Specifically, we are seeing more employers utilize 162 Bonus Plans to provide executives with supplemental benefits through the purchase of life insurance. Could a 162 Bonus Plan benefit your company and its key employees? The following should help you answer that question.
How It Works
The name “162 Bonus Plan” refers to Internal Revenue Code (IRC) Section 162(a)(1), under which an employer sponsoring a bonus plan is able to deduct the bonus amount paid to the covered employee as an “ordinary and necessary business expense” (e.g., reasonable compensation). In a 162 Bonus Plan arrangement, the employer typically funds an employee’s purchase of life insurance through the payment of bonuses, or by directly paying the premium to the insurance carrier. Under this agreement, the employee owns the policy and has the right to name the beneficiary. The employer does not plan to recover any of the policy premiums. They are not a beneficiary and do not own any interest in the policy.
The executive and employer enter into a 162 executive bonus plan.
A life insurance policy is purchased on the executive’s life. The employer pays the premiums and these are taxed to the employee as bonuses. The bonuses are potentially tax-deductible for the employer.
A REBA is filed with the life insurance company. The form states that the exercise of any policy ownership rights (except for beneficiary designation) requires the signature of both the executive and the employer.
Once the REBA is removed from the policy, the executive may access the cash value of the life insurance policy.
At the executive’s death, the life insurance death benefit proceeds may be paid to the executive’s beneficiaries on a tax-free basis.
Pros and Cons
When using life insurance, 162 Bonus Plans have several advantages for employers:
- Plans are simple to implement and easy to administer. An executive bonus arrangement is not considered a nonqualified deferred compensation plan and, therefore, isn’t required to comply with IRC Sections 101(j) or 409A.
- The employer can be selective about which key employees receive the benefit. There are no minimum participation requirements.
- Bonuses used to pay the policy premiums may allow for a tax deduction. The deductibility of the bonus is subject to the reasonable compensation limits established by IRC Section 162(a).
- A 162 Bonus Plan provides a supplemental retirement benefit that typically includes pre- and post-retirement benefits that are specifically intended for key executives.
- In these arrangements, employers typically impose a restricted executive bonus arrangement (REBA) on the policy to incentivize executives to remain with the company.
In addition to the employer advantages, 162 Bonus Plans can also be advantageous for key executives in a number of ways:
- The executive owns the policy, allowing them to name the beneficiary and exercise all ownership rights, subject to any REBA.
- In the event of the executive’s death, the death benefit proceeds are paid to the named beneficiary and are received federal income tax-free.*
- The policy cash values accumulate in a tax-deferred manner. The cash value in the policy generally can be accessed through policy loans and / or withdrawals, subject to any REBA. Upon separation from service or retirement, the policy may be surrendered for the cash surrender value.
- The bonus is taxable to the executive; however, a 162 Bonus Plan can be structured to pay the premium and the income taxes generated by the bonus.
A few items for employers and executives to take into consideration:
- The employer is unable to recover costs.
- The executive must recognize any bonus payment as taxable income.
- The death benefit of the policy will be included in the executive’s estate, unless additional planning is done.
- If the executive separates from service, or the arrangement is terminated, the executive will have to pay any future premiums or the policy may lapse.
The bonus is taxed as ordinary income to the executive at their normal income tax rate. In some situations, employers may gross-up the bonus so the executive has a zero net cost. As previously mentioned, the employer can recognize an income tax deduction for bonuses paid under the 162 Bonus Plan, provided that the payments (when combined with the employee’s other compensation) are reasonable and the employer is not directly or indirectly a beneficiary of the policy. Because the bonus is treated as wage income, it is subject to both Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) withholdings.
An employer may structure the 162 Bonus Plan as a REBA. A REBA can require the executive to stay with the company for a specific period of time or repay bonuses if they separate from service prior to the specified date. It can also restrict the executive from certain policy ownership rights such as surrendering, loaning or withdrawing from the policy without the employer’s consent. Depending on the terms and structure, a REBA may not provide the anticipated results regarding tax consequences. Employers should consult with their tax and legal advisors before creating a REBA. See the following page for an illustrative breakdown of 162 Bonus Plans.
An organization’s success often hinges on the talent it employs, so maintaining competitive benefits should always be a top priority. Through the purchase of life insurance, 162 Bonus Plans can offer a simple and flexible option for providing supplemental benefits that aim to attract and retain key executives. With a number of advantages and minimal drawbacks, both employers and employees can enjoy this type of plan. If you believe this strategy is a good fit for your organization, we encourage you to contact our Executive Benefits Team to find out more.
* For federal income tax purposes, life insurance death benefits generally pay income tax-free to beneficiaries pursuant to IRC Sec.101(a)(1). In certain situations, however, life insurance death benefits may be partially or wholly taxable. Situations include, but are not limited to: the transfer of a life insurance policy for valuable consideration, unless the transfer qualifies for an exception under IRC Sec. 101(A)(2) (i.e. the “transfer-for-value rule”); arrangements that lack an insurable interest based on state law; and an employer-owned policy unless the policy qualifies for an exception under IRC Sec. 101(j)
This article originally appeared in the 2017 | ISSUE THREE of the SilverLink magazine, under the title “Executive Benefits | Your Ultimate Competitive Advantage?” To receive a complimentary subscription to the SilverLink magazine, sign up here.