Section 162 executive bonus plans

A Section 162 executive bonus plan is an arrangement in which a company gives a selected employee a bonus that is used to pay premiums on a life insurance policy the employee owns. The name comes from IRC section 162(a)(1), which lets a business deduct reasonable compensation. The bonus is taxable income to the executive, deductible to the company, and the policy belongs to the executive, so the plan is simple but not tax-free: its appeal is that the executive gets personal coverage and cash value with the employer's help, and the company gets a retention tool without the complexity of other arrangements.

How the plan works

1. The company and executive agree on a bonus, usually in writing, sized to cover the premium (and sometimes the executive's tax on the bonus).
2. The executive applies for and owns a permanent policy, often whole life or universal life, and names their own beneficiaries.
3. The company pays the bonus, either to the executive who pays the insurer or directly to the insurer on the executive's behalf. Either way it is reported as W-2 wages.
4. The executive pays income and payroll taxes on the bonus.
5. The executive later uses cash value for retirement income through withdrawals and loans, or leaves the policy in force for beneficiaries.

Because the executive owns the policy, the plan is much simpler than a split-dollar arrangement, where ownership and rights are shared.

The tax picture

Two points deserve emphasis.

The executive pays tax on the premium. An executive in the 24% federal bracket receiving a $20,000 bonus keeps less than $20,000 after tax, so a bonus meant to cover a full premium must be grossed up (a "double bonus") or the executive must pay the gap. The gross-up raises the cost to the company and is itself taxable.

The company's deduction depends on "reasonable" pay. The deduction is available only if total compensation, including the bonus, is reasonable for the services performed. Closely held companies paying an owner-employee face the most scrutiny.

Because the executive is the owner and the company has no right to the proceeds, the employer-owned life insurance rules of IRC section 101(j) generally do not apply to a true bonus plan. They do apply to arrangements where the company is owner or beneficiary, as in key person life insurance. If the company keeps rights to recover premiums, the arrangement may be a split-dollar arrangement governed by Treas. Reg. section 1.61-22.

Keeping the executive: the "golden handcuffs" variants

A plain bonus plan gives the executive the policy immediately, with no strings. Companies that want retention often add one of these:

• Restrictive endorsement or vesting agreement. The policy is pledged or subject to a written agreement that the executive repays some or all of the bonus, or forfeits the policy, if they leave early. Courts and the IRS look at how the agreement is written. If the company becomes entitled to recover premiums from the policy proceeds, the arrangement may be treated as split-dollar; if the company can claw back by contract, other rules, including IRC section 409A on deferred compensation, can come into play. See life insurance in nonqualified deferred compensation.
• Surrender-charge structure. Choosing a policy with a long surrender-charge period makes cashing out early costly for the executive, though that is a product feature, not a legal restriction. See life insurance surrender charges explained.

Both approaches are reasons to have an employment and tax attorney review the paperwork rather than copy a template.

Costs and trade-offs

A hypothetical example: say a 45-year-old executive receives a $15,000 annual bonus that goes entirely to a permanent policy premium. With a 24% federal bracket, 7.65% payroll tax and a 5% state tax, the executive's tax on the bonus is very roughly 37%, or about $5,500, which the company either grosses up or the executive pays from other funds. The figures are illustrative only. Real rates, brackets and premiums vary.

For the plan

• The executive owns a portable policy that goes with them if they leave.
• Easy to administer; no cap on who can be offered it; no qualified-plan nondiscrimination testing.
• The company can choose which executives to reward, unlike a broad-based plan.
• Permanent coverage can supplement 401(k) limits: the 2026 employee deferral limit is $24,500 according to the IRS.

Against the plan

• The executive pays tax every year on money used for premiums.
• The company gets little retention power unless it adds restrictions, which add legal complexity.
• Permanent insurance has fees and surrender charges; poorly funded policies can lapse.
• A policy overfunded too quickly can become a modified endowment contracts and the 7-pay test, which taxes loans and withdrawals less favorably.
• The company gets no claim on the cash value or the death benefit.

Alternatives

Executives who simply want to buy permanent coverage with their own money can do that without the plan; see the types of life insurance, explained for what to compare.

Questions to ask before adopting

• Is the executive's total pay reasonable once the bonus is added?
• Who pays the tax on the bonus, and is a gross-up budgeted?
• What happens if the executive leaves, is terminated or dies in the first years?
• Does the company want any restriction, and does the written agreement create split-dollar or deferred compensation consequences?
• Is the product suited to the use: guaranteed death benefit, cash accumulation, or both?

Plan documents, tax reporting and reasonable-compensation analysis are the places an attorney and CPA add value, particularly for owner-employees.

Key takeaways

• A Section 162 bonus plan pays an executive a taxable bonus that funds a policy the executive owns.
• The company generally deducts the bonus if total pay is reasonable; the executive pays income and payroll tax on it.
• The death benefit is generally income tax-free, and the plan avoids the employer-owned life insurance rules because the company is not the owner or beneficiary.
• Retention restrictions can turn the arrangement into split-dollar or deferred compensation, with different tax rules.
• Grossing up the bonus for tax raises the real cost, so budget for it.