Executive Bonus Arrangements
What is an Executive Bonus Arrangement?
An Executive Bonus Arrangement, sometimes called
a Section 162 Arrangement, is employer-financed personal life and/or
disability insurance that is intended to benefit select executives.
Properly structured plans allow an employer to provide valuable
life insurance and/or disability protection for select executive(s)
through a bonus of the premium by the employer to help retain, attract
and reward key executives. It is an informal plan and therefore
does not need IRS approval and, in most cases, is not subject to
ERISA.
Is it the same as Key Employee Insurance?
No. Key Employee Insurance is not the same as
an Executive Bonus Arrangement. Key Employee Insurance is intended
to protect the business from losses resulting from the key employee's
death or disability. An Executive Bonus Arrangement is designed
to provide benefits to selected employees and their families.
Why is it called a "bonus?"
The funds that are bonused to the individual
are considered to be "in addition" to the executive's normal compensation.
Who can benefit from an Executive Bonus Arrangement?
A large number of individuals can qualify for
an Executive Bonus Arrangement. They are:
All executives of a C-Corporation
All non-owners of:
S-Corporations
Limited Liability Corporations, LLCs
Limited Liability Partnerships, LLPs
General Partnerships
Sole Proprietorships
Can a Shareholder-Executive benefit from
an Executive Bonus Arrangement?
If the individual is in a lower marginal tax
bracket than the business it may be cheaper for income to be taxed
to the shareholder rather than to the corporation.
For example:
The employer is considering paying a $10,000
bonus to a shareholder-executive.
The shareholder-executive to be bonused is
in the 25% federal tax bracket. The employer is in the 35% federal
tax bracket.
If the employer retains the $10,000, the
employer will pay $3,500 in federal income taxes.
If the employer provides a $10,000 bonus,
that will result in a $2,500 tax obligation for the executive.
Paying the bonus to the shareholder-executive
results in a lower net tax bill. The net leverage is $1,000.
Does the employer have to include all
executives?
No. The Executive Bonus Arrangement can be completely
selective in coverage. The employer is free to select the executives
it wishes to benefit.
An Executive Bonus Arrangement is employer-financed
personal life and/or disability insurance that is intended to benefit
select executives.
Who owns the policy?
The executive usually applies for and owns the
policy, naming someone other than the employer as beneficiary.
How are premiums paid?
The cash bonus or premium is reported as additional
compensation on the executive's Form W-2 each year. The annual taxes
on the bonus can, in some cases, be funded by an additional cash
bonus to the executive.
Who receives the death benefits?
At the executive's death, the executive's designated
beneficiary generally receives the death proceeds free of federal
income taxes under IRC Section 101(a).
Can the policy cash values be accessed?
Yes. In an Executive Bonus Arrangement the policy
owner will have access to all of the policy's values. They can take
tax-free withdrawals to basis and/or policy loans. Policy loans
or withdrawals will, of course, reduce the death benefit and may
have tax consequences.
Are there any limitations on how the
policy owner can use the policy's cash values?
No. Policy owners can use the cash values as
emergency funds or as a means of supplementing their retirement
income.
What types of insurance policies are
typically used in Executive Bonus Arrangements?
Many times the life insurance policies used in
Executive Bonus Arrangements are designed to accumulate cash value
as opposed to providing maximum death benefit.
How is the amount of the bonus
determined?
The size of the bonus is left to the employer's
discretion. If the goal of the bonus is executive retention the
size of the bonus should be large enough to be meaningful and large
enough to pay the premiums on a life insurance policy and/or a disability
policy.
Are There Written Agreements in an Executive
Bonus Arrangement?
Because the executive is the owner of the life
insurance or disability policy, the agreement does not have to be
in writing. However it is good practice to have the employer execute
a corporate resolution authorizing payment of bonuses to fund life
insurance or disability premiums.
What are the tax
consequences of an Executive Bonus Arrangement for the employer
and employee?
Since the bonus is taxed as additional compensation
to the executive, it is deductible by the employer in the year paid
provided it qualifies as reasonable compensation to the executive.
