A 162 Executive Bonus Plan lets business owners reward key executives without incurring additional tax exposure.
At its core, a 162 Executive Bonus Plan should feature a whole life insurance policy.
Here’s how it works:
- The company buys the policy and pays the premiums on behalf of the employee.
- The employee names beneficiaries for the policy’s death benefit and also can control the policy’s cash value.
- The policy’s cash value and potential death benefit become part of the employee’s compensation.
- The company considers the policy’s premiums a business expense that can be tax deducted.
162 Executive Bonus Plan: Innovative Compensation
Necessity often leads to innovation in business. During World War II, the federal government froze wages, meaning companies needed methods besides salary increases to retain talented employees.
Industries started including health insurance benefits in employee compensation, a decision whose legacy still resonates in today’s health insurance marketplace.
The government no longer caps wages, but tax structures can limit a company’s ability to reward and retain key staff members with cash or stock bonuses.
Other issues, such as cash flow limitations, can also prevent a company from sweetening compensation packages.
A 162 Executive Bonus Plan — named after the Internal Revenue Code Section 162 which makes it possible — provides a tax efficient and a cash efficient way to reward and retain key employees.
Pros of an Executive Bonus Plan
Along with extending compensation beyond the actual outlay of taxable resources, a 162 Executive Bonus Plan has other pros, both for the employer and the employee:
162 Executive Bonus Plan Pros for Employers
Companies considering whether to incorporate an Executive Bonus Plan into compensation packages can benefit from a plan’s:
- Ease of Administration: Bonus plans can be created and maintained quickly and easily, unlike bonuses which draw upon stocks or other investments.
- Flexible Inclusion: An employer can choose which employees to include in the Executive Bonus Plan based on internal rules and preferences. Discontinuing a plan can be done without timing investment losses.
- Retirement Supplement: The cash value portion of the life insurance policy can enhance the retirement package companies offer high-level employees.
- Possible Tax Deduction: It’s possible for an employer to deduct the cost of a 162 Bonus Plan’s premiums, so long as the employer isn’t the owner of the policy.
162 Executive Bonus Plan Pros for Employees
Employees, of course, receive the benefits from the plan, but they may also appreciate:
- The Coverage Itself: Life insurance coverage can create a sense of peace about dependents’ financial security after an unexpected death. Having premiums paid by an employer frees up cash for the employee to use elsewhere.
- The Cash Value: Each time an employer pays an annual life insurance premium on behalf of an employee, the whole life policy increases in value. The employee can redeem or borrow against this value depending on the plan’s rules.
- Tax Deferment: A policy’s cash value accumulates in a tax-deferred manner, exempting the bonus plan from current income taxes.
- Tax Shifting: While the premiums paid on behalf of the employer must be reported as taxable income, the IRS allows a company to compensate the employee for that expense. Some plans call this arrangement a “double bonus.”
Cons of an Executive Bonus Plan
In most cases an Executive Bonus Plan offers a win-win scenario: It gives the employer an efficient way to sweeten an employee’s compensation package while the employee benefits from owning and controlling the whole life policy.
Still, both parties should consider the limitations of a 162 Executive Bonus Plan, which will make less sense when:
- The Employee Is Harder to Insure: Life insurance underwriters consider a policy owner’s health conditions and age as they set premiums. A bonus plan loses some of its efficiency if a policy requires cost-prohibitive premiums to pay for a large coverage amount.
- Employment Will End Soon: When employment is terminated, the employee must take over premium payment or the coverage will lapse. If the employee retires, the premiums could be built into a pension plan.
- Employer Wants More Control: Unless a company sets limitations on how an employee uses a policy’s cash value, the employee has full control and can erode the value, reducing its value to both parties.
Using REBA to Limit a Bonus Plan
An employer concerned about relinquishing control in an Executive Bonus Plan can set limits to preserve the value of the policy.
A Restricted Executive Bonus Arrangement, or REBA, can prevent an employer from accessing a policy’s cash value without first getting the employer’s permission.
Often, a REBA will have an expiration date, which can enhance the value of the bonus plan as an incentive for the employee to remain under contract.
The expiration clause can be timed to:
- An actual date: 10 years into the future, for example.
- A triggered date: An as-of-yet unknown event such as retirement or death can trigger the expiration of the REBA.
- An event: Theoretically, a bonus plan’s REBA could expire when the employee meets specified goals within the company.
Some plans refer to these restrictions as “golden handcuffs.”
How to Set Up an Executive Bonus Plan
Though simple on the surface, a company’s tax advisor should be involved with the construction of a life insurance Executive Bonus Plan.
It also helps to have someone involved who understands how to shop for life insurance.
A bonus plan should be crafted to:
- Cover an employee’s tax burden from the bonus if the company wishes to create a “double bonus” to protect the employee from taxes.
- Make sure the company’s contributions remain tax deductible through Section 162 of the Internal Revenue Code which prohibits tax deductions if compensation is considered unreasonable. Defining “unreasonable” can be an exercise in subjectivity; hence the need for tax advice.
- Protect the policy’s beneficiaries from taxes on the death benefit, which is easy unless the death benefit goes directly into an employee’s estate after death.
Buying the Life Insurance Plan
A whole or universal life insurance policy serves as the heart of a 162 Executive Bonus Plan. Understanding how life insurance works will help a company craft the best plan.
- Whole or Universal: Both policies can work well for the purposes of a bonus plan. Whole policies tend to be simpler. Their cash value builds gradually, as it would in a savings account. A universal policy’s cash value tends to be more flexible and can even impact the premiums and the coverage amount.
- Coverage Amount: A larger coverage amount will be more attractive to the employee, but higher coverage amounts require higher premiums. Companies should set a standard with the desired balance between costs and benefits while realizing some employees will cost more to insure.
- Medical Underwriting: Medically underwritten coverage tends to offer the most coverage at the lowest premiums, but these policies require the policyholder to get a medical exam. The bonus plan administrator may be able to arrange an in-office exam with some insurance carriers.
- Quality of Coverage: An insurer with higher grades from independent rating agencies will offer higher quality and more dependable life insurance coverage.
Put the Executive Bonus Plan in Writing
The company official responsible for building and maintaining an Executive Bonus Plan should keep clear records about policies purchased, beneficiaries named, and REBA restrictions in place.
Keeping clear records makes it easier to expand a plan to add employees fairly as needed and to answer tax questions as they arise.
Life Insurance Experts Can Help
When you’re ready to start an Executive Bonus Plan, check with a life insurance agent about the best whole or universal policy options.
An independent life insurance agent will have the most options to help you find the right kind of coverage to build your plan around.
Independent agents have access to dozens of companies and have already helped other companies customize Executive Bonus Plans that retain key executives more efficiently.