Despite the wealth of strategies available—and the importance of the choice generally—developing tax-efficient compensation plans for key executive employees who are vital to the operation of a successful business can prove to be more complicated than anticipated for employers.  

Income limits will often prohibit these executives from contributing to traditional retirement accounts on a tax-preferred basis, and contribution limits make it difficult to accumulate substantial account values. Fortunately, various nonqualified compensation strategies exist that use life insurance as the funding mechanism to provide additional compensation to valuable employees. Importantly, these strategies simultaneously offer important tax benefits to the employer while avoiding the complications that can arise in establishing a qualified plan.

Types of Life Insurance-Funded Plans

The basic form of the employer-sponsored life insurance-funded executive bonus plan is referred to as a Section 162 bonus plan. In this nonqualified compensation arrangement, the employer pays a bonus to the key employee, which is then used to pay the premiums on a life insurance policy. The employee in this arrangement is both the owner of the policy and the insured.

A modification of this basic arrangement can allow the employer to place conditions on the employee’s rights to the benefits under the plan. For example, the employer can also require that the employee enter into an agreement providing that the employee must remain with the employer for a certain period of time before he or she is entitled to the plan benefits. If the employee fails to complete the specified term of employment, the employee can be required to repay the employer for amounts expended on the insurance premiums.

Further, in this situation, the parties will typically specify that the employee cannot surrender (or otherwise access the value of) the policy until the employment term requirement is satisfied and the employee becomes completely vested in the benefit. This is accomplished by filing a policy instructions form with the company that issued the life insurance policy.

If an employer wishes to provide a life insurance funded executive bonus plan as an option, but does not want the expense of funding the entire policy, it can also take steps to allow the employee to purchase the insurance on a pre-tax basis. Through this arrangement, the employee pays for the policy and the employer matches the amount of taxes that the employee would be liable for on the premium amounts.

Employers who offer a tax match to employees typically will also require that the employee complete a certain period of employment, or will be required to repay the matched amount. Further, a policy instructions form is filed with the insurance company to prevent the employee from surrendering or otherwise accessing the value of the policy before the expiration of the employment period.

The Benefits of the Plan

Life insurance-funded nonqualified executive compensation plans are primarily attractive as employee retention tools because they allow the employer to deduct the cost of premiums (or tax matching contribution) in the current year, assuming the total amount of compensation paid to the executive is reasonable.

The cost of the premiums paid by the employer are treated as income to the employee in the year they are paid, though the employer has the option of reimbursing the employee for these amounts through the tax match strategy discussed above. Death benefits received by the employee’s beneficiaries will be received tax-free (as life insurance proceeds). If the employee is permitted to take a loan from the policy, that loan will be taxed as though the employee owned the policy (i.e., tax-free loans are generally available, depending upon the cash value accumulated in the policy—the presence of the bonus arrangement is ignored).

Further, for many employers, an important benefit of a life insurance funded nonqualified plan is that it avoids the qualification requirements that can apply to other types of plans—the employer is free to offer participation selectively, without worrying about the nondiscrimination requirements that apply to other plans.

Conclusion

A life insurance funded executive compensation plan can provide a solution to allow small business clients to retain key executives—offering those employees a valuable insurance benefit while securing a current tax deduction in the process.

Originally published on Tax Facts Onlinethe premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.    

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See the complete lineup of articles in ThinkAdvisor’s 23 Days of Tax Planning Advice: 2016.