Section 162 executive bonus plans represent a potential flexible and tax-effective way of rewarding key executives. So named because of Section 162 of the Internal Revenue Code, the plans enable companies to treat bonuses as ordinary income, which is deductible as a business expense while the executives pay income tax on the bonus amount received.

In contrast to stock options or stock grants, Section 162 plans can provide immediate financial rewards and allow for annual flexibility, thus potentially constituting an effective mechanism for recruiting and retaining key executives. Further, the plans tie executive compensation to corporate objectives, encouraging executives to generate overall success. 

Mechanism of Section 162 Plans

In a Section 162 executive bonus plan, a company offers bonus compensation to chosen executives. The bonuses may be tied to performance goals, company profitability, personal objectives, or merely a fixed amount over a specified number of years. The plans are not based on corporate financial performance, like profit-sharing or equity-based compensation, so companies have complete control over the design.

After the agreement is established, the employer finances the bonus and pays the premium to the insurance company for a personally owned life insurance policy held by the executive. Over the long run, the executive can use the policy's cash value to supplement their retirement income, and the death benefit is transferred to their beneficiaries tax-free as long as the policy remains in force.

Taxes and Administration

From a tax perspective, the business receives an income tax deduction for the bonus, while the executive must pay tax on the amount received. Compared to other executive compensation structures, these plans are straightforward to implement, require minimal administrative work, and do not need to be filed with the IRS.

For companies that might not have the budget to provide more elaborate executive benefits packages, Section 162 plans offer an affordable option that is still an effective retention and recruitment strategy. Moreover, since the executive takes over the responsibility of the policy if they depart, it provides an incentive to remain with the firm. 

Structuring a Section 162 Plan

A Section 162 plan can be structured in two ways:

Single-Bonus Arrangement

·         The company offers a bonus equivalent to the life insurance premium.

·         The executive pays the taxes on the bonus personally.

Double-Bonus Arrangement

·         The company offers a bonus for both the insurance premium and the taxes the executive owes.

·         This renders the arrangement tax-neutral to the executive.

·         The entire bonus is still deductible to the company. 

Advantages of a Section 162 Plan

To the Executive:

·         Offers life insurance coverage at a lower or no out-of-pocket expense.

·         If designed as a double-bonus, the executive does not have to pay income tax on the bonus from personal funds.

·         Complete ownership and control of the policy from day one.

·         The potential to access policy cash value as a supplemental retirement income source.

·         Death benefit proceeds are transferred to beneficiaries tax-free.

For the Business:

·         Immediate tax deduction for every bonus payment.

·         Assists in retaining key executives by linking benefits to employment.

·         Simpler and less expensive than complicated non-qualified plans.

·         No IRS filings or regulatory compliance beyond standard tax reporting.

The Restricted Executive Bonus Plan

This arrangement retains the ease and simplicity of the basic Executive Bonus Plan but includes an added measure of employer control.

• The employer and employee formally agree that the employee’s access to policy cash values will be restricted until a specific event occurs—typically after the employee has worked a certain number of years for the employer, at which point all restrictions cease.
• The employee agrees to elect the “Select Security Rider” for the policy.

The Select Security Rider is the formal document that restricts the employee’s access to cash values. The rider language states that it cannot be removed without the employer’s consent.

The employee must fulfill all obligations under the contract (i.e., work the requisite number of years). Once fulfilled, the employer will sign the revocation of rights required by the Select Security Rider. If the employee quits or is fired for cause before the required period of employment ends, damages in a stated sum may have to be paid to the employer. At that point, the employer will agree to have the rider removed. 

Choosing the Appropriate Life Insurance Product

Any life insurance product can be used in a Section 162 plan, including term insurance. However, for executives looking to accumulate cash value, permanent life insurance products such as whole life or universal life are typically preferred. These products not only provide a death benefit but also allow the executive to build a pool of tax-advantaged cash value for retirement income¹. 

Hypothetical Case study 

Among other benefits, Ben has provided his top executive, Mark, with a 401(k) plan. As Mark gets closer to retirement, he continues to contribute the maximum amount allowed to his 401(k) account. But even with the additional “catchup” contributions that Mark is eligible to make to his account beginning at age 50, he isn’t sure if he’ll be able to meet his retirement income goals, so he considers an offer of employment from one of Ben’s competitors. Ben doesn’t want to lose a key employee like Mark. That’s why, as an additional incentive, Ben offers Mark a whole life insurance policy. Because Ben’s company pays the bulk of the premium, Mark can afford to put more of his own money into the policy for a potentially greater buildup of the policy’s cash value. This gives Mark a valuable life insurance policy, as well as a benefit that can help him supplement his retirement income. As the business owner, Ben receives an income tax deduction on the bonus amount and more importantly, manages to retain one of his company’s most valuable executives.

This material is intended for general public use. By providing this content, The Guardian Life Insurance Company of America, and their affiliates and subsidiaries are not undertaking to provide advice or recommendations for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact a financial representative for guidance and information that is specific to your individual situation. Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. ¹Some whole life polices do not have cash values in the first two years of the policy and don’t pay a dividend until the policy’s third year.

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