 What
is an Executive Bonus Plan?
How
do Executive Bonus Plans Work?
Key
Executive Bonus Options
Advantages
and Disadvantages of Executive Bonus
What is an Executive Bonus Plan?
An executive bonus plan (Section 162) is a way for business
owners or companies to provide additional supplemental benefits
to key employees or executives of their choice. The benefits
usually include life insurance policy death benefits as well
as cash value accumulations that can be used as a retirement
income supplement. With an executive bonus plan, the business
can use tax deductible company funds to selectively provide
valued benefits to key people. An executive benefit plan,
used effectively, can be a valuable tool to attract and retain
key executives.
Executive bonus plans are simple in design and easy to implement.
The executive bonus plan works as follows:
| 1. |
The company provides the
key executive with a bonus that is taxable as income
to the recipient. The bonus is generally a deductible
business expense for the company.¹ |
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| 2. |
The key employee may choose to use
the bonus to purchase a whole life or universal life
insurance policy that builds cash value that grows tax
deferred. |
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| 3. |
The life insurance policy, if properly
structured, may provide an attractive benefit to the
executive in the form of cash value growth. Any cash
value accumulation will grow tax deferred and may be
accessed by the employee income tax-free through withdrawals
and policy loans. The policy’s cash value can be
used to supplement retirement income or for any other
financial need.² |
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| 4. |
If the key executive dies, in most
cases, her heirs will receive the death benefit proceeds
from the life insurance policy income tax free. |
Variations of Executive Bonus Plans
In addition to the basic executive bonus plan, there
are other common plan variations. These options
include a double
bonus arrangement and a restricted or controlled
executive bonus plan.
With a double bonus arrangement, the company will provide
the key executive with a bonus large enough to
pay the life insurance premiums as well as the income taxes
incurred
by
the key executive on the bonus. The company can
use the double bonus arrangement to eliminate any out of
pocket
expense
for the key executive.
If the company wishes to retain some measure of control
over the bonus, the controlled executive bonus
design is a good choice. With a controlled executive bonus,
the company
and the key executive enter into an agreement
which includes a vesting schedule on the policy’s cash value growth.
The vesting schedule is a form of “Golden Handcuffs” that
allows a company to limit the availability of the cash value
benefits until the executive has fulfilled the terms of the
agreement. At that time, the executive is “vested”.
Once the key executive is vested, they gain full and complete
access to the policy’s cash value.
Advantages of Executive Bonus Plans
Executive bonus designs using life insurance have several
advantages including:
| 1. |
An executive bonus
plan is simple to implement and easy to administer. |
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| 2. |
The business can selectively choose
the key employees they wish to reward. |
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| 3. |
The bonus payments may be considered
a fully deductible expense to the company. |
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| 4. |
The key employee is able to name
the beneficiary of the entire death benefit of the life
insurance policy. |
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| 5. |
In many cases, unless there is
a “restricted or controlled executive bonus”,
the key executive will have immediate access to policy
cash value and may access that cash value without income
tax through policy loans and withdrawals. |
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| 6. |
Executive bonus plans are not subject
to “qualified plan limits”. |
Disadvantages of Executive Bonuses
There are also some inherent disadvantages in
using an executive bonus plans including:
| 1. |
The company
is unable to fully recover its costs from the
policy’s death benefit since the key
executive names the policy beneficiary. |
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| 2. |
Executive bonus plans offer
the company very little control of the policy.
Even if a controlled executive bonus is utilized,
it only restricts the key employee’s
access to the policy’s cash value. The
bonus is never recovered by the company even
if the key employee leaves the company prior
to vesting. |
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| 3. |
The key executive must include
any bonus in his or her taxable income. |
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| 4. |
Without additional planning,
the life insurance policy’s death benefit
will be includable in the key executive’s
taxable estate. |
¹ The deductibility of the employee bonus is subject
to the reasonable compensation limits established
by (Section 162-a of the Internal Revenue Code).
²
The tax free status of withdrawals and loans is
subject to the policy being a non-MEC policy. After
the initial 15 policy years withdrawals can be
made up to the policy’s cost basis income
tax free. Once the policy’s cost basis has
been reached through withdrawals, policy loans
may be access without income taxation subject to
certain conditions. Withdrawals, policy loans and
partial surrenders will reduce policy values and
may reduce death benefits.
This information is for illustrative purposes
only. MEG Financial and its representatives are
in no way providing tax or legal advice. Please
consult your CPA or tax attorney for any questions
on the taxes as they relate to your specific circumstances.
Other Key Executive Compensation
Strategies:
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