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.
? The executive can direct the full amount of the life insurance policy death benefit to a beneficiary of the executive’s choosing.
? The executive generally will have access to the life insurance policy’s cash value and may access that cash value without income tax through policy loans and withdrawals, unless the arrangement is a controlled executive bonus.
? The policy is also portable should the executive separate from service from the employer.
? An executive bonus using life insurance generally is not subject to either the final split-dollar regulations or Internal Revenue Code Sections 101(j) or 409A, since the bonus is not considered a split-dollar or nonqualified benefit plan.
? Executive bonuses using life insurance involve little, if any, administration.
? The employer has discretion in the selection of executives to whom it wishes to offer this benefit.
Of course, there are disadvantages to using an executive bonus executive compensation strategy versus split-dollar arrangements or nonqualified deferred compensation plans including:
? The employer is unable to recover costs from the life insurance policy’s death benefit because the executive names the beneficiary of the policy’s entire death benefit.
? Executive bonus strategies provide the employer very little, if any, control of the life insurance policy, since it is owned by the executive. Even a controlled executive bonus only restricts the executive’s access to the policy’s cash value. The bonus amounts are never returned to the employer, even if the executive separates from service prior to vesting.
? The executive must include each bonus in his or her taxable income.
? Unless additional estate planning is implemented, the death benefit of the life insurance policy will be included in the executive’s taxable estate for estate tax purposes.
Despite these disadvantages, an executive bonus using life insurance is ideal for business owners who want to provide executive benefits but do not want an executive compensation program that must comply with the legislative changes that have affected split-dollar arrangements and nonqualified deferred compensation plans. Simple in both design and implementation, the strategy is well suited to companies that want to reward an executive with significant benefits.
Please note that every executive compensation arrangement is different. So make sure the employer and executive consult with their tax and legal counsel prior to entering into an executive bonus arrangement.