Executive Bonus Plans Can Be Important Strategies For Retaining Top Executives
by Kevin Marty
Many business owners would agree that their company’s most valuable asset is its people, particularly key executives who provide leadership, specialized knowledge and skills which contribute significantly to the bottom line.
Bonus Plans can Help Retain and Recruit Top Talent for Your Company
To claim a deduction, Section 162 requires the bonus must be:
an ordinary and necessary expense that was
paid or incurred during the taxable year
in providing a trade or business activity. (A)
- Providing needed coverage at little or no cost to the employee.
- Offering an income tax free death benefit for their beneficiaries.
- Becoming a potential source of retirement income. (B)
Tax-Free Exclusion
Using the Section 162 executive bonus plan, the company simply provides a bonus to the insured. The bonus is, of course, taxable as income to the insured, but it is tax deductible to the company. The death benefit retains its tax-free status.
This tax-free exclusion also extends to death benefits made under modified endowment contracts (MECs), worker’s compensation insurance contracts, or accident and employer-provided group health insurance contracts.
The IRS has deemed that if life insurance premiums are deducted as a business expense, the death benefit becomes taxable.
Generally, it’s possible to withdraw limited amounts of cash from a life insurance policy. The amount available differs based on the type of policy and the company issuing it. The main advantage of cash-value withdrawals is that they are not taxable up to your policy basis, as long as your policy is not classified as a modified endowment contract.
Any pre-death distributions are taxed as income first – not basis first – meaning they are taxable to the extent of gain in the policy (c).
Easy to Set Up
Executive bonus plans are usually easy to implement. Instead of the company paying the premium, the company provides the key executive with a bonus that is considered taxable as income. The bonus is a form of compensation to the executive/employee, and it is tax deductible to the company. This can be done selectively for the employee(s) of the company’s choosing.
Executive bonus plans often come with favorable loan provisions.
Cash value loan provisions under code section 7702 enable tax-free retirement income.
Plan designs can be customized for the key executive(s) with various riders.
The Executive Maintains Control
The executive maintains a high level of control because the policy is owned by him or her. The company sets the budget and lets the executive select the life insurance plan. Any tax due on the bonus can be covered by an additional bonus from the company (see “Plan Variations” below. ) The key executive selects the beneficiary and allocation of the assets. The executive chooses when to make retirement withdrawals. One strategy the employee might use is to select a dividend-paying whole life policy. (B)
Executive Bonus Plan Variations
Double bonus arrangement: The key executive is provided with a bonus large enough to pay the life insurance premiums as well as the income taxes incurred.
Controlled executive bonus: The company and the executive enter into a vesting schedule agreement on the policy’s cash-value growth. The vesting schedule allows the company to control the availability of the cash value until the executive has fulfilled the terms of the agreement.
Other Considerations
While an executive bonus plan can be a viable key employee retention strategy, there are other factors to consider:
The company is unable to recover its costs from the policy’s death benefit, since it is the key executive who names the policy beneficiary.
The bonus is never recovered by the company, even if the executive leaves the company.
The key executive must include any bonus in his or her taxable income.
Without additional planning, the life insurance policy’s death benefit will be included in the executive’s taxable estate.
Experts Agree: Bonus Plans and Benefits Help You Retain Your Best Executives
A comprehensive benefits package is among the most important factors for keeping and attracting top talent, according to a study from the Harvard Business Review Analytic Services research unit. “If your best executives and employees feel like you are taking care of them, they are going to be more engaged and loyal,” Alex Clemente, managing director of HBR Analytic Services, tells Business News Daily. While small businesses might not be able to afford all of the costs associated with large scale benefit plans, which often include life insurance and even local gym memberships, Clemente says being able to offer some of them selectively is a plus. (d)
(a)Source: IRC Section 162