Module 3: EXECUTIVE BONUS
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One of the concerns that business owners often have concerning benefit plans is that they are complicated and burdensome to administer. Unquestionably, in the case of certain benefits, that concern is justified — just consider the job of administering a defined benefit pension plan.
In this Module, we will consider a benefit plan that, in simplicity and ease of administration, is about as far from a qualified plan as possible. Despite that simplicity, however, this benefit plan meets a number of important executive and business objectives.
Upon completion of this Module, you should understand:
executive bonus plans and the reasons companies provide them to executives;
the criteria to be used in setting goals for the achievement of a bonus;
how a board of directors authorizes an executive bonus plan;
why life insurance is a suitable financial vehicle for funding executive bonus plans;
the advantages and disadvantages of executive bonus plans to employers and executives;
who can and should participate in an executive bonus plan;
how to design an executive bonus plan to achieve specific objectives; and
the taxation issues involved in executive bonus plans for both the employer and the executive.
Fundamentals of an Executive Bonus
The word bonus is important to executives. In certain professions, a year-end bonus may be as large as or larger than an executive's annual salary. Regardless of whether the bonus an executive receives is a blockbuster or something more modest, it sends a message:
"You are responsible for the success of this organization, and this organization believes that you should participate in its rewards".
No matter where the executive is in the hierarchy, this message is a powerful incentive to do an even better job next year.
Executive bonus plans are often referred to as Section 162 Plans because this section of the Internal Revenue Code states that an employer may deduct all ordinary and necessary business expenses including a reasonable allowance for salaries or other compensation for personal services actually rendered. (Section 162 establishes limits on the amount of compensation that may be deducted by employers as a business expense — generally speaking, $1 million). Section 162 provides the legal basis for the income tax deduction of bonuses and other compensation that is paid.
An executive bonus plan is an arrangement under which an employer pays the premiums on a permanent, cash value life insurance policy. Although the employer pays the premiums, the executive-not the employer-owns the life insurance policy. The basic executive bonus plan is simplicity itself. It is in the application of the plan that some complexity enters the arrangement.
The need for an executive bonus plan often arises out of an employer's desire to add a certain extra incentive to its executive compensation. Sometimes this is coupled with the employer's desire to provide death protection for its executives, give its executives an opportunity to make contributions and give itself a current income tax deduction. The executive bonus plan does all of those things.
Although the emphasis in an executive bonus plan is on death benefits, the policy's cash value also may provide additional retirement income for an executive. That income may supplement an existing qualified retirement plan or represent the only retirement program offered by the employer-not an uncommon situation in young companies in which sufficient, stable earnings may not be available. Even if a qualified plan is installed, the employer may wish to single out one or more key executives for special treatment, reflecting their contribution to the enterprise.
In an executive bonus plan, the employer makes a premium payment on a permanent life insurance policy and bonuses the premium payment amount as salary to the executive.
Although an employer may design the bonus arrangement in almost any fashion, including agreeing to pay an annual premium amount without regard to business results, the maximum business benefit often is obtained by tying the granting of a bonus to the executive's achievement of particular benchmarks.
What this means is that if the executive doesn't perform well, he or she receives little or no bonus. Making such a bonus arrangement work in the business requires that the employer identify the results that it wants to reward.
Let's assume that the employer's objective is to achieve sales growth of 20 percent—from an existing $10 million to $12 million—for the current year and it looks to its Sales Vice President to make that growth happen.
The employer could provide no bonus for achieving the first $10 million of sales, 1/2 percent bonus for the next $1 million and 1 percent for every additional $1 million of sales in excess of $11 million.
A similar approach can be used in areas other than sales. For example, the bonus for the Production Vice President may be based on a 10 percent increase in output that meets existing quality control standards.
The bonus, if based on the meeting of some goal or objective, should be based on criteria that:
stretch the individual and his or her area of responsibility; and
are within the executive's control.
It would make no sense and would be counterproductive to base the sales officer's bonus on production or the production manager's bonus on sales.
When we discuss bonus design later in this course, we will look at formulas, flat amounts and combination approaches that help businesses to achieve results that they may never have thought possible. The key to making the bonus arrangement attractive to the employer usually lies in determining the objective that the employer wants to achieve and providing a bonus for it.
