A (Section 162) Executive Bonus Plan is designed for Employers to provide additional benefits to key Employees on a selective basis. The major difference between the preceding plans and a Sec 162 Plan is that in the case of the latter, the Company can take an immediate tax deduction for the benefit provided to the Employee. Conversely, the Employee is taxed on that benefit in the year the contribution is made by the Company.
The mechanics of a Sec. 162 Plan are relatively simple:
- The Company and the Employee enter into an agreement whereby the Company will fund a very specially engineered cash value life insurance contract on behalf of the Employee.
- The policy is (usually) on the life of the Employee and owned by the Employee.
- The Company will receive a tax deduction for the amount of the contribution.
- The Employee will pay income taxes on the amount of the contribution to the policy.
- The cash value in the life insurance policy will grow on a tax-deferred basis.
- The cash value in the policy will be used by the Employee to take tax-free retirement income (somewhat akin to a Roth IRA).
- The Company has the option to employ a variation of the Plan by including a “double bonus” arrangement, whereby the Company will bonus the Employee sufficient funds to pay the taxes on both the contribution to the plan and the tax on the bonus.
- If the plan is designed as an Employee Retention strategy, the Company could add an additional variation known as a Controlled Bonus Plan. Using this process, the Company can restrict the Employee from using the cash value until such time as the Employee vests in the Plan. Vesting is usually determined by a number of years.
Advantages of Executive Bonus Plans
To the Company:
- The plan can be discriminatory inasmuch as the Employer can determine which Employees participate in the Plan.
- The Plan is relatively simple to implement and administer.
- The bonus is fully deductible to the Company.
- The Company can restrict access to the cash value using a Controlled Bonus arrangement. This serves as a “Golden Handcuff” strategy to retain the Employee for the period necessary for the program to vest.
To the Executive:
- The Executive is able to name their beneficiary to the policy. In the event of their death, the policy proceeds will be paid income tax-free.
- Retirement distributions are accessed tax-free from the policy’s cash value.
- If the Company includes a double bonus arrangement, the Employee will have no tax consequence from the Plan.
Disadvantages of Executive Bonus Plans
To the Company:
- Without a Controlled Bonus arrangement, the Company has no “handcuff” on the Executive. Even with a Controlled Bonus arrangement if the Executive were to leave the Company prematurely, while they would not have access to the policy cash values for retirement, there would be no way of the Company recovering its investment in the Plan.
- As the policy is owned by the Employee, there is no recovery of Plan costs as there would be in the case of a SERP.
To the Executive: Without a “double bonus” arrangement, there is a taxable cost to the Employee.
