The success of a business, especially a small business, is often predicated on the performance and retention of a few key employees. The financial impact and stress resulting from the departure of an important employee can be significant. One way business owners can try to retain and reward their key employees is by offering extra compensation in the form of a nonqualified executive bonus (IRC Section 162) plan. These types of plans often use permanent life insurance as the funding vehicle.
What is it?
An executive bonus arrangement is an addition to regular salary or compensation that business owners can provide to key employees or executives of their choice. The bonus may be used by the employee to purchase permanent life insurance.
There are no legal requirements for anything to be filed with the government or for the plan to be in writing. However, a written plan is often desirable because it can outline the conditions that must be met in order for the employee to qualify for the bonus, and it can state the obligations of the business to pay the bonus.
How does it work?
The business provides extra compensation to the key employee in the form of a bonus. If life insurance is used as the funding vehicle, the employer may make the bonus payment directly to the insurance company, or the employee can make the premium payments.
In some instances, the employer will pay a "double bonus" to the employee to pay for any income taxes owed by the employee that are attributable to the bonus. To cover premium payments and to maintain the tax advantages of cash accumulation for the employee, the employer should plan on making ongoing bonus payments instead of a one-time bonus so the policy isn't classified as a modified endowment contract.
The employee is the insured and owner of the life insurance policy and may name the policy beneficiaries. The life insurance policy may accumulate cash value, which can be accessed by the employee during his or her lifetime. Generally, any cash accumulation within the policy will grow tax deferred. Policy death benefits are paid to the employee's beneficiaries named in the policy.
What are the tax considerations?
Bonuses are generally deductible by an employer according to the same rules as other forms of cash compensation. A bonus cannot be deducted unless it constitutes a reasonable allowance for services actually rendered.
A bonus is taxed to the employee as ordinary taxable income. Because employees generally file taxes according to the cash method (rather than the accrual method), the bonus is taxable to the employee when it is received.
Considerations for the employer
- Extra compensation in the form of a bonus can attract, motivate, and retain key employees.
- The plan is generally simple to implement and easy to administer, with no formalities or funding requirements.
- The employer has complete discretion in selecting which employees to reward.
- The employer may be able to deduct the bonus as a reasonable business expense.
- The employer can set terms and conditions that must be met by the employee to qualify for the bonus.
Considerations for the employee
- The employee receives life insurance protection for his or her family at little or no cost (assuming the employer also covers the tax obligation of the employee attributable to the bonus).
- The employee owns the policy and names the policy beneficiaries.
- Permanent life insurance may accumulate tax-deferred cash value over time, which the employee can access to supplement retirement or to meet other needs or expenses.
- The bonus may be contingent on continued employment or performance goals.
- The employee must be insurable in order for life insurance to work as the plan funding vehicle.
A way to retain and reward employees
A principal challenge to employers is figuring out how to retain and reward key employees. These goals can be promoted by providing executive bonuses to key employees, who can use the bonuses to fund a life insurance policy. Life insurance may be a useful funding vehicle because it can provide a tax-free benefit to the employee's chosen beneficiaries and it may accumulate tax-deferred cash value.