PRINT -- Chapter 4
Executive Bonus Plans
The important points addressed in this lesson are:
Executive bonus plans are easy to understand and simple to administer
Executive bonus plans are often referred to as Section 162 plans since their tax-deductibility is referenced in Section 162 of the Internal Revenue Code
Bonuses play an important financial and emotional role in adding incentive compensation to executive compensation packages
Although the emphasis in executive bonus plans is on the death benefits provided, an executive bonus plan may provide substantial supplemental retirement income for the executive
By linking executive bonuses to quantifiable results, maximum business benefit may be obtained
The board of directors' authorization of the executive bonus plan can serve as the plan document
Universal life insurance is generally preferred for use in executive bonus plans because of its flexibility and easy cash value access
The tax deductibility of premiums in an executive bonus plan may cause employers to prefer them over other nonqualified plans
Portability and flexibility are important participant benefits in an executive bonus plan
The employer's premium payments in an executive bonus plan are currently taxable to the executive, but cash values grow on a tax-deferred basis
Distributions to the executive are taxable only to the extent that they exceed basis, and tax liability may be minimized or avoided depending on the strategy employed
The Why and How of an Executive Bonus Plan
Section 162 of the Internal Revenue Code is the section that states that an employer may deduct certain expenses-including salary and other compensation-that are ordinary and necessary business expenses. It is in reference to this Code section that certain nonqualified plans, known as executive bonus plans, are sometimes referred to as Section 162 Plans. In its simplest form, an executive bonus plan is one in which an employer pays the premiums on a permanent life insurance policy owned by an employee.
Employers often seek additional incentives to motivate their executives, and an executive bonus plan provides that facility. In addition, the life insurance policy that provides the vehicle for the plan enables executives to make additional premium contributions.
In addition to providing death benefits, the cash value in the policy may provide supplemental income at retirement. While the supplemental retirement income may be in addition to a qualified retirement plan, it may also be the only retirement plan that the employer offers-at least at the current stage of its development. As in all nonqualified plans, the executive bonus plan may simply be used by the employer to provide special treatment to a key executive in compensation for his or her contribution to the success of the company.
The employer's bonus in an executive bonus plan is accounted for as salary to the executive. As such, it is deductible to the employer (within the limits of reasonable compensation) and taxable to the executive. It is important to keep in mind that the premium payment made by the employer is deductible only because it is compensation, not because it is a nonqualified plan contribution.
The employer sponsoring an executive bonus plan may design it any way it chooses. Although it is not required, many employers try to tie bonus payments to the executive's meeting of pre-determined corporate goals. As a result, if the executive performs poorly he or she receives no bonus. If the benchmarks are met, the bonus can be substantial.
Not surprisingly, the bonus arrangement works most effectively when the business clearly identifies the results it will reward. The most effective goals are ones that:
Can be achieved within the period being measured
Cause the executive to stretch his or her talents, and
Are under the control of the executive
We will consider formulas, flat amounts and combination approaches that can be used in an executive bonus plan to help businesses achieve the results they are looking for when we examine how to design a bonus, later in this chapter.
The Board Resolution
Adjustments to management compensation are major expenditures. For that reason, establishing an executive bonus plan should be preceded by a resolution from the board of directors authorizing it.
To authorize the plan, the board should pass a written authorization that will:
Identify the plan participants by name
Clearly state the bonus is additional compensation that will purchase individual, permanent life insurance, and
Identify each participant as a member of a select group of corporate managers
The attorney for the employer should draft the board resolution.
The Life Insurance Sale
A life insurance policy is not the only financial vehicle that can fund an executive bonus plan. However, life insurance offers several benefits that may make it especially attractive.
Although any kind of permanent life insurance will generally work in an executive bonus plan, some policy types work better than others. Because of the flexibility that it brings to the plan, the most desirable life insurance product to use in funding an executive bonus plan may be a universal life insurance policy. Universal life insurance easily facilitates:
Bonus differences from year to year (making flexible premiums important), and
Access to cash value on a FIFO basis
In all executive bonus plan cases, the executive owns the policy and names the death benefit beneficiary.
Employer's Executive Bonus Plan Advantages
It should go without saying that a bonus plan must have advantages for all parties to it in order to be successful. The advantages to the employer of an executive bonus plan include:
Current tax deduction, and
An executive bonus plan is a nonqualified plan. As such, it permits an employer to select one employee or a class of employees to participate in the plan and exclude all others. For the employer, selectivity results in a reduction in costs, since wide participation is not required. An additional benefit results from the favorable impact that the plan has on the executive. Both the bonus nature of the compensation and the particular executive's selection may satisfy the executive's need to feel valued by the employer, and this feeling helps build employer loyalty.
Current Income Tax Deduction
Although an employer may avoid nonqualified plans because of its desire for a current income tax deduction, an executive bonus plan is an exception since the employer's premium payment is deductible as compensation.
The contributions made by an employer to the plan are deductible in the year in which the contribution is made. As compensation, the bonus is included in the executive's W-2 form and taxable as ordinary income.
