• In a Section 162 executive bonus plan, the employer provides the employee with a bonus in the form of a life insurance premium
• The employee applies for and owns the policy and is responsible for naming a beneficiary
• Bonus payments are tax-deductible by the business, but the employee must pay income tax on the benefit.

Section 162 executive bonus plans are a popular compensation tool used by employers to provide additional financial incentives to key executives. These plans, named after Section 162 of the Internal Revenue Code, offer employers a flexible and tax-efficient way to reward executives based on their performance and contributions. The strategy enables bonuses to be structured as ordinary income, enabling employers to deduct the bonus payments as business expenses, while executives are taxed on the bonuses received. 

Executive bonus plans can be tailored to suit the specific needs and goals of the company. They allow employers to attract and retain top talent, motivate executives to achieve strategic objectives, and align executive compensation with overall company performance. Unlike other types of executive compensation arrangements, such as stock options or equity grants, Section 162 executive bonus plans provide immediate financial rewards and can be easily adjusted on an annual basis. 

How Section 162 plans work

Under a Section 162 executive bonus plan, the employer agrees to pay bonuses to selected executives. These bonuses may be based on predetermined criteria such as performance targets, company profitability, or individual goals. Otherwise, bonuses are usually paid as a flat dollar amount for a set number of years. Unlike other types of executive compensation plans, the arrangement is not tied to the company's profits or shareholder returns. Instead, Section 162 plans allow employers to reward key executives for contributions without being restricted by specific corporate metrics. 

Once the agreement has been executed, the business pays the bonus, which will be used to fund a personally-owned life insurance policy on the employee. The business can either pay the premium directly to the life insurance company on the employee’s behalf or pay the bonus to the employee, who then pays the insurance premium. 

Paying the bonus directly to the carrier ensures that the bonus is being used toward its intended purpose. 

The employee can supplement his or her retirement using the policy’s cash value, if sufficient. Eventually, the death benefit will be paid to the policy’s beneficiaries tax-free, provided the policy is still in force.

Taxes and administration

The business gets an income tax-deduction for, and the employee must pay tax on, the total bonus provided each year. In comparison to other compensation plans, these bonus structures are relatively simple and inexpensive to install and administer and are not required to be filed with the IRS. 

Some employers may lack the financial means to set up a relatively complex executive benefits package due to the administrative costs. An executive bonus plan may offer an alternative to a complex benefits package as an effective recruitment and retention tool.

In addition to providing additional funds that can be accessed during retirement, Section 162 plans may help to keep employees tied to the business. Should an employee leave during his or her tenure, they (rather than the business) would assume responsibility for paying the premium on the policy, providing an incentive to remain.

Section 162 plan design

The bonus structure can be designed in one of two ways: with a single-bonus or a double-bonus. The choice of which design to implement is entirely up to the business owner.

In a single-bonus arrangement, the business provides a total bonus equal to the amount of life insurance premium. The employee pays income tax out of his/her own pocket on this amount. 

In a double-bonus arrangement, the business provides a bonus equal to the amount of the life insurance premium plus the taxes the employee would have to pay. This makes the arrangement income tax-neutral to the employee. The entire bonus amount is also tax-deductible to the business. 

Benefits of a 162 plan

Employee benefits

An executive bonus plan can provide an employee with a needed life insurance policy at a significantly reduced out-of-pocket cost. If structured as a double bonus arrangement, the employee gains the additional benefit of not having to pay income tax on his or her bonus out of their own pocket. 

The employee retains full control and ownership from day one, with all rights to the cash value of the policy and the right to name a personal beneficiary. The policy cash value could be accessed at any point for supplemental retirement purposes, while the death benefit will be provided to the employee’s heirs.

Implementation for business owners

While an executive bonus plan is traditionally established for non-owner key employees of a business, it can also be implemented on the business owners themselves. In order to do so, the business would have to be set up as a C-corporation. 

In other corporate structures (S-corp, partnership, sole proprietorship, etc), the flow-through nature of the business would not provide any tax leverage to the business owner. 

Employer benefits

A Section 162 plan offers the business an immediate tax deduction on each bonus payment. It can also serve as a retention tool to keep the employee from leaving the business prematurely. 

Section 162 executive bonus plans are also relatively simple to implement compared to other non-qualified benefit plans like deferred compensation or split dollar arrangements. The bonus plans do not need to be filed with the IRS.

Restricted Executive Bonus Arrangements (REBAs)

A business can implement a Restricted Executive Bonus Arrangement (REBA) to increase the retention benefits of a Section 162 plan. 

In a REBA, a vesting schedule is incorporated into the arrangement. The employee does not have complete access to the cash value of the life insurance policy until he or she is fully vested. 

The vesting schedule can be customized to a specific timeframe decided upon by the business owner. If the employee leaves prematurely, any unvested portion of the bonus would be repaid to the business. In many cases, the cash value of the life insurance policy can be used to help pay back this portion. However, if the employee leaves too early, the cash value may not be significant enough, especially when taking surrender charges into account, so it may further entice them to stay with the business. 

Product selection

Any type of life insurance product can be used in an executive bonus arrangement, including term insurance. In most cases, however, it is desirable to utilize a product that accumulates cash value in addition to providing a death benefit, such as universal or whole life insurance. The cash value of the policy can be used as a source of retirement income by the employee. 

Case study

Bob, age 50 and in good health, is a key employee at ABC Construction Company, which has seen significant financial success over the last few years. William, the business owner, wants to put an executive benefit plan in place for Bob to reward him for his role in driving revenue for the company. However, William is wary of implementing any compensation agreements that require significant administration or reporting. As a result, he decides to implement a traditional executive bonus plan. 

William decides to provide Bob with an additional compensation bonus of $26,315 per year over the next 10 years, at which point Bob will likely retire. Bob applies for a life insurance policy with an annual premium of $20,000 over those same 10 years. With the bonus that William provided, Bob would pay $6,315 in income taxes (assuming a 24% income tax), which would leave Bob with a net of $20,000 to pay the life insurance premium. 

The business receives an income tax deduction based on the full bonus of $26,315. At age 66, Bob is able to take an annual tax-free income of $29,429 for 15 years until age 80 to supplement his retirement.* His named beneficiaries would receive any residual death benefit left in the policy when Bob passes. 

* Based on a male, age 50, preferred nonsmoker with Nationwide’s UL Accumulator II assuming a 6.03% indexed crediting rate