D—Executive Bonus Plan

The executive bonus plan, also known as a Section 162 Bonus Plan or executive equity, is an employee benefit plan that allows an employer to provide valuable life insurance protection for a selected employee on a tax deductible basis to the employer. Executive equity plans are also referred to as executive bonus plans, executive retirement bonus plans, and Section 162 bonus plans” (after Section 162(a)(1) of the Internal Revenue Code, which authorizes a business to deduct a “reasonable allowance” for salaries or other compensation for personal services actually rendered).

The employer has total discretion to select the employee, or employees, to be covered by the agreement, and the amounts of insurance to be provided. It can be made available to both the stockholder-employee and the nonstockholder-employee. If executive equity is to be effective with owner-employees, it must usually be used in a regular C corporation (not an S corporation). Neither the sole proprietorship nor the partnership provides the separate taxable entity that is essential for the concept to be an attractive benefit for owner-employees.

DURING LIFETIME. Under the agreement, the employee purchases and owns a permanent life insurance contract on his or her life. Because the contract is entirely owned by the employee, it is not essential that the agreement be in writing. However, it is good practice to have the terms of any important agreement in writing; and the agreement could help defend against an IRS attempt to characterize the bonuses as nondeductible dividends. The employer pays premiums to the insurance company, which are fully tax-deductible by the employer as compensation to the employee.

These premiums are considered taxable income to the employee, upon which the employee is responsible for paying taxes to the IRS. The employee owns the life insurance contract, including all policy cash values, and the annual increase in these values may more than offset any taxes paid by the employee.

The premiums paid by the employer are reported as “other compensation” on the employee’s W-2 form. Likewise, this compensation is subject to both the Social Security Tax (FICA) and the Federal Unemployment Tax (FUTA). Underlying any discussion of employee benefits is the assumption that, if challenged by the Internal Revenue Service, the increased compensation would be considered “reasonable.” 

If desired, these taxes could be paid with borrowed or withdrawn policy cash values, or dividends, if funded with a participating policy. In designing executive equity illustrations, it is particularly important to emphasize the direct comparison between the yearly income taxes paid by the employee and the annual cash value increases, all of which are owned by the employee. For example, if the employer pays a premium of $2,500 for $100,000 of insurance protection, this $2,500 will constitute taxable income to the employee. Assuming the employee is in a 25 percent tax bracket, the employee will have to pay $625 of additional income taxes (.25 × $2,500). However, if the cash values owned by the employee increased by $1,300 in that year, this more than offsets the taxes paid. The increase in cash surrender value is not taxable.

UPON DEATH. At the employee’s death, the insurance company pays the total death benefit directly to the employee’s beneficiary. Because it is the death benefit of a life insurance contract, this payment is received free of all income taxes.

Executive equity offers something for everyone –  tax deductibility to the employer, cash value accumulations for the employee, ease of installation, and premium payments with a business check. If the employee-stockholder’s marginal tax bracket is less than his corporation’s marginal tax bracket, then executive equity should be attractive to the employee-stockholder who wishes to withdraw profits from the corporation. However, because of the 2017 Tax Act, employee-stockholders will less frequently have a lower marginal tax bracket than the business making this planning technique less used for employee-stockholders and mostly focused on non-owner key-employees.

Note that with executive equity, the employer has no interest in either the cash values or the death benefits. This contrasts with a split-dollar arrangement, under which the employer usually owns most, if not all, of the cash values, and receives a portion of the death benefits. The restrictive bonus plan provides an interesting alternative to both executive equity and split-dollar plans.