E—Restrictive Bonus Plan

The restrictive bonus plan is an employee benefit that allows an employer to provide valuable life insurance protection for a selected employee on a tax deductible basis to the employer. (Note: The restrictive bonus plan is also referred to as a restrictive endorsement bonus arrangement (REBA), a golden executive bonus arrangement (GEBA) and a controlled executive bonus plan.) 

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 is typically made available to a minority stockholder or a nonstockholder-employee since there is no reason for a majority owner to restrict his or her access to the bonus.

DURING LIFETIME. Under the agreement, the employee purchases and owns a permanent life insurance contract on his or her life. Added to the policy is a restrictive endorsement that requires the employer’s consent for the employee to: (1) surrender the policy; (2) assign or pledge the policy for a loan; (3) change ownership of the policy; or (4) withdraw or borrow the cash values of the policy.  The endorsement will typically provide for these restrictions to expire upon the earliest to occur of: (1) the retirement of the employee; (2) disability of the employee, (3) attainment of a specific age; (4) a period of years; (5) release by the employer; or (6) the bankruptcy or dissolution of the employer.

By separate written agreement, the employer agrees to provide a bonus to the employee by paying all premiums to the insurance company, which is fully tax-deductible by the employer as reasonable compensation to the employee. If desired, a “double bonus” could be given (i.e., the bonus is large enough to pay not only the premium, but also the tax on the bonus). 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 as “reasonable.” 

The premiums are considered taxable income to the employee, upon which the employee is responsible for paying taxes to the IRS. A more aggressive plan design requires the employee to reimburse the employer for some or all of the premiums paid, should the employee terminate employment prior to normal retirement date (or within a certain period of time). While the tax results of this reimbursement are not entirely clear, it seems likely the employee would not be allowed to deduct the repayment and the employer would be required to include the repayment in income. The employee’s interest must to fully vest in order for the employer to get a current deduction for the premiums paid (i.e., not subject to a substantial risk of forfeiture, thus taxed on bonus. 

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. Note that with both the restrictive bonus plan and 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 offers tax deductibility to the employer, a simple yet attractive “golden handcuff” for attracting and retaining a key employee, life insurance protection together with cash value accumulations available to the employee upon retirement, ease of installation, and premium payments with a business check.

It is important that the employer have no interest in the life insurance contract, because Code section 264 would seem to disallow the employer’s tax deductions for the bonuses if the employer is directly or indirectly a beneficiary under the policy. It is also important to keep the written agreement entirely separate from the policy endorsement, particularly if the employer has a right to be reimbursed for bonuses given the employee. Code section 83 provides, in effect, that the employee is not taxed on property “transferred in connection with the performance of services,” if the property: (1) is not transferable by the employee; and (2) is subject to a substantial risk of forfeiture. It is clear that the first condition is met since the endorsement prohibits the employee from transferring the policy. Therefore, if the second condition is met, the employee is not taxed and the employer cannot take a current tax deduction.