Business Solutions FAQ
What is a section 162 executive bonus?
An executive bonus plan (Section 162) is a way for business owners or companies to provide additional supplemental benefits to key employees or executives of their choice. The benefits usually include life insurance policy death benefits as well as cash value accumulations that can be used as a retirement income supplement. With an executive bonus plan, the business can use tax deductible company funds to selectively provide valued benefits to key people. An executive benefit plan, used effectively, can be a valuable tool to attract and retain key executives.
- The company provides the key executive with a bonus that is taxable as income to the recipient.
- The bonus is generally a deductible business expense for the company.
- The key employee may choose to use the bonus to purchase a properly structured life insurance policy that builds cash value that grows tax deferred.
- The life insurance policy, if properly structured, may provide an attractive benefit to the executive in the form of cash value growth.
- Any cash value accumulation will grow tax deferred and may be accessed by the employee income tax-free through withdrawals and policy loans.
- The policy’s cash value can be used to supplement retirement income or for any other financial need.
- If the key executive dies, in most cases, the heirs will receive the death benefit proceeds from the life insurance policy income tax free.
Executive Bonus Plan Options
In addition to the basic executive bonus plan, there are other common plan variations. These options include a double bonus arrangement and a restricted or controlled executive bonus plan.
With a double bonus arrangement, the company will provide the key executive with a bonus large enough to pay the life insurance premiums PLUS the income taxes incurred by the key executive on the bonus. The company can use the double bonus arrangement to eliminate any out of pocket expense for the key executive.
If the company wishes to retain some measure of control over the bonus, the restricted executive bonus plan is a good choice. With a restricted executive bonus, the company and the key executive enter into an agreement which includes a vesting schedule on the policy’s cash value growth. The vesting schedule is a form of “Golden Handcuffs” that allows a company to limit the availability of the cash value benefits until the executive has fulfilled the terms of the agreement. At that time, the executive is “vested”. Once the key executive is vested, they gain full and complete access to the policy’s cash value.
Advantages of Executive Bonus Plans using Cash Value Life Insurance.
- An executive bonus plan is simple to implement and easy to administer.
- The business can selectively choose the key employees they wish to reward.
- The bonus payments may be considered a fully deductible expense to the company.
- The key employee is able to name the beneficiary of the entire death benefit of the life insurance policy.
- The key executive will have access to policy cash values and may access that cash value without income tax through policy loans and withdrawals.
- Executive bonus plans are not subject to “qualified plan limits”.
Disadvantages of Executive Bonus Plans
- The company is unable to fully recover its costs from the policy’s death benefit since the key executive names the policy beneficiary.
- Executive bonus plans offer the company very little control of the policy. Even if a controlled executive bonus is utilized, it only restricts the key employee’s access to the policy’s cash value. The bonus is never recovered by the company even if the key employee leaves the company prior to vesting.
- The key executive must include any bonus in his or her taxable income.
- Without additional planning, the life insurance policy’s death benefit will be includable in the key executive’s taxable estate
What is a supplemental executive retirement plan (SERP)?
A supplemental executive retirement plan is a deferred compensation agreement between the company and the key executive whereby the company agrees to provide supplemental retirement income to the executive and his family if certain pre-agreed eligibility and vesting conditions are met by the executive. Properly structured cash value life insurance contracts can be an ideal vehicle to facilitate a SERP.
Any deferred benefits are not currently taxable to the key executive. When paid, the benefits become taxable to the executive as income and tax deductible to the company. A typical example of a plan would provide the executive a retirement benefit from all employer provided retirement benefit plans equal to 70% of the executives high three year average compensation. The company will book an annual expense equal to the present value of the stream of future benefit payments.
Because of its many advantages, most companies use cash value life insurance to finance the SERP agreement. The company purchases a life insurance policy on the key employee’s life that is sufficient to recover the cost associated with the future benefits outlined in the agreement. The company pays the premiums, owns the policy and is the policy beneficiary. The policy cash values grow tax deferred and can be used at any time by the company at its discretion.
At retirement, the key executive receives supplemental income, paid by the company, based upon the terms of the agreement. In the event of the key employee’s death, the policy’s death benefit is payable to the company to recover the cost of the plan and which can also be used to provide continued supplemental benefits or to provide a lump sum benefit to the executive’s named beneficiary.
Company Advantages with SERPs
- SERPs are relatively easy to implement and require no IRS approval or involved administration.
- The company can select the executives it wants to reward with supplemental benefits.
- The company controls the plan, owns the policy and has book income from policy cash value growth.
- Cash value within the life insurance policy accumulates tax deferred.
- When the supplemental income benefits are paid to the key employee, the company gets a tax deduction.
- The life insurance policy can be structured to allow the company to recover its cost.
Executive Advantages with SERPs
- The plan can be custom designed to meet the key employee’s specific needs.
- Supplemental retirement income can be accumulated without incurring any up front taxes.
- In the event the executive dies, the life insurance policy death benefits are available to fund the plan and provide a lump sum benefit to the executive’s beneficiary subject to the terms of the agreement.
Disadvantages of SERPs
- The company does not get an immediate tax deduction on the premium payments. The deductions come for the business when plan benefits are paid to participant.
- The cash value build up that accumulates inside the life insurance policy used to fund the SERP is subject to the creditors of the company and is not protected if the company becomes insolvent.
What is a non-qualified deferred compensation plan?
