still be income tax-free to the beneficiary under these scenarios, though some combinations may result in an adverse result. Care must also be taken to avoid classification of the policy as “Employer Owned Life Insurance” under IRC Sec. 101(j). The typical design should avoid this classification.
See Rev. Rul. 58-90
See IRC § 162(a)(1).
Subject to limitations based on life insurance policy performance and product characteristics, such as surrender charges.
See IRC. § 101(j).
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