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November 30, 2008 at 02:00 PM
The executive bonus is a familiar technique to recruit, retain and reward key non-owner employees, and is a well-known way to fund a life insurance policy. The significant characteristic of an executive bonus arrangement is that, by handling the premium as additional compensation, the premium becomes tax-deductible for the employer, subject to the reasonable compensation limits in IRC ?162(a)(1).
Weak handcuffs
Unfortunately, the arrangement puts only a very weak “golden handcuff” on the employee. As long as the employee stays, the premium payments continue. If the employee leaves, the premium payments end. And if the policy is to be continued, the employee has to take on the obligation. However, if the employee leaves, the policy and its internal values go with the employee.
Control through REBA
One way to give the employer more control is with a restrictive executive bonus arrangement. One version of the REBA calls for the employee to place a restrictive endorsement on the policy. The typical restrictive endorsement allows the employee to change the beneficiary without the employer’s consent, but that’s all. Partial surrenders, loans, complete surrenders, assignments as collateral and so on must have the approval of the employer.
In the case of a variable life insurance policy, the employee might also have the right to change separate account elections without the employer’s consent. A restrictive endorsement would typically be released upon the employer’s cessation of business. It might also have a stated expiration date. The restrictive endorsement puts more of a hold on the key employee than the standard executive bonus. However, if the employee is patient, the restriction will eventually expire, making all the values available to the employee.
Is there something better? Yes, the document granting the employee the pay raise can also contain a vesting schedule requiring the repayment of some or the entire raise if the employee leaves before the repayment provisions are satisfied.
For example, a 5-year cliff vesting provision would require the employee to repay all of the raises if the employee leaves before 5 years have elapsed. A graded vesting provision might call for the repayment obligation to decrease at the rate of 20% per year.
Vesting in a REBA is handled differently than in a deferred compensation plan. With respect to the latter, the vesting schedule tracks the increase in the employee’s rights under the plan. In a REBA, the vesting schedule tracks the decrease in the repayment obligation.
A REBA is a nonqualified arrangement, so no Department of Labor or IRS rules specify or limit the vesting schedule. Instead, vesting is determined based on the agreement between the employer and employee. The vesting provisions, however, can’t be too stringent; employees may refuse to accept them. And state laws limit them if they’re unconscionably long (similar to non-compete covenants). Anywhere between 5 and 10 years with either graded or cliff vesting would be good starting points.
The vesting schedule shown in the chart would say that (assuming the raise in pay is $10,000 per year) if the employee leaves early these would be the amounts repayable to the employer, depending on when the employee leaves.
Only after 5 years of service is completed will the repayment obligation in this example disappear. Given this vesting schedule example, as of the first day of the 6th year of service the employee will be fully vested.
Typically the REBA policy endorsement has a calendar year expiration date. That expiration date generally coincides with the employee becoming fully vested in the additional compensation.
