Budget bonus is truly a simpler way to place an executive bonus case. The following scenario gives an idea of how this might work for your clients.
Let’s look at the case of Eileen (a fictional character), who owns an event-planning business. She has a particularly effective employee, Janice, who has a flair for selling, organizing and designing meetings and other events. Better still, Janice is a loyal, dedicated employee. Eileen plans to make her a partner within the next few years, but she would like to do something for Janice now.
Janice is a single mom with pre-school children. She needs additional life insurance and needs to start saving for her children’s college education. Peter is Eileen’s insurance agent, who suggests variable universal life insurance, funded with a raise in pay through an executive bonus arrangement. The raise in pay will reward Janice. The insurance will provide her with additional life coverage. Tax-favored access to cash values in the future will help fund college. And access to variable sub-accounts will offer the prospect of participating in equity investments, subject to market risk and possible loss of principal.
This information assumes that the life insurance is not a modified endowment contract or MEC. As long as the contract meets the non-MEC definitions of IRC Section 7702A, most distributions are taxed on a first-in/first-out basis. Surrender charges may apply to partial surrenders.
Loans and partial surrenders from an MEC will generally be taxable, and if taken prior to age 59 1/2 , may be subject to a 10% tax penalty. Loans and partial surrenders will reduce the cash value and the death benefits payable to beneficiaries, and withdrawals above the available free amount will incur surrender charges. If the contract were to lapse with a loan outstanding, the loan amount in excess of basis will be treated as a distribution and all or a portion will be subject to income tax.
Eileen likes the idea. The premium will be deductible, and Janice will benefit from the needed insurance and from the potential future benefits. Eileen suggests $12,000 and a monthly premium mode, which will make the cash flow a lot easier. Eileen’s business is a C Corporation in the 34% tax bracket, and Janice is in the 25% bracket as a single mom filing as a Head of Household.
Payroll, state and local income taxes will add another 10% to both income tax rates, making Eileen’s overall tax bracket 44% and Janice’s 35%. The logistics call for Eileen to pay the premium then withhold it from Janice’s paychecks.
Peter returns the following week with some illustrations, reviewing them with Eileen and Janice. In designing the case, he provided Janice with more than the minimum non-MEC death benefit, but illustrated a premium that over-funded the policy and that was well in excess of target.
Everyone is very pleased with the illustrated death benefits and performance, but Janice is curious about how her paycheck will be affected. She’s fairly comfortable at an annual salary of $96,000, but she still has to be careful. The first illustration is a single bonus, which makes Janice responsible for the taxes. The consequences of the raise and taxes are illustrated in chart 1.
Upon reviewing the numbers, Janice says she’s flattered and wants to go forward. Unfortunately, she can’t take a $450 cut in take-home pay.
Peter had anticipated this objection and proposes grossing up Janice’s pay to cover both the premium and the associated taxes. That approach is illustrated in chart 2.
The first question for Peter is “how did you come up with a $1,538 raise in pay?” He shows them the formula:
Raise in pay = $1,000 ? (1- tax rate)
Raise in pay = $1,000 ? (1- .35)
Raise in pay = $1,000 ? .65
Raise in pay = $1,538
Then Eileen points out that originally they were talking about $12,000 a year, but with a monthly income increase of $1,538, she’s looking at a total annual commitment of $18,456, which is almost $6,500 more than what she had budgeted for this benefit. She can’t afford the extra cost. There has to be an alternative that will let her stay within her budget and still not give Janice a short paycheck.
Peter then suggested that they let the budget drive the calculation instead of the premium. (See chart 3.) In that context the monthly premium becomes:
Monthly premium = Budgeted raise – taxes
Monthly premium = $1000 – ($1000 X 35%)
Monthly premium = $1000 – $350
Monthly premium = $650
Now both Eileen and Janice are happy. Eileen stays within her budget and Janice doesn’t get a pay cut. Peter had to drop the death benefit a little but he’s happy to have served Eileen and Janice. The premium did go down but it’s still in excess of target, so Peter is being well compensated for his efforts. In addition, he has two happy customers in Janice and Eileen and he can look forward to more business with both of them in years to come.
Last, but not least, the budget bonus calculation was much easier to grasp, so everyone is more comfortable with that. Truly, the budget bonus is an easier way to place executive bonus cases.
David K. Smucker, CPA, CLU, ChFC, is a senior consultant in advanced sales for Nationwide Financial Services, Inc. in Columbus, Ohio. He can be reached at