Executive Bonus Plan: Section 162 Life Insurance

An executive bonus plan under Section 162 life insurance rules is one of the simplest ways a business can give a key person a benefit worth keeping. The company pays a bonus, the employee uses it to fund a permanent policy they own, and the business generally deducts the bonus as compensation. There is no annual filing with the IRS, no plan document with the Department of Labor, no participation testing. Most owners we talk with are surprised by how little machinery is involved.

What A Section 162 Executive Bonus Plan Actually Is

Section 162 of the Internal Revenue Code is the ordinary business deduction rule. It lets a company deduct ordinary and necessary business expenses, and it specifically names a reasonable allowance for salaries and other compensation for services actually rendered. You can read the statute itself at Cornell's Legal Information Institute. Nothing in it mentions life insurance.

That is the whole idea. The arrangement does not create a special shelter. It routes an ordinary deductible bonus into a permanent policy the employee owns, so the money keeps working long after a cash bonus would have been spent.

Three pieces make up the plan:

• A short written agreement between the business and the key employee
• A permanent life insurance policy on that employee, owned by the employee
• A bonus, usually annual, sized to cover the premium

Because the employee owns the contract, the arrangement sits outside the qualified plan rules. The business chooses who participates. One person, or four. There is no requirement to offer it to everyone on payroll, which is the practical reason most owners look at it in the first place.

How The Money Moves

Every year the sequence is the same.

1. The business runs a bonus through payroll to the key employee, sized to the annual premium.
2. Withholding and payroll taxes apply, because the bonus is compensation.
3. The employee pays the premium to the carrier. Some carriers will take the payment from the employer as a convenience, and the tax treatment does not change, because the amount was still income to the employee.
4. Cash value builds inside the policy, and the employee can generally reach it later through policy loans or withdrawals depending on how the contract is written.
5. If the employee dies, the death benefit goes to their family, generally free of income tax.

The business never owns the policy and never carries it on the books. That is what keeps the bookkeeping light, and it is also the tradeoff. If the employee resigns in year six, the policy walks out the door with them and the company recovers nothing it has paid.

What Each Side Gets From The Tax Code

The business

The deduction is the headline. A bonus paid to fund an executive bonus plan is treated like any other compensation, so a profitable company generally deducts it in the year paid. The requirement worth taking seriously is reasonableness. Total pay for that person, salary and bonus and everything else together, has to be reasonable for the work actually performed. A modest bonus layered on top of market pay rarely draws attention. A large bonus to an owner's relative who does very little draws plenty. Have your CPA look at the numbers before the first premium goes out.

The executive

They owe income tax on the bonus in the year they receive it. There is no deferral on the bonus itself. What they receive in exchange is ownership of an asset that can grow tax deferred, cash value they may borrow against, and coverage that can stay in force for life when the policy is funded and managed properly.

Owners often solve the tax bite with what the industry calls a double bonus. The company pays enough to cover both the premium and the tax the employee will owe, so the benefit arrives whole rather than shrinking on the way in. It costs the business more, and the full amount is still deductible compensation.

The Restricted Version, And Why Owners Use It

A plain executive bonus plan comes with no strings. The employee can stop funding it, surrender it, or take a job across town and carry it along. An owner who is paying for retention usually wants more than a thank-you gift.

A restricted executive bonus arrangement, shortened to REBA in most carrier material, adds an endorsement to the policy that requires the employer's consent before the employee can reach the cash value or surrender the contract. The restriction lifts on a schedule you define. Five years, ten years, at a stated retirement age, or in stages.

The death benefit typically stays available to the family the entire time, so the employee is protected from the first premium even while the living benefits vest. The restriction has to be written into the plan agreement and endorsed on the policy, which means an attorney who has drafted these before should handle the language. A downloaded template is a poor place to start.

Why The Policy Design Decides Whether This Works

Section 162 is the wrapper. What sits inside it does the work, and that is where a lot of these plans quietly disappoint.

If the policy is built for the largest death benefit per premium dollar, the early cash value will be thin, and a key employee who opens the statement in year three will decide the benefit was mostly on paper. A participating whole life policy designed the other direction, with a minimum base and a heavily funded paid-up additions rider, turns much more of each premium into cash value the employee can see and use early. That is the design we reach for when an owner wants the benefit to feel real while the person is still working.

This is the same thinking behind what we call The No-Compromise Asset. Protection the family needs, and money the employee can use while living, inside one contract. Our overview of strategies for high earners and business owners shows where an executive bonus plan sits next to the other tools.

The plan is only as good as the policy inside it. Two arrangements with identical bonuses can look nothing alike at year five, purely because of how the contract was structured.

Where An Executive Bonus Plan Fits, And Where It Does Not

It fits well when:

• You have one to five people whose departure would genuinely hurt, and you want to reward them differently from the rest of the team.
• The business is profitable enough that a deduction is worth something this year.
• The employee is insurable and actually wants life insurance. If they do not, the benefit lands flat no matter how generous it is.
• You want something you can start, pause, or end without ERISA filings and annual testing.

It fits poorly whenever the business itself needs to own the value. Two common cases: protecting the company against the financial hit of losing a key person, and funding an ownership transition. Both call for a different structure. We covered the first in our piece on key person insurance for a small business, and the second in funding a buy-sell agreement with life insurance. Plenty of owners we work with run all three at the same time, because each one answers a different question.

If you are weighing this for someone on your team, a short conversation usually settles whether it is the right shape before anyone fills out an application. You can schedule a time to talk it through, and we are glad to walk the numbers with you and your CPA together.