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.