Revisiting The Executive Bonus Plan

Over the last several years, significant legislative changes have had a substantial effect on split-dollar and nonqualified deferred compensation plans. Split-dollar, once a cornerstone of executive compensation planning, has been limited–or in some cases eliminated–as a viable strategy by both the final split-dollar regulations and the Sarbanes-Oxley Act. Likewise, nonqualified deferred compensation has become less attractive for some companies since the enactment of Internal Revenue Code Section 409A and Internal Revenue Code Section 101(j). These legislative changes have left many employers looking for alternative executive compensation designs.

An executive bonus using life insurance is an executive compensation strategy that may provide executives some of the benefits traditionally offered by employers through either split-dollar or nonqualified deferred compensation plans while avoiding the limitations established by the legislative changes affecting these arrangements. An executive bonus using life insurance should be considered for owner and non-owner executives of C-corporations, and non-owner executives of pass-through entities such as S-Corporations, partnerships and limited liability companies.

The executive bonus using life insurance strategy is simple in both design and implementation. The basic structure is as follows:

? The employer pays the executive a taxable bonus. The bonus may be a deductible business expense for the employer.

? The executive may use the bonus to purchase an individually-owned cash value life insurance policy. Generally, the executive is the person insured by the policy, and he or she names the beneficiary of the policy’s death benefit.

? The executive may take potentially tax-free income by accessing the policy’s cash value through policy loans and withdrawals for emergencies or other financial needs.

? At death, the executive’s heirs may receive the life insurance death benefit proceeds income tax-free.

One variation to a basic executive bonus using life insurance strategy would allow the employer to retain some measure of control over the bonus via a controlled executive bonus using life insurance, which requires a written agreement between the employer and the executive.

The agreement requires the employer to pay a bonus or a series of bonuses to the executive. These bonuses are generally paid directly to the life insurance company as premium payments for the executive’s personally owned life insurance policy. Additionally, the agreement provides the terms for the employer’s control of the life insurance policy’s cash value and may include a vesting schedule.

A direction form is then filed with the life insurance company stating that the exercise of any ownership rights, except for beneficiary designations, requires the signature of both the employer and the executive. The agreement, the vesting schedule and the direction form give the employer some control by preventing an executive from accessing the life insurance policy’s cash value until a specified date. Once the executive meets the terms of the agreement, the direction form may be removed from the life insurance policy, giving the executive full access to the policy’s cash value.

In either the traditional executive bonus strategy or the controlled executive bonus strategy, the employer may “gross-up” the bonus to the executive through a double bonus. In a double bonus, the employer provides the executive with a bonus large enough to pay not only the life insurance premiums but also the income tax incurred by the executive upon receiving the bonus. By using a double bonus, the employer is limiting or possibly eliminating any out-of-pocket expense for the executive to purchase a life insurance policy.

Executive bonuses using life insurance strategies have several advantages when compared to both split-dollar arrangements and nonqualified deferred compensation plans including:

? Each bonus paid to the executive may be considered a fully deductible expense for the employer. In contrast, contributions to both split-dollar arrangements and nonqualified deferred compensation plans are not considered deductible business expenses.