Executive Bonus Arrangements

What Is an Executive Bonus Arrangement?

Under an executive bonus arrangement, the employer pays a bonus each year to selected employees, typically either in cash or in the form of premiums on life insurance or disability policies on their lives. This is not the same as key employee insurance, which is intended to protect the business from losses resulting from the employee's death. Rather, it is employer-financed personal life and disability insurance intended to benefit the selected employee.

The employee usually applies for and owns the policy, naming someone other than the employer as beneficiary. The cash bonus or premium is declared as additional compensation on the employee's W-2. The annual taxes on this bonus are, in some cases, funded by an additional cash bonus to the employee. Eventually, the policy's annual cash value increase will exceed the tax on the bonus and may be borrowed or withdrawn to pay taxes. Policy loans or withdrawals will, of course, reduce the death benefit and may have tax consequences.

The executive bonus arrangement, sometimes also called a Section 162 arrangement, can be completely selective in coverage. The employer is free to select the employees it wishes to benefit.

Since the bonus is taxed as additional compensation to the employee, it is deductible in the year paid by the employer provided it qualifies as reasonable compensation to the employee.

As with other life insurance, the death proceeds usually will be received income tax-free by the employee's personal beneficiary under IRC Sec. 101(a). Disability insurance benefits generally will also be received income tax-free by the employee.

The employer selects the employee(s) it wishes to benefit and pays tax-deductible premiums (or a cash bonus) for a policy on the employee's life or disability insurance.

The employee reports the premium (or bonus) as compensation each year for income tax purposes.

At the employee's death, the beneficiary generally receives the death proceeds free of federal income taxes under IRC Section 101(a).

Benefits to the Employee and Employer