HOW IT WORKS

Why is an executive bonus plan referred to as a Section 162 bonus plan? 

Section 162 refers to Internal Revenue Code (“Code”) Section (“§”) 162. Code § 162 provides that businesses may deduct all ordinary and necessary expenses incurred or paid in carrying on a trade or business. 

Under an executive bonus plan, can the employer deduct the premium (bonus) amount? 

Under Code § 162, businesses may deduct compensation paid as an ordinary and necessary expenses. As executive bonus plans provide compensation to the employee, bonuses paid fall within the purview of § 162. However, to be deductible as a trade or business expense, compensation payments must (among other things) be for services rendered and reasonable in amount. What is reasonable? Good question! 

In determining what portion of compensation paid is reasonable, and therefore deductible, the Internal Revenue Service (“IRS”) looks at the facts and circumstances of the situation. More specifically, factors that determine reasonableness of compensation include (but are not limited to) the employee’s qualifications and role, the hours the employee works, the employee’s overall contributions to the company, a comparison of the employee’s compensation with that paid by similar companies for similar services, the complexity and size of the business, and the employee’s salary history with the company. 

Is there a limit on the amount of compensation that may be deducted? 

For publicly-held corporations, the deduction is limited to $1 million per year for compensation paid to the most highly compensated officers and executives. A similar $1 million compensation limitation applies to most tax-exempt organizations, which are subject to an excise tax on compensation in excess of $1 million paid to individuals who comprise a group of the most highly compensated. 

For privately-held companies, generally there is no maximum compensation limit. Instead, the compensation deduction available to privately-held companies is governed by the reasonable compensation standard discussed above. 

Does the bonus result in any income tax consequences to the employee? 

Yes. This amount is considered compensation (wages) to the employee. The employee must report this as income and will pay ordinary income tax on the amount. 

Additionally, employer cash bonuses (premium payments) are considered supplemental wages to the employee and therefore subject to payroll taxes via FICA and FUTA withholding. FICA stands for the Federal Insurance Contributions Act and generates revenue to fund the Social Security and Medicare programs. FUTA stands for the Federal Unemployment Tax Act and generates revenue to fund unemployment benefits for people who are out of work. 

How are income and payroll taxes calculated and withheld? 

Calculation 

Generally, employees are subject to federal income tax at a rate that is based on the family net income. Employees may also be subject to state income tax, if applicable. 

If the employer is entitled to a compensation deduction, the amount of the deduction is based upon the corporate income tax rate. 

Regarding payroll taxes, the employer and employee equally share the liability for Social Security taxes and Medicare taxes. However, employers are solely responsible for the federal and state unemployment taxes. 

Withholding 

Bonuses are classified as “Supplemental Wages” in the eyes of the IRS. This means they are considered compensation paid in addition to the employee’s regular wages. The employer may withhold taxes on supplemental wages in one of two ways: the percentage method or the aggregate method. 

Under the percentage method the IRS establishes a flat tax rate for all supplemental wages. This rate plus any applicable FICA withholdings apply to the bonus. This method is typically chosen if the bonus is paid in an off-cycle payroll check. 

Under the aggregate method, the bonus is added to the employee’s normal paycheck and withholdings are in accordance with the withholding tables used for normal wages as specified in the employee’s W-4 withholding form. This amount may be more or less than the percentage method depending on the filing status and number of dependents declared. 

The payroll service used by the employer should be informed of the bonus amounts to process the withholdings properly. 

For more information on the calculation and withholding of income and payroll taxes, see these pages of the IRS website: 

• Tax Information for Employees 
• Tax Information for Business 
• About Publication 15 (Circular E) – Employer’s Tax Guide 
• About Publication 15-T – Federal Income Tax Withholding Methods 
• Understanding Employment Taxes 

Your clients should always consult with their tax and legal advisors on income and employment tax consequences related to their unique situations. 

Will there be an impact to the employee’s regular paycheck? 

It is possible that a bonus plan may adversely impact an employee’s normal paycheck. If the bonus arrangement is not designed to cover all the employee’s costs, this should be communicated to the employee prior to the plan being implemented. 

A single bonus design where the employee is responsible for the taxes should have the appropriate payroll taxes withheld at the time of the bonus payment. This will reduce the amount of the employee’s regular paycheck. If taxes are not withheld, it is possible the IRS will assess an underpayment penalty if the bonus is large and creates a tax deficiency for the employee. 

FICA taxes are also due on any bonus payment. If the employer does not take that into account in determining the bonus amount and policy premium, any shortfall will be taken from the employee’s regular paycheck. 

When designing the plan, all sources of applicable taxes should be considered to ensure the assumed tax brackets are realistic and accurate. 

Are executive bonus plans governed by ERISA? 

Yes. 

The Employee Retirement Income Security Act, or ERISA, divides employee plans into two categories: welfare plans and pension plans. 

