To reward top executives, companies sometimes choose to pay annual bonuses, either in cash or in the form of premiums on a personally-owned life or disability policy. Whether a bonus is paid in cash or as premiums on behalf of the executive, the amount must be reported to the executive as additional taxable compensation.
Insurance purchased in a bonus arrangement is intended to reward the executive, not to protect the business. The executive usually owns the policy and the beneficiary is someone other than the business.
This arrangement benefits the employer because the arrangement is simple to administer and the bonus typically is designed to qualify as a tax deductible, ordinary and necessary business expense. It benefits the executive by providing life or disability insurance coverage. In addition, if life insurance is involved, the executive generally has access to the policy cash value.
Supplemental Executive Retirement Plans and
Elective Deferred Compensation Arrangements
Companies may choose another common method of executive compensation, which rewards executives with retirement benefits that go above and beyond the employer's current plans. These benefits may be either in addition to, or in lieu of, current compensation and are commonly referred to collectively as nonqualified deferred compensation plans.
A deferred compensation arrangement is a contractual agreement between an employer and executive under which the employer promises to provide certain benefits to the executive in the future. A nonqualified deferred compensation plan is one that does not meet the ERISA and tax code requirements for a tax-qualified plan.
The agreement specifies how future benefits will be paid to the executive. When constructed properly, the benefits accumulate on a tax-deferred basis until received by the executive. Once the benefits are paid, they are income-taxable to the executive and the employer may be able to deduct the payments as an ordinary and necessary business expense.
Deferred compensation arrangements help employers reward a select group of management or key employees with a degree of flexibility that is not available under qualified plans. Within these arrangements, employers are free from most discrimination rules or funding limits. Executives benefit from deferred compensation arrangements because they receive additional future benefits that otherwise might not be possible, without current income tax consequences.
Many employers elect to informally finance their nonqualified deferred compensation arrangements. Informal financing helps to reduce executive concerns that the employer may not have adequate resources to pay the future benefits. It also may provide the cash flow at the time the benefits are to be paid out.
Permanent cash value life insurance is a commonly used informal financing vehicle. The employer is the owner, payer, and beneficiary of the policy. Under current law, policy cash value grows tax-deferred and can represent a valuable asset on the employer's financials. The death proceeds generally are received income-tax free. While the premium payment is a non-deductible business expense, the employer typically recovers the premiums it has paid from the death proceeds.