The board of directors of a company should authorize major expenditures that may be outside of the routine, day-to-day expenses incurred by the business. Management compensation adjustments, such as executive bonuses, are such major expenditures.
In order to authorize an executive bonus plan, the board of directors should pass a written authorization. The authorization should:
identify the specific executives who will participate;
state that the bonus is intended as additional compensation to each named executive;
state that the bonus will be used to purchase individual, permanent, cash value life insurance (unless the key executive is uninsurable);
establish that each participating executive is a member of the select group of corporate management (so that the favorable ERISA provisions will apply); and
define the claims procedure.
The resolution should define the claims procedures to meet plan document requirements for ERISA. According to ERISA requirements, the procedure must call for providing written notice in the event of a claim denial and an opportunity for a beneficiary to receive a full hearing. Because of the nature and operation of an executive bonus plan, the claims procedure requirement is somewhat academic. In other words, an insured bonus plan should be established only for the select group in order to avoid ERISA reporting and disclosure requirements.
Corporate counsel should draft the board resolution. Even if the financial professional recommending and installing the plan is an attorney, he or she should resist the impulse to prepare any documents used to authorize or install the plan. A separation of these activities helps to avoid any appearance of a conflict of interest.
Use of Life Insurance
Although other financial vehicles may be used to fund an executive bonus plan, life insurance provides a substantial number of benefits and tax advantages that make it particularly suitable. Any type of individual, permanent life insurance policy may be used as the funding vehicle in an executive bonus plan. Certain policy types may work better in plans whose bonus amount may vary from year to year. In many cases, the most desirable product is a universal life insurance policy. While the individual policy used may provide for cash value growth on a declared-rate, equity indexed or variable basis depending on the particular executive's investment risk tolerance, the use of universal life insurance more easily adapts to:
variations in premium deposits; and
tax-advantaged access to cash value through withdrawals.
Irrespective of the type of policy used, the executive owns the policy, names the beneficiary (which should not be the employer) and chooses the appropriate settlement option.
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.
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 for the Executive
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.
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.
Disadvantages of and Executive Bonus Plan
Full and fair disclosure is an important aspect of suitability. In practical terms, this means that the financial professional is expected to make a balanced presentation to the prospect of both the advantages and disadvantages of any recommendation. While the executive bonus plan has many advantages for both the executive and the employer, there are certain disadvantages that need to be acknowledged.
For the executive, the only significant disadvantage is the required current recognition of income. Although the income tax liability on the growth realized in the cash value is deferred, the executive is required to recognize current income equal to the bonused premium payment each year.
The disadvantages for employers are considered more significant. An important disadvantage is the loss of control over the life insurance policy and its values. Since the executive is the policyowner, the employer's control is limited to the premium payment.
The employer may reduce the current bonus-or pay no bonus at all-but the life insurance policy and its values, paid for by previous bonuses, are entirely under the control of the executive. Accordingly, as a vehicle to retain executives, an executive bonus plan offers only the carrot of possible future contributions without the stick of benefit loss in the event of termination.
A second employer disadvantage of executive bonus plans is their inability to provide for employer cost recovery. As we will examine in our discussion of split-dollar and deferred compensation, the possibility of employer cost recovery makes these plans particularly attractive in the proper situations. Unfortunately, employer cost recovery is not a feature of executive bonus plans.
The final employer disadvantage of executive bonus plans relates to its general tax inappropriateness for sole proprietors or owners of S corporations. Since in both of these organizations there is no distinction between the owners' income tax bracket and the income tax bracket of the employer-both organizations being tax conduits-there is no tax benefit arising from the difference in tax brackets. Executive bonus plans may be used in both of these organizations for non-owners, however. A sole proprietor may derive all of the advantages of any employer offering an executive bonus plan to its non-owner executives.
Who should be included in an executive bonus plan? Should it be an owner? What about rank and file employees? Does the type of organization matter in the decision to implement an executive bonus plan or in choosing its participants? These are important questions, and we will offer insight in arriving at their answers.
An executive benefit plan is considered an employee welfare benefit plan under ERISA since it provides death benefits in addition to any other benefits it provides. Based on that fact alone, an insured bonus plan is subject to the reporting and disclosure requirements of ERISA. However, there is an important exception to these requirements.