• Pension plans (also known as employee pension benefit plans) provide retirement income to employees or defer income to the termination of employment or beyond.

• Welfare plans (also known as employee welfare benefit plans) provide for items such as: medical, surgical, or hospital benefits; benefits in the event of sickness, accident, disability, death; or benefits in the event of unemployment. Visit Resources for the full definition of welfare benefit plans under ERISA. 

Executive bonus plans are considered ERISA welfare benefit plans because 1) there is no deferral of income; and 2) a death benefit is provided. While restricted bonus plans should also generally be considered welfare benefit plans, care should be given to the timing of the restriction release to avoid appearing like retirement income (and therefore be considered a pension plan instead of a welfare benefit plan). 

As an ERISA welfare benefit plan, what ERISA requirements apply to executive bonus plans? 

In Writing 

ERISA requires that welfare benefit plans “be established and maintained pursuant to a written instrument.” Often, employers (particularly smaller employers) rely on the board of directors’ resolution as the written agreement. Other times, the client’s legal counsel drafts the written agreement. Your clients should consult with their legal advisors on which approach is most appropriate for them. 

Regardless of the form of the written agreement, ERISA requires the agreement to: 

• Designate a fiduciary who has the authority to control and manage the administration of the plan (often this is the employer); 
• Provide a procedure for establishing and carrying out a funding policy (for example, include a provision that the premiums required to keep the policy in force will be paid when due); 
• Provide a procedure for allocating the fiduciary responsibilities for the operation and administration of the plan; 
• Provide a procedure for amending the plan (including a procedure for identifying those with authority to amend the plan); 
• Specify the basis on which payments are to be made to and from the plan; and
• Contain claims procedures, which afford the employee notice of the method of filing a claim for benefits and the procedure used to appeal any denial of a claim. 

Generally, welfare benefit plans are subject to the full reporting and disclosure requirements of ERISA. However, welfare benefit plans can be fully exempt from the reporting and disclosure requirements if: 

• the plan is unfunded and noncontributory, meaning the benefits under the plan are: 1) paid, as needed, solely out of the general assets of the employer, or 2) provided exclusively through insurance contracts for which all premiums are paid directly by the employer or out of its general assets; and 

• the plan is maintained primarily for a select group of management or highly compensated employees (commonly referred to as Top Hat employees). 

As no regulatory agency has defined “primarily for a select group of management or highly compensated employees,” we must rely on case law for general direction. From case law and other non-regulatory material, we observe that determining a “select group” has been based on a consideration of all pertinent facts and circumstances. Factors considered include: 1) the percentage of employees covered by the plan; 2) how the average salary of the plan participants compares to the average salary of all employees; 3) the reasonableness of considering the selected plan participants as management and/or highly compensated employees; and 4) whether the employees, by reason of their position or compensation level, have the ability to influence the design of the plan. 

Although exempt from ERISA’s reporting and disclosure requirements, employers must provide plan documentation to the Department of Labor upon request. Also, for plans that include only a select group of management or highly compensation employees, employers are required to submit to the Department of Labor Top Hat Plan Statement. Visit Resources for more information. 

Are there consequences associated with violating ERISA? 

Yes. Any person who willfully violates any provisions of ERISA potentially faces both civil and criminal penalties. The civil penalties range from approximately $170 to $1,700 per day depending on the nature of the violation. The criminal penalties may include imprisonment for up to 10 years and fines up to $100,000 for individuals and up to $500,000 for companies. 

How frequently can § 162 bonus payments be made? 

While most plans involve annual bonus payments, this is not required. The bonus payments may be monthly, or even as frequently as weekly. Alternatively, the bonus payments can align with the frequency of the life insurance policy’s premium payments (for example, on a monthly basis). 

Does Code § 409A impact § 162 executive bonus plans? 

Generally, no. 

Code § 409A applies to nonqualified deferred compensation plans, which may include bonus deferral arrangements and long-term bonus arrangements. Code § 162 executive bonus plans are generally not considered to be nonqualified deferred compensation plans so are not subject to § 409A. Moreover, § 162 bonus plans are often designed to be exempt from § 409A under its short-term deferral exception (which means the bonus plan is designed to pay the bonus (premium payment) no later than 2½ months after the end of the year in with the right to the payment becomes vested). 

Code § 409A is very complicated, and the consequences of non-compliance can be very significant. For this reason alone, your clients should have their legal advisors draft the written § 162 bonus plan agreement to ensure compliance with § 409A. 

Can an employer include a vesting schedule in an executive bonus plan? 

As the employer pays the bonus premium directly to the insurance carrier and as the executive purchases and owns the life insurance policy, vesting schedules are generally not recommended with executive bonus plans. If an employer adds a vesting schedule, it may subject the program to § 409A and may delay the income tax consequences (employer deduction and employee income inclusion). An employer should consult with their tax and/or legal advisors to review the requirements of § 409A and to advise on whether adding a vesting schedule is prudent. 