Ease of Communication and Administration
The employer's job of communicating to the executive how the plan operates and its benefits is relatively simple. The premiums paid constitute compensation, and the policy explains the executive's rights and benefits. A possible complication to the overall plan relates to the method used to determine the bonus. Bonus design is an employer decision to be made as easy to understand as the employer chooses, and there are usually no government reporting or disclosure requirements to which the executive bonus plan must comply.
Executive bonus plan administration is as simple as its communication. For the employer's accounting, the bonused premium payment is just compensation, so the accounting done for salary payments also applies to the payment of premiums. There are typically no other administration requirements.
Executive's Bonus Plan Advantages
The executive advantages of an executive bonus plan outweigh the benefits to the employer and include:
The use of corporate dollars, and
Portability and flexibility
Unlike many employer-provided benefits, the executive benefits derived from the bonus plan don't end when the executive's service with the employer ends. An executive bonus plan provides additional life insurance benefits after his or her retirement. Although the bonuses end at the executive's retirement, death benefits may remain in force, subject to policy provisions. In addition, the executive may continue to pay premiums if he or she chooses, thereby increasing the cash values and, possibly, the death benefits.
The executive's modest cost is a distinct advantage and is limited to the tax liability on the bonused premium. An executive in a 28 percent marginal income tax bracket whose $10,000 annual premium is bonused by the employer would pay $2,800 in federal income taxes. Since the executive's cash value may have increased by $10,000 or more as a result of the premium payment, a $2,800 cost would represent considerable value. Often, however, the executive has no cost at all because the employer bonuses the tax that is due on the bonused premium payment in a double-bonus executive bonus plan.
Corporate Dollars Used to Meet Personal Needs
Executive bonus plans use employer funds to meet personal life insurance needs. Additionally, the policy's cash value is available for the executive to borrow against or withdraw funds from to meet any personal need.
FIFO income tax treatment enables the executive to withdraw funds tax free to basis. Basis is equal to the aggregate employer premiums on which the executive paid income taxes increased by any premium payments made by the executive.
Portable and Flexible
An executive bonus plan characteristic that is normally seen as an executive benefit is a disadvantage to the employer: portability. Specifically, an executive bonus plan moves with the executive. Although the employer would cease bonused premium payments, the cash value and death benefits would continue, subject to the terms of the policy.
The flexibility that is typical of a life insurance policy enables the policyowner to assign the policy and remove its death benefit from his or her estate. In addition, the executive may make a gift of the policy to children or assign it to an irrevocable life insurance trust to exclude it from his or her federal gross estate.
Executive Bonus Plan Disadvantages
There is probably no plan that is entirely free of disadvantages. The disadvantages associated with an executive bonus plan include:
For the executive, the disadvantage of an executive bonus plan is the required current recognition of income
For the employer, the disadvantages include:
Loss of control over the policy and its values
Inability to recover plan costs
Structuring the Plan
Designing the bonus is limited only by the employer's imagination. In general, the simpler the plan design, the more effective the plan is likely to be. Since no government approval is required, the bonus structure may be changed, as needed, to meet the employers objectives. The basic approaches to executive bonus plan design may involve the following:
A formula method
A flat amount/flat percentage method, and
Employers that are trying to further business goals through their bonus plans usually want to tie the amount of bonus to the executive's meeting agreed-upon benchmarks. A sales executive's goals, for example, may include a particular level of sales growth in the coming year, and the bonus could be established at a certain percentage of that growth.
Similar formulas may be developed for executives responsible for production and other functions that can be quantified. The rationale behind the formula approach is that it pays for results. As such, it is not only fair but also one to which both employers and employees respond positively.
Flat Amount/Flat Percentage Method
Although a formula approach is highly desirable, it is not the only acceptable method for designing bonuses. A flat amount method may be used when there are few participants or when the employer wants benefit or contribution equity. Two basic variations in the flat amount method of executive bonus plan design exist:
Defined contribution, and
In a defined contribution approach, a flat amount of bonus is determined for all years and may be:
the same amount for all participants
the same amount for all participants in a particular class, e.g. all vice presidents
the same percentage of base compensation for all participants, e.g. 5 percent for all participants , or
the same percentage of base compensation for all participants in a particular class, e.g. 5 percent for all vice presidents.
As in all defined contribution type plans, the value available to the executive at retirement determines the income that the executive may receive.
In a defined benefit approach, an income to be paid at retirement is determined by the employer. For example, the retirement income determined might be:
the same amount for all participants, e.g. $25,000 per year for 10 years;
the same amount for all participants of a certain class, e.g. all vice presidents receive $25,000 per year for 10 years, and all senior vice presidents receive $35,000 per year for 10 years;
the same percentage of final compensation for all participants; or
the same percentage of base compensation for all participants of a certain class, e.g. 5 percent for all vice presidents, and 7.5 percent for all senior vice presidents.
Under this approach, a calculation is made for each participant to determine the premium level that will provide the promised retirement benefit. Because of the substantial level of complexity that is added, employers generally prefer the defined contribution approach.
