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.