If the employee misbehaves, can the employer get their money back? 

No, as Code § 162 bonus plans do not carry a risk of forfeiture. 

Can a small business offer a § 162 bonus plan to all employees? 

Yes; however, in doing so the plan would be subject to more ERISA reporting and disclosure requirements than it would be if it were maintained primarily for a select group of management or highly compensated employees. The Top Hat exemption protection is not honored if the group offered the plan is too broad. 

Can executive bonus plans be appropriate for non-profit organizations? 

Yes, § 162 bonus plans may be appropriate for non-profit organizations. Although the bonus amount (premium payment) would be included in the employee’s income, the corresponding compensation deduction for the non-profit organization is irrelevant if the organization is tax-exempt. However, bear in mind the excise tax that is levied on tax-exempt organizations that pay over $1 million in compensation to a small defined group of senior management and highest-paid employees. 

Regarding the life insurance policy, are any forms other than the application required? 

Generally, no additional forms are required. However, if the executive bonus plan covers multiple employees, you may want to establish a group or list bill. Moreover, if the plan is a restrictive executive bonus arrangement, the Restricted Ownership Provision Request Form (# 6502) – the policy endorsement – is the only additional form that might be required. 

Charlie realizes Patty is critical to the future success of the business and wants to reward her for her contributions. He would also like to find a way to incentivize her to stay with the company. 

Providing a cash bonus is one solution, but Charlie would like to find a way to provide Patty with the survivor income protection she needs as well as a vehicle to provide her supplemental income during retirement. 

Charlie, in consultation with his life insurance agent and his tax/legal advisors, has determined that an executive bonus plan will meet his objectives. His attorney will draft the written bonus agreement specifying the rights and responsibilities of both Patty and the business. Putting the agreement in writing will help ensure compliance with ERISA. 

In drilling a bit deeper into this arrangement, Charlie wants to contribute $10,000 to the plan. Charlie wishes that Patty incurs zero out-of-pocket costs associated with this bonus arrangement, so he implements a double bonus plan. As we saw in the double bonus example, for Charlie to contribute $10,000 in premiums with zero out-of-pocket costs to Patty, his annual outlay would be $15,385. 

The design of the life insurance policy is driven by Charlie’s primary objectives, which are to: 1) provide Patty survivorship protection during her working years; and 2) to allow Patty to leverage the cash value for potential supplemental income when she retires. Knowing Patty’s intent to retire at age 65, Charlie wants to stop contributions to this bonus arrangement at that time. With these factors in mind, it is hypothetically possible to design a policy (assuming Patty is elite, non-tobacco) that provides Patty: 

• An initial death benefit protection of approximately $200,000, which grows to approximately $380,000 at Patty’s age 65;** and 
• Over $20,000 of supplemental annual income starting at age 65 (which will result in a decreasing death benefit).**

Patty is thrilled with this arrangement. Through the bonus plan, she owns of the life insurance policy and designates who will be the beneficiaries of the death benefit. The business pays the premiums via a grossed-up double bonus arrangement, so Patty incurs no out-of-pocket costs. The life insurance policy provides valuable death benefit protection, particularly as it relates to providing survivor income to Patty’s family in the event of her premature death. Moreover, the policy cash value is available to supplement her retirement income generally in an income tax-advantaged manner. Finally, the living benefits of the policy provide Patty additional life-time protection should she experience a qualifying illness or injury.***

Knowing that the policy provides both living and death benefits provides Patty with peace of mind. Appreciating the importance of these benefits to Patty provides Charlie with peace of mind as Patty now has an additional reason to remain employed with his business. 

Patty is thrilled with this arrangement. Through the bonus plan, she owns of the life insurance policy and designates who will be the beneficiaries of the death benefit. The business pays the premiums via a grossed-up double bonus arrangement, so Patty incurs no out-of-pocket costs. The life insurance policy provides valuable death benefit protection, particularly as it relates to providing survivor income to Patty’s family in the event of her premature death. Moreover, the policy cash value could be available to supplement her retirement income generally in an income tax-advantaged manner. Finally, the living benefits of the policy provide Patty additional protection should she become ill or injured. 

Knowing that the policy provides both death and living benefits provides Patty with peace of mind. Appreciating the importance of these benefits to Patty provides Charlie with peace of mind as Patty now has an additional reason to remain employed with his business. 

**Assuming maximum non-guaranteed illustrated rates – actual results may be more or less favorable

***Living Benefits are provided by no additional premium Accelerated Benefit Riders.  Receipt of Accelerated Benefits will reduce the Cash Value and Death Benefit otherwise payable under the policy, may result in a taxable event, and may affect your client’s eligibility for public assistance programs.  Riders are supplemental benefits that can be added to a life insurance policy and are not suitable unless the client has a need for life insurance.  Riders are optional, may require additional premium and may not be available in all states or on all products.