Vesting-as that term is used in qualified plans-is not applicable to executive bonus plans. Nonetheless, by specifying in the resolution authorizing the plan that the bonus is to be used only for the purchase of permanent life insurance, the employer has the assurance that the bonus will be used for that purpose.
There is a "golden handcuffs" aspect to an insured bonus plan to the extent that the executive will become accustomed to the insurance coverage, will want the retirement benefit, and may carefully consider the value of the benefit when other employment opportunities arise. Also, although somewhat unusual, an employer may restrict the executive's rights to the policy by limiting cash value access only after a period of time specified by the employer.
Funding the Plan
Insured executive bonus plans are funded by a permanent life insurance policy, and any type of policy may be used. However, one type of life insurance plan may be more appropriate than others depending on the formula used.
A plan with a bonus formula under which a bonus is payable only if certain objectives are met probably ought to be funded with universal life insurance because of its premium flexibility. Even though a whole life insurance policy with an attached rider designed to accept premiums in excess of the policy premium can offer some flexibility, it is difficult to approximate universal life insurance flexibility in any other life insurance policy design. Furthermore, the easy access to cash values by withdrawal helps make universal life insurance the preferred policy.
The employer or participant may choose declared-rate universal life insurance, equity-indexed universal life insurance or a variable universal life insurance policy. That choice typically depends on risk tolerance level. If premium flexibility is not a concern and the participant wants substantial guarantees, a whole life insurance policy may be the right choice.
A deferred annuity may also be used as a funding alternative for an executive bonus plan, especially for the uninsurable executive. Despite their lack of a substantial death benefit and FIFO tax treatment, annuities can be issued to any executive, regardless of health and may produce larger cash values than permanent life insurance.
Plan Tax Treatment
Tax treatment of an executive bonus plan is quite simple. Any bonus paid is includable in the executive's gross income as compensation, whether the employer pays the life insurance premiums on a policy owned by the executive or pays the executive a cash bonus. The cash value of the policy is tax-deferred.
Revenue Ruling 58-90, 1958-2 C.B. 88
Revenue Ruling 58-90 discusses IRC Section 162 related to executive bonus plans and permits a tax deduction for employer-paid premiums or bonuses if the: 1. payment of the premiums or bonus is in the form of additional compensation 2. total amount of compensation to the executive is not unreasonable and 3. employer is neither a direct nor indirect beneficiary of the life insurance policy The last requirement is particularly significant since it appear to prohibit an employer from any form of cost recovery in an executive bonus plan.
Income Taxation of Distributions
The participant in an executive bonus plan may access the policy's cash value at any time and for any reason. Although the policy may impose charges-surrender charges, for example-there is no IRS penalty due to taking a loan or withdrawal. The taxation of any gain may depend on the method used by the executive to access policy values. Three methods are available to access a universal life policy's cash values:
Cash surrender the policy
Take a withdrawal from the cash value, or
Surrender the policy and take the proceeds in a settlement option
If the participant surrenders the policy for cash, any surrender proceeds in excess of the sum of the employer's bonused premium payments plus the participant's additional premium payments are taxable as ordinary income. The surrender proceeds equal to the premiums paid are received tax free as a recovery of basis.
If the participant takes withdrawals from the cash value, he or she will have no taxable income until the total withdrawals exceed the policyowner's cost basis. So, the participant may take withdrawals until his or her entire basis is recovered and then switch to policy loans in order to continue to receive tax-free distributions.
If the participant surrenders the policy and takes the proceeds in a periodic payment settlement option, part of each payment will be tax-free as a recovery of his or her basis. The balance of the periodic payment is taxable as ordinary income. Once the participant's entire basis has been recovered, any further periodic payments are fully taxable.
One of the principal advantages of executive bonus plans arises out of their simplicity. As a result, they are easy for both employers and participants to understand and uncomplicated to administer. The simplicity of the plan extends to its documentation, and the resolution of the board authorizing the establishment of the executive bonus plan may serve as the plan document.
For the employer, executive bonus plans have the added attraction of their contributions being tax-deductible. These contributions are not tax-deductible as plan contributions but, rather, as compensation paid to the executive. Since the premium payments made by the employer constitute executive compensation, they are taxable as income to the participant in the year made.
Bonuses play an extremely important role in the executive's identification with the employer and in gaining a sense of his or her value in the employer's eyes. Furthermore, through the linkage of goal attainment and bonus payment, significant business benefits may be obtained. Unlike many nonqualified benefits, the executive bonus plan is portable. While this aspect of these plans may not be seen as an advantage by employers, executives view portability as an important advantage in a business environment characterized by increased employee movement.
Universal life insurance, although not the only plan that may provide the basis for an executive bonus plan, is generally preferred both for its premium flexibility and the executive's easy access to the policy's cash value. The executive may access the cash value at any time, and, as long as the policy is not considered a modified endowment contract, withdrawals are received tax-free to basis.
An executive bonus plan's bonus structure may be designed in a wide range of ways using either a defined contribution or defined benefit approach. While the defined benefit approach offers certain benefits, it tends to be far more complicated than the defined contribution method and is, therefore, seldom utilized.