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.  

The Need

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 Bonus

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.