A deferred compensation plan is an arrangement whereby an executive or owner defers some portion of their current income until a specified future date. Wages earned in one period are actually paid at a later date.
Properly structured cash value life insurance contracts can be an ideal vehicle to fund a deferred compensation plan. The deferred amounts can be used to pay premiums on cash value life insurance. The cash value can then be available at retirement to supplement other income or, if the insured dies before retirement, the insured’s designated beneficiary would receive the insurance policy’s death benefit.
- The employer is not entitled to tax deductions until such time as the benefits are actually paid to the employee
- Benefits are taxable to the employee at such time as the employee has the right to receive the benefits without regard to when the benefits are actually paid.
The advantages of a nonqualified deferred comp plans are:
- The employer can pick and choose among the recipient employees without regard to years of service, salary level or any other criteria
- Allows a business to provide benefits to officers, executives and other highly paid employees
- The amount of the employer’s contributions are not limited
- A nonqualified plan is less expensive to set-up than a qualified plan
- There are no significant filing or reporting requirements
What is a split dollar arrangement?
A split dollar arrangement is a plan in which a life insurance policy’s premium, cash values, and death benefit are split between two parties. A split dollar arrangement can be helpful in estate liquidity planning to minimize income, estate, and gift taxes. This type of plan has been used for years to help individuals with the funding of large premiums, and/or to reduce the cash flow required to fund a much needed life insurance policy
These types of plans have also been used by tax exempt corporations as an executive benefit to encourage employees to remain with the company. In some instances, a corporation can also use a Split Dollar plan to fund the replacement of a valuable executive.
In 2003 Final Split Dollar Regulations changed the Split Dollar landscape in some important ways. A properly structured Split Dollar plan still remains a viable and important planning approach.
Business Continuation. What are cross-sell and buy-sell agreements?'
Where the appropriate plan of action would be to sell the business interest, establishing a formal plan for the sale of your business may be one of the most important actions you ever take with respect to your business. A buy-sell agreement using properly structured cash value life insurance is one way to help ensure the continuation of your business, guaranty a buyer and help make sure your family is taken care of financially.
WHAT IS A BUY-SELL AGREEMENT?
A buy-sell agreement is a contract between a company and its key shareholders or a company’s co-owners to sell an owners interest in the business to the company or the other co-owners in the event of death, disability, withdrawal or retirement. One of the most efficient means of funding and facilitating the agreement is through the use of properly structured cash value life insurance contracts. In a nutshell each owner’s life is insured and the cash values and/or death benefits are to be used to execute the buy-sell agreement upon death, disability, withdrawal or retirement.
BUY-SELL AGREEMENT BENEFITS:
- Guarantees a buyer
- Establishes a fair price
- Promotes a smooth transfer of the business
- Helps avoid conflicts
- Sets the terms of the purchase and identifies the events that trigger a buyout
- Assures the remaining owners and employees that the ownership of the company will not transfer to an unsuitable person
ADVANTAGES OF USING LIFE INSURANCE TO FUND THE BUY-SELL AGREEMENT:
- Complete financing is guaranteed from the beginning
- Proceeds may be free from income tax
- Cash values can be used for a buyout due to retirement or disability
- Credit position could be strengthened
- It is generally an economical method
What is key person coverage?
What happens to the business in the future if one of the key contributors becomes disabled or dies suddenly? The loss to any business can be devastating, particularly in a small business. How long can the business sustain that loss before a replacement is hired, trained and equally productive? Can the business even replace that key contributor? Key Person insurance could be part of the solution.
A properly structured cash value life insurance policy owned by and benefiting the business may provide access to needed funds during a difficult time. Life Insurance can be a cost-efficient method of providing these benefits.
- The employer and Key Person apply for the Life insurance policy.
- The business is the owner and beneficiary of the policy; while the Key Person employee is insured.
- The business pays the premium, and the value of the policy is an asset of the business. This means the life insurance may be subject to the creditors of the business.
- The employer can access the policy cash value for business needs. It can also be used to fund survivor benefits for the Key Person’s beneficiary.
- In addition, the Key Person may be given the opportunity to purchase or receive a bonus of the valuable life insurance protection as part of a future benefits package.
How could a Bank On Yourself designed policy be used for business financing?
Every situation will be unique, so the diagram below is a hypothetical example of how an equipment leasing program might work using a Bank On Yourself designed whole life insurance policy to finance the program. Your results may be different and you should consult your own legal and tax professionals prior to implementing any strategy…
- The individual opens a Bank on Yourself designed insurance policy
- When the policy is funded, the Individual borrows from the policy and buys equipment needed by the corporation
- The individual leases the equipment to the corporation or partnership at a market value price
Individual reports the lease income on Schedule E of his/her individual Form 1040. The equipment is expensed via a depreciation deduction over a period of 5 – 7 years on average. Interest expense on the loan from your bank is also deducted on this form. Structured properly this could be a net zero transaction.
Corporation or Partnership has rental expense that is deducted on the entity’s income tax return, reducing the individual’s K-1 income (and K-1 income IS subject to the 15.3% self-employment tax).
*Since the individual received the lease payments as non-earned income, there is no 15.3% self-employment tax due on it. The individual takes a tax write-off for depreciation on the equipment. The individual may also be able write off the interest they pay back to their banks.
This hypothetical example uses an equipment leasing program, however a similar structure could be used for a variety of business financing needs.