If the executive bonus plan includes only highly compensated employees or applies only to a select group of management employees, it is exempt from all reporting and disclosure requirements. The plan must, however, be prepared to provide copies of the plan document to the Secretary of Labor, if asked. As we noted earlier, the plan document is often just the board of directors' resolution.
To meet plan document requirements, the resolution should also define the claims procedure. According to ERISA requirements, the procedure must call for providing written notice in the event of a claim denial and an opportunity for a beneficiary to receive a full hearing. Because of the nature and operation of an executive bonus plan, the claims procedure requirement, although necessary, is somewhat academic. In other words, an insured bonus plan should be established only for the select group in order to avoid ERISA reporting and disclosure requirements.
An executive bonus plan, because it is characterized as an employee welfare benefit plan, also is exempt from all of the participation, funding and vesting requirements of ERISA. The plan document can be as liberal or as restrictive as the employer desires. While a written plan instrument and a fiduciary-usually a corporate officer-are legally required for almost all forms of executive bonus plans, the requirements are easily satisfied.
The Nature of the Business Entity
Smaller organizations may choose initially to provide the insured bonus plan only to the owner. Such an approach is entirely satisfactory. As the business grows and prospers, additional executives can be added to the plan as determined by senior management.
Some S corporations and partnerships will choose not to establish a Section 162 plan because the tax advantages-specifically, the employer tax deduction and tax bracket differential-of a C corporation are not available to them for owner participants. Despite this limitation, some business owners may feel that an executive bonus plan of any type is better than no plan at all.
Sometimes an organization may consider providing a benefit for all employees under an executive bonus plan, rather than only to a select group of management employees. If the employer goes ahead with such a plan, ERISA reporting and disclosure requirements would apply. Furthermore, the relative benefits of a qualified retirement plan would need to be considered. It is difficult to envision a situation in which an employer, seeking to include all employees in such a plan, would not be better served by a qualified retirement plan. It may be that in the judgment of management, limited corporate resources would best be spent on a matching Section 401(k) plan or perhaps the volatile profits dictate a profit-sharing plan.
The financial professional should be aware and should help the prospective client understand that an executive bonus plan can be established as a supplemental plan to all other employee benefit plans. It need not be an alternative to a qualified plan.
The actual executive bonus plan design can take many forms. Such plan design flexibility is both an advantage and a potential pitfall. If the plan is overly complicated, the employer and the executives may not feel comfortable with it. As a general rule, the simpler the plan design, the happier all involved are with it. A simple plan design leads to clear solutions for readily perceived needs. No government approval of the executive bonus plan design is required, and it may be changed periodically to better fit the organization's requirements. Let's turn our attention now to some basic approaches to executive bonus plan design.
Setting the Benefit
Some employers use a formula approach in determining the benefits of and contributions to an executive bonus plan. Yearly retirement benefits could be equal to a percentage of final compensation, such as 30 or 40 percent or more, and the annual bonus paid would be equal to the amount of annual premium needed to purchase a life insurance policy on the executive that would generate the agreed on lifetime retirement income.
Another common formula approach ties the retirement benefit to Social Security benefits. In essence, the result is an executive bonus plan "integrated" with Social Security, is similar to "permitted disparity" in a qualified plan. However, unlike a qualified plan there are no formal integration rules to comply with it. An example of this type of formula would be a benefit equal to 15 percent of the first $500 of monthly compensation and 50 percent of monthly compensation thereafter.
While either of these formula plan design approaches may be suitable for a particular organization, an employer seeking to further corporate objectives through its benefit plans often wants to connect the bonus amount to predetermined goals achieved by the participant. We noted earlier that a sales executive's goals may specify a percentage of sales growth for the coming year, say 20 percent. If the employer wanted to grow sales from its current $10 million level to $12 million, for example, it would be reasonable for the employer to provide an executive bonus plan formula, which it may change as follows from year to year:
A similar approach could be designed for the executives responsible for customer service, production and other quantifiable functions. The important element of this formula approach is that it pays for results-not only a fair way of allocating bonus compensation, but one to which employers often respond positively
Flat Amount Method
A formula approach to bonuses is not the only acceptable method for allocating bonus funds, of course. The flat amount method is commonly used when there are only a few participants or when benefit or contribution equity is desired. There are two basic variations in the flat amount method of executive bonus plan design:
a defined contribution approach; and
a defined benefit approach.
