TAXATION OF AN EXECUTIVE BONUS PLAN
Employer Income Tax Issues
Internal Revenue Code Section 162 determines the deductibility of a business expense. It sets out three requirements that must be met for an expense to be deductible:
ordinary and necessary;
paid or incurred by the employer; and
paid for services actually rendered.
Ordinary and Necessary
The first requirement of deductibility is that the expense be ordinary and necessary, which means that the expense must occur in the usual course of business and must be necessary or helpful in the furtherance of the goals of the business. Notice that there is no requirement that the expense be essential. The ordinary and necessary requirement includes the reasonableness of compensation test.
Paid or Incurred
The second requirement is an accounting requirement that the bonus must either be actually paid or incurred in the year in which it is deducted.
Services Actually Rendered
In order for expense payments to be deductible, they must pass the actually rendered test. In terms of the executive bonus plan, the executive bonus must be in payment for services actually rendered to the employer and must be incurred in a trade or business. Thus, an employment relationship is necessary.
An attempt to include a non-employee shareholder in an executive bonus plan would have adverse tax consequences for both the organization and the shareholder. A shareholder who is not an employee, if paid a bonus under an executive bonus plan, would be considered to have received a dividend. The dividend would not be income tax-deductible to the corporation and would be taxable to the recipient.
Executive Income Tax Issues
The rule concerning bonus taxability for the executive is simple. Whether the employer pays the life insurance premiums on a policy owned by the executive or pays the executive a cash bonus is immaterial. The amount of the bonus is includable in the executive's gross income as compensation for services.
Growth on Contributions Tax-Deferred
Although the executive is required to recognize the premium payment made in an executive bonus plan as currently taxable compensation, the premium payments grow inside the life insurance policy on a tax-deferred basis.
Revenue Ruling 58-90
Revenue Ruling 58-901958-2 C.B. 162 concerns IRC Section 162 as it relates to executive bonus plans. This ruling allows deductions for employer-paid premiums or bonuses:
if the payment of the premiums or bonuses is in the form of additional compensation;
if the total amount of compensation to the executive is not unreasonable; and
if the employer is neither a direct nor indirect beneficiary of the life insurance policy.
Thus, unlike a salary continuation or deferred compensation plan, an executive bonus plan cannot use any form of cost recovery.
Income Taxation of Distributions
An important aspect of an executive bonus plan is the wide range of options it affords the executive. Many executives choose to keep the life insurance policy in force beyond their retirement to provide funds for any of the personal needs they have, such as providing survivor income or paying estate settlement costs. However, the executive bonus plan participant may choose to access the life insurance policy's cash value in order to supplement his or her retirement income or for any other purpose. How the executive accesses those values dictates how any gain is taxed. Generally, there are three methods of accessing policy cash values:
surrender the policy for cash;
withdraw cash from the cash value; or
surrender the policy and take the cash value in periodic income payments.
However the executive accesses his or her policy's cash value, income tax liability will be based on the executive's cost basis in the policy, generally equal to the sum of the after-tax premiums paid for the policy less any dividends or other excludable amounts received by the executive. In the case of an executive bonus plan, all premiums paid by the employer that were recognized by the executive as taxable income are included in the executive's cost basis.
Surrendering the Policy for Cash
If the executive surrenders the life insurance policy for cash, the entire cash surrender proceeds constitute taxable income to the extent that the proceeds exceed the executive's cost basis. The income thus recognized is taxed at ordinary income rates.
For example, let's suppose that Bill Simpson, an executive at DotCom, Inc. received a bonus of $10,000 under an executive bonus plan in which he participated for 30 years. At his retirement, Bill's policy cash value is $800,000. Each year, when the policy premium was bonused, Bill included the $10,000 in his gross income for tax purposes. Since Bill's policy is non-participating universal life insurance, he received no dividends that would reduce his cost basis, nor did he take any policy loans or withdrawals. So, Bill's cost basis is $300,000. ($10,000 x 30 years = $300,000)
If Bill surrenders his life insurance policy, he will receive $800,000 in cash. However, $500,000 of that amount represents previously-untaxed gain in the policy. That untaxed gain is fully taxable as ordinary income in the year in which the surrender occurred. If Bill is in a 31 percent marginal income tax bracket in the year of surrender, his federal income tax liability attributable to the surrender will be $155,000. ($500,000 x .31 = $155,000) For many retiring executives, the option of taking the cash value through policy surrender may be an expensive one.