As with other life insurance policies, the death proceeds from Executive
Bonus Arrangements are usually received income tax-free by the executive's
designated beneficiary under IRC Sec. 101(a). Disability insurance
benefits generally will also be received income tax-free by the
executive.
The employer selects the executive(s) it wishes
to benefit and pays tax-deductible premiums (or a cash bonus) for
a policy on the executive's life or disability insurance. The executive
reports the premium (or bonus) as compensation each year for income
tax purposes.
More care is required if the employer pays premiums
of an executive-owned policy directly to the insurance company.
When this occurs the deduction is allowed only if all of the following
conditions are met:
The executive's total compensation package
including the bonus is reasonable in view of the services rendered
to the employer.
The employer is not a beneficiary of the
policy, directly or indirectly.
The salary or bonus used to pay premiums
represents an ordinary and necessary business expense of the
employer.
If the insured executive is also a shareholder
in the employer, the premium cannot be construed as a constructive
dividend to the shareholder-executive.
The employer must pay the employer's share
of FICA and Medicare taxes on bonused amounts.
Can an Executive Bonus Arrangement trigger
the Corporate Alternative Minimum Tax?
No. Since the policy is owned by the executive
and not the corporation, there will be no problem with the corporate
alternative minimum tax (AMT). No proceeds ever pour into the corporation
that could result in a preference item potentially subject to the
AMT.
Can an executive Bonus Arrangement affect
the insured executive's estate tax taxes?
Yes. The death proceeds of the executive bonus
policy are usually includible in the insured executive's gross estate
at death because he or she owned the policy. However proper planning
may eliminate or mitigate such estate taxation.
Can installing an executive Bonus Arrangement
place a company into a lower tax bracket?
Yes. If a company has taxable income of $100,000,
spending $50,000 to provide an executive bonus will reduce the company's
taxable income to $50,000. This will reduce the company's income
tax from $22,250 to $7,500.* A tax savings of $14,750!
How can the bonus be structured?
The payment of a bonus to the executive will
result in the executive having a higher income. The higher income
will result in higher taxes and could result in out-of-pocket costs
for the executive. The payment of an additional bonus can minimize
the impact of the additional taxes. Generally there are two levels
of bonuses available:
Single Bonus - The amount of the additional
bonus is equal to the additional tax. (Seldom used).
Double Bonus - Results in a "zero" net out-of-pocket
cost. (Commonly used).
Assuming a bonus of $25,000
and a 30% tax bracket, the various bonus levels will break out as
follow:
Is there a quick way to calculate the
Double Bonus?
The double bonus amount can be calculated by
dividing the tax liability by "1" minus the individual's tax bracket.
Assuming a liability of $25,000 and a 30% tax bracket the double
bonus would be calculated as follows:
$25,000 / (1-0.30) = $35,715
Why are Executive Bonus Arrangements
a good idea for a company?
Creating an Executive Bonus
Arrangement can:
- Put the company in a lower tax bracket
- Build "good will" between the company and
its executives
- Create "defacto" golden handcuffs especially
if an executive becomes rated or uninsurable
Summary
Benefits to the Executive
- executive owns the policy, so it is portable
if he or she terminates employment
- the death benefit is tax free
- the executive can use the cash value of
the policy to, among other things, supplement retirement income
(with a reduction in death benefit and possible tax consequences)
Benefits to the Employer
- Salary or bonus used to pay premiums represents
an ordinary and necessary business expense of the employer,
and, to the extent compensation is "reasonable" in the
aggregate, is tax-deductible under IRC section 162.
- The agreement does not have to be pre-qualified
by the IRS, nor is it subject to the annual reporting and disclosure
rules.
- There are no annual administrative costs
- the employer may freely select the executive(s)
it whishes to benefit and vary the benefit among the participating
executives.
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1 IRC Sec. 2001(c), 2010(c)
2 IRC Sec. 2001(c), 2010(c)
3 IRC Sec. 2001(c), 2010(c)
4 IRC Sec. 1(e)
For use with non-registered products
only. The annuity and insurance products described may be issued
by various companies and may not be available in all states. All
comments about such products are subject to the terms and conditions
of the annuity and/or insurance contract issued by the carrier.
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