ADVANTAGES OF EXECUTIVE BONUS PLANS


Advantages for the Employer

For any plan to be workable over the long-term, it must be advantageous to all parties. We will discuss the advantages, as well as the disadvantages of executive bonus plans to both the executive and employer. Let's start by looking at the advantages that an employer can expect to receive by installing an executive bonus plan.


Selectivity

Not unlike nonqualified plans, an executive bonus plan allows an employer to include a single employee or a class of employees in the plan and exclude all other employees. The selectivity provided by an executive bonus plan affords clear advantages to the employer.

The most obvious advantage is that, since the employer is not required to include other employees (as it would be in a qualified plan), the plan costs are reduced. A less obvious-but equally important-advantage is the favorable impact that an executive bonus plan has on the executive. Although the bonus nature of the compensation is certainly motivating, the fact that the particular executive has been selected by his or her employer for special compensation and treatment satisfies the executive's need to feel important and helps build loyalty. The executive bonus plan thus enables the employer to reward the key executive both financially and emotionally.


 Current Income Tax Deduction

One of the initial employer concerns about nonqualified plans is that they do not qualify for a current employer income tax deduction since they fail to meet the nondiscrimination, participation and other ERISA qualified plan requirements. The executive bonus plan does not present this obstacle to the sale.

Employer contributions to an executive bonus plan are deductible from the employer's income in the year in which the contribution is made. The reason that the employer receives the current tax deduction is because the premium paid for the executive-owned life insurance is considered current compensation to the executive, rather than a contribution to a nonqualified plan. As compensation to the executive, the amount of the bonus is included in the executive's W-2 statement of earnings and taxable as ordinary income.


Ease of Communication and Administration

Communicating the operation and benefits of a basic executive bonus plan to an executive is a simple matter. Premiums paid are compensation, subject to ordinary income taxation, and the life insurance policy details the executive's rights and benefits. The only area in which communication may be problematic relates to the method-if any-in which the bonus is determined. That, however, is entirely within the control of the employer.

Plan communication requirements are not solely in relation to the plan participant, however; reporting and disclosure requirements may also apply. As we will discuss at greater length later in this course when we examine ERISA requirements, there are no government reporting or disclosure requirements that apply to the typical executive bonus plan.

Administration of an executive bonus plan is equally simple. From the employer's perspective, the bonused premium payment is nothing more than compensation, identical to the executive's salary. The accounting that applies to salary also applies to the premium payment. Other than furnishing the plan document (usually the resolution of the board of directors), if requested, to the Department of Labor there are no administration requirements.


 Advantages to the Executive  
Post-Retirement Benefits

From the viewpoint of the executive, one of the drawbacks of many employer plans is that benefits end when the executive's service ends. Consider some of the major employee benefits. Group health, life and disability insurance all generally cease at the time the executive retires. Not so the benefits of an executive bonus plan.

Not only does an executive bonus plan provide additional life insurance benefits during the executive's years as an employee of the firm, those benefits continue at his or her retirement. While the bonused premium payments would cease at retirement because the executive was no longer an employee, the death benefits would remain in effect, subject to the provisions of the policy. Furthermore, the executive could continue to pay premiums if he or she chose. Whether or not the executive personally pays premiums following retirement, the policy-unlike many other employer-provided benefits-may continue to protect the executive's family.


Limited Cost

Executive cost is another advantage. The cost to the executive is limited to the income and Social Security tax paid on the bonused premium. In many cases, an executive in a 31 percent marginal income tax bracket whose $10,000 annual premium is bonused would pay $3,100 in federal income tax and $145 for the HI portion of Social Security.  (The executive's total compensation will exceed the Social Security taxable wage base for OASDI contributions of 6.2 percent.) Considering that the executive's cash value may have increased $10,000 or more by virtue of the premium payment, a cost of only $3,245 would seem to represent outstanding value.

In many cases, however, the executive's cost may be zero. This is achieved through a double bonus, by which the employer bonuses not only the premium but also the tax due on the premiums.




Corporate Dollars Used to Meet Personal Needs

In an executive bonus plan, the funds used to purchase the life insurance policy are employer funds. In addition to allowing the executive to meet family life insurance needs with corporate money, the policy values are available to the executive at all times to borrow or withdraw for family emergencies, tuition, retirement or any other reason.

To understand the significant potential that an executive bonus plan has for developing supplemental cash for the executive, let's look at the cash value resulting from an executive bonus plan begun when the executive was 35 years old and that provided for a $10,000 bonus each year. By the time the executive retires at age 65, the policy's cash value is approximately $800,000, based on conservative current universal life crediting. If he or she so chose, the executive could withdraw $300,000 in a single sum without any income tax consequences and could continue to enjoy tax-free access by subsequently borrowing from the cash value.

The FIFO tax treatment afforded life insurance permits the executive to withdraw funds entirely tax-free up to basis, and basis is equal to the total premiums paid by the employer into the policy. (If the policy is considered a modified endowment contract, FIFO tax treatment is forfeited, and LIFO tax treatment takes its place, causing withdrawals to be taxed on an income-first basis.)


 Portable and Flexible

Just as corporate benefits are often lost when an executive retires, they also are lost when he or she moves on to another employer. In an executive bonus plan, however, the life insurance policy is portable and generally moves, in its entirety, with the executive. The former employer would cease making premium payments, of course, but the cash value and death benefits would continue, subject to the terms of the policy.

A life insurance policy also gives the policyowner a certain flexibility, regardless of the type of policy. Part of that flexibility has to do with policy ownership. Specifically, a policyowner may assign the policy and remove its death benefit from his or her estate. Since the executive owns the policy in an executive bonus plan, the executive may gift the policy to children or assign it to an irrevocable life insurance trust and, provided the transfer is made at least three years prior to death, the life insurance proceeds will be excluded from his or her estate for tax purposes.