Taking Policy Withdrawals
Bill can significantly improve his income tax position by pursuing a different strategy. As long as the life insurance policy is not a modified endowment contract (MEC), Bill can withdraw an amount equal to his cost basis-$300,000 in this case-entirely income tax-free. This is considered a recovery of his costs.
Life insurance policies enjoy an income tax treatment of withdrawals known as FIFO, which stands for "first-in, first out". Since premiums are considered to be placed in the policy before any gain accrues, the premium is the first to be removed in a withdrawal under FIFO tax treatment.
Modified Endowment Contract
A life insurance policy is deemed a modified endowment contract (MEC) if the accumulated premium amounts the policyowner paid under the contract during the first seven policy years exceed the sum of the net level premiums that would have been required (on or before such time) if the contract provided for paid-up future benefits after seven level annual premiums.
If the life insurance policy is an MEC, the tax treatment is LIFO (last-in, first-out), and the gain is deemed to be withdrawn first.
So, Bill may take the entire $300,000 out of the policy in a single sum without incurring any income tax liability. Alternatively, he may take successive withdrawals of a lesser amount, and, when the total withdrawals equal his cost basis, subsequent withdrawals are fully taxable as ordinary income in the year in which the withdrawal is taken.
The tax-efficient strategy of taking policy withdrawals often includes a switch to policy loans when the total withdrawals equal the cost basis. Since policy loans are not considered distributions (except in the case of an MEC), Bill may access the remaining $500,000 by taking policy loans without incurring any income tax liability-even though his cost basis has been exceeded by the total of withdrawals plus loans. Subsequently, when Bill dies and the death benefit is paid, less any policy loans or withdrawals, the entire death benefit is received income tax-free.
Although the withdrawal-policy loan strategy works extremely well in enabling the policyowner to avoid income taxation, it should be used only if the policyowner understands the tax treatment on surrender. The problem is that the policy loans received tax-free in excess of the executive's cost basis become taxable on surrender of the policy.
Let's look at what could happen to Bill if he pursues the policy withdrawal-policy loan strategy and then allows the policy to lapse. Since Bill has recovered his entire cost through withdrawals, any cash value that he receives in excess of that cost basis is taxable. When the policy is subsequently surrendered or, in Bill's case, is permitted to lapse, the total policy loan amount is considered surrender proceeds. Since the gain on the policy is $500,000, the total gain will be considered taxable. As we noted above, if Bill is still in the 31 percent marginal tax bracket, the tax liability will be $155,000. Unfortunately, there are no further policy proceeds with which to pay the tax bill. The moral of the story is clear: when using a withdrawal-policy loan strategy, the policy must never be surrendered or permitted to lapse.
Taking Periodic Income Payments
At retirement, Bill may surrender the policy and choose one of the several available settlement options. Under the annuity rule that governs the income taxation of periodic payments, the portion of each installment which represents the premiums paid, less any dividends withdrawn by Bill, is received income tax-free as a return of his investment in the contract (also known as his cost basis). The balance of the income is taxable to Bill as ordinary income.
If a life income option is chosen, Bill divides the total investment by his life expectancy to determine the amount of each payment that is excluded from his income. If Bill chooses a fixed period or fixed amount option, the total investment is divided by the period over which Bill receives the income.
Executive Estate Taxation
Death benefits payable to a named beneficiary are income tax-free. However, if Bill owns the policy or has any incidents of ownership in the policy at his death, the policy will be included in his estate for tax purposes. If Bill's estate is the beneficiary of the policy, all proceeds will be included in the executive's estate for both distribution and estate tax purposes.