The defined contribution approach is by far the simpler of these two variations. In this 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 of a certain class, for example, all vice presidents;
the same percentage of base compensation for all participants; or
the same percentage of base compensation for all participants of a certain class, for example, 5 percent for all vice presidents.
Under this approach, the life insurance policy cash value that the executive has at retirement will determine the extent of income that the executive may receive.
The defined benefit approach is more complicated. In this approach, the employer selects an amount of income to be paid at retirement under the plan. As in the defined contribution approach that we just examined, that retirement income may be:
the same amount for all participants, for example, $50,000 per year for 10 years;
the same amount for all participants of a certain class, for example, all vice presidents receive $50,000 per year for 10 years and all senior vice presidents receive $75,000 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, for example, 5 percent for all vice presidents and 7.5 percent for all senior vice presidents.
In the defined benefit approach, a calculation must be made to determine the contribution amount level that will provide the promised retirement benefit. Not surprisingly, since a defined benefit approach adds a substantial level of complexity to the plan, many employers will tend to avoid it.
Since the employer pays the bonus to the executive, and the executive buys the life insurance on his or her own life, vesting (in the sense that the term is used in qualified retirement plans) normally is not applicable to executive bonus plans. However, by specifying in the resolution authorizing the plan that the bonus is to be used for the purchase of personally owned, permanent cash value life insurance, the employer has the assurance that the bonus will be used for that purpose.
The insured bonus plan does provide a variation of the golden handcuffs concept, especially if the benefit amount is large with a correspondingly large life insurance policy funding the benefit. The executive will become accustomed to the insurance coverage, will want the retirement benefit and will consider the value of the benefit when other employment opportunities arise. An employer also may restrict the executive's rights to the policy by allowing him or her access to the cash value only after a specified period of time.
Employers may be interested in defraying some or all of the income tax cost of the bonus to the executive. We noted earlier that a double bonus arrangement may be used and we will expand on that approach when we examine the taxation of an executive bonus plan. Some plans provide for loans from the employer to the executive to cover the additional income tax on the bonus amount.
If loans are made from the employer to the employee, they should be defined clearly as loans with a written loan instrument, specifying a reasonable interest charge and a repayment schedule. If the loans are not characterized properly, the IRS may deem them additional income or, in the case of a shareholder executive participant, dividends.
If the loans are not repaid, they become deductible bad debts for the employer and taxable income to the executive. The plan document may provide for all loans to be forgiven at the executive's death or retirement. In that event, the loans are income tax-deductible by the employer as an additional death or retirement benefit. Loans forgiven are included in the executive's or beneficiary's gross income.
If the life insurance purchased in the executive bonus plan is participating, any and all policy dividends are payable to the executive. The executive may choose any dividend option, including cash as a means of offsetting the end-of-year income tax liability caused by the bonus. For younger executives, the dividend may offset the entire income tax liability, particularly in the later years of the policy.
Funding the Plan
Any form of permanent, cash value life insurance may be used to fund the plan. Depending on the design formula, certain life insurance plans may be more appropriate than other plans. For example, an employer that institutes an executive bonus plan that ties bonuses to performance is likely to find universal life preferable to whole life insurance. Although a whole life policy with a rider designed to accept amounts in excess of the base policy premium can offer some premium flexibility, the flexibility built into a universal life insurance policy is difficult to approximate in any other product. In addition, the ease of accessing policy cash values through withdrawals-a feature that is a part of universal life insurance-helps make it the vehicle of choice.
If policy flexibility is needed, the employer or individual executive may choose a declared-rate universal life insurance policy, an equity-indexed life insurance policy or a variable universal life insurance policy, depending on his or her risk tolerance level. If there is a need for life insurance coupled with cash value guarantees, a whole life insurance policy may be appropriate provided that flexibility is not a primary concern.
Annuity contracts also may be used as a funding alternative for an executive bonus plan. Although annuities lack the advantage of a preretirement death benefit and FIFO tax treatment, they can be issued to any executive regardless of health. Also, annuity contracts may produce greater cash values at any duration when compared with some forms of permanent life insurance. The annuity chosen may be a variable, equity-indexed or declared-rate annuity.
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.
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.