As we move into the second decade of the new millennium, we find ourselves in a time of great change. One thing that has not changed is that employers still need to find ways to recruit, reward and retain key employees in their businesses. Executive bonus plans remain a simple and cost effective tool for employee retention.
Executive Bonus Plans, also referred to as “Section 162 Bonus Plans”, have been around a long time. The title refers to the part of the IRS Code that allows for bonus compensation to employees to be deductible to the employer as long as that compensation is considered reasonable (I.R.C. ? 162(a)(1)). http://www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00000162—-000-.html
Many other traditional methods of providing non-qualified retirement savings or benefits to key employees have become increasingly complex to implement. The advent of the 409(A) regulations have put strict rules in place as to plan design, and created heavy penalties for the participants should the plan not meet those guidelines. www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00000409—A000-.html
Employers are wary of the potential for lawsuits should they fail to meet all the necessary guidelines of 409(A). In addition, in our current economic climate, executives are increasingly wary of tying their retirement funds to the financial viability, or legal liabilities, of their employer. A requirement of traditional nonqualified plans is that they are unfunded, and that any funds supporting the plan are subject to the general creditors of the employer. This can appear as a great risk to the employee.
Executive Bonus Plans are experiencing a renaissance: they provide a way for a key employee to purchase life insurance using employer dollars. Generally, the employer pays the premium and adds the bonus to the employee’s W2 income. Alternatively, the employer could bonus the employee cash and the employee would then use the after tax dollars to pay the premiums.
The life insurance can provide death benefit protection to the executive’s family, and it can also be funded to provide tax advantaged retirement income as well. As the life insurance is employee owned, the creditor risk of a traditional nonqualified plan is avoided. There are no required distributions at age 70 1/2 as there are for IRAs or other qualified plans, and there are no penalties for removing funds from the life insurance policy prior to age 59 1/2 .
Executive Bonus Plans are very flexible. There are no participation requirements – the employer can fully discriminate as to whom the plan is offered. Incentives, such as sales goals or company profitability, can be built into the arrangement if desired. Restrictions can be placed on the plan, requiring repayment of some or all of the bonuses, if the key executive leaves prior to a designated amount of time.
So, how does it work?
- First the employer and executive agree that the bonus plan is an important part of his or her compensation package.
- The executive purchases a life insurance policy.
- The employer makes premium payments on the policy and the executive pays tax on the bonuses as ordinary income.
- The executive can receive income through withdrawals and loans from the insurance policy’s surrender values. [i] If the executive dies at or before retirement, income tax free death benefit proceeds are paid to his or her beneficiaries.[ii]
Where does the flexibility come in?