By Jason Wellmann
Small business owners have a number of challenges to manage within the normal course of running a company. These challenges include everything from the big-picture details such as making sure the company is profitable and that the lights stay on, to the more routine (but no less important) tasks such as customer service and employee engagement.
Part of employee engagement is making sure employees feel valued on a day-to-day basis. But the larger efforts must address things such as competitive salaries and benefits, offering great perks, and providing a positive work environment. While these are all important aspects of keeping employees happy, sometimes more is necessary to attract and retain high performers.
Through executive bonus plans, life insurance can be part of an innovative solution you can offer your small business clients who are looking to reward and motive their key employees. Even better, it’s a strategy that can produce a tax deduction for their business.
Bonus plan basics
Section 162(a)(1) of the Internal Revenue Code allows businesses a tax deduction for salaries or other compensation as a “reasonable allowance for personal services actually rendered.” Certain executive bonuses are included in this definition of “reasonable compensation,” which is why they’re sometimes called Section 162 executive bonus plans.
Such bonuses are generally deductible by an employer according to the same rules as other forms of cash compensation – although no deduction is generally allowed for compensation in excess of $1 million for publicly traded companies when the employee is the CEO or among the four highest compensated officers as defined in IRC Section 162(m).
Structuring a bonus plan to buy life insurance for employees
Many businesses choose to pay their bonuses in cash, but the business owner might consider offering their key employees other choices. One option could involve using part – or all – of their bonus to purchase life insurance when there is a need for coverage.
Here’s how it works.
Under the executive bonus plan, the employer pays a bonus to the employee so the employee can purchase (and own) a fixed indexed universal life (FIUL) insurance policy. The employee then uses the bonus to pay the entire policy premium directly to the insurance company. Because the employee is the owner of the policy, the employee can access any available cash value accumulation through policy loans and withdrawals (if needed).
One way to better understand the value of executive bonus plans is via a hypothetical scenario.
The owner of a company, ABC Inc., decides to give its key employee, John, an annual bonus. John receives the annual bonus from ABC Inc., and uses a portion of the bonus to pay his income taxes. With the remaining portion of the bonus, John buys a fixed indexed universal life insurance policy.
The result of this arrangement is that ABC Inc. can claim a tax deduction for the bonus because it’s part of John’s compensation and will be taxed to him. John gets life insurance protection. In addition, if the need arises, he also can use his policy to help supplement his retirement income though policy loans or withdrawals (assuming there is sufficient cash value available). Note that fixed indexed universal life insurance does not provide a stream of income in retirement.
Executive bonus plans can help employees feel valued and appreciated
If the executive bonus is used to purchase life insurance, it can offer other tangible benefits by:
- Providing a death benefit that is generally income tax-free to their beneficiaries.
- Becoming a potential source of tax-free supplemental retirement income through loans or withdrawals from any available cash value.
Executive bonus plans =also can benefit your client
In addition to the tax advantages described above, an executive bonus plan can help your client’s business attract and keep top talent. And remember that, as a business owner, they can set up an executive bonus plan for themselves, too, as long as the business owner is also an employee of the company – so they can enjoy the same tangible benefits as their other employees.
Executive bonus plans are straightforward to set up
There are no government reporting costs, and a complicated written agreement is usually not required because the employee owns the policy, and the employer has no rights or benefits in the policy.
Executive bonus plans are also flexible. Your client can decide who will receive the benefit and in what amount. They can tie the bonus to company performance or to individual goals, and they can start or discontinue an executive bonus plan at any time. The bonus paid to the employee also can be set up to include the tax incurred on the bonus.
It is important that your client consult with an attorney and an accountant before they set up an executive bonus plan. Other important considerations include:
- The employee targeted for an executive bonus plan must be insurable. Life insurance policies require health and financial underwriting.
- The policy is portable – the employee can take the policy with them if employment terminates, so it does not tie the employee to the business.
- If your client (the employer) stops paying annual bonuses, the employee, as the policy owner, would be responsible for paying the policy premiums to keep the policy in force.
- The business does not have any ownership or other rights to the life insurance policy.
- The bonus paid to the employee is taxable, however, the double bonus could cover the employee’s tax.
If you have a client who is a small business owner, encourage them to consider talking to their attorney and accountant about the value of incorporating an executive bonus plan into their business. Not only could it be a valuable addition to their employee retention strategy, providing this level of guidance can also demonstrate the new and creative ways you are looking out for their financial well-being.
Jason Wellmann is senior vice president of life insurance sales for Allianz Life. Jason may be contacted at [email protected].
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