Life Insurance and Executive Bonuses

When you want to reward executives with a bonus but don’t have the cash flow to do it, executive bonus arrangements funded by life insurance may be an efficient option. Also known as Internal Revenue Code (IRC) Section 162 plans, executive bonus arrangements are typically additional compensation – or bonuses – given to executives and other key employees.

The Details

Because the IRC defines Section 162 plans as nonqualified, the plans don’t offer the tax-deferral advantages of 401(k) and other qualified retirement plans. But, as nonqualified deferred compensation (NQDC), they also don’t have the contribution limits deferred compensation plans have.

Executive bonus plans may give business owners the ability to deduct premium payments as a business expense. However, the business cannot recover expenses from the death benefit, because the insured owns the policy and names the beneficiary.

Because there is some flexibility in how cash value and loans are handled, business owners may restrict key executives from taking cash value or loans from the policy for a period of time. This approach can provide an incentive for key employees to remain with the company. Conversely, key employees may have access to cash value and loans throughout the life of the agreement.

Pros and Cons

While life insurance is an efficient way to provide an executive bonus, the arrangement itself has a few potential pitfalls of which business owners need be aware. The key disadvantage is the life insurance policy’s portability. Because key executives name beneficiaries of the policy, business owners have little control over this method of compensation. For example, executives leaving the firm can take the policy’s death benefits with them.

However, business owners that use Section 162 plans appreciate their ability to help attract and retain key employees and their ease of administration compared to qualified plans.

Executive Points

Key employees who benefit from Section 162 plans need be aware of a couple of tax implications. First, premiums paid by the company are taxable to the employee. However, the company may offer a double bonus arrangement that includes extra compensation to pay the tax. Second, the death benefit becomes part of a potentially taxable estate.

Consult you financial and tax professionals to learn more.