Section 162 Plans FAQs

There are questions surrounding Section 162 plans. Life insurance is a big deal in any household. Without it, you’d have to worry about your loved ones. There are many options to choose from when it comes to buying life insurance. Our experts answer some questions revolving around this topic.

Question – What is a controlled executive bonus arrangement?

Answer – A controlled executive bonus arrangement, also known as a restrictive or golden executive bonus arrangement, generally prohibits the insured employee from accessing the policy cash values without the consent of the employer. Thus, with a standard controlled executive bonus arrangement the employer has some very limited control over the policy, although it can’t recover its outlay in the event the insured employee terminates employment. This is generally accomplished by filing a restrictive endorsement with the insurance carrier which prohibits the insured employee from accessing the policy cash values or surrendering the policy without the written consent of the employer. This limited element of control should not be sufficient to cause the employer to lose its up-front income tax deduction, since the policy is not subject at any time to a risk of forfeiture.

There is a more aggressive variant of controlled executive bonus which does allow the employer to be repaid its premiums in the event the insured employee terminates employment. This is generally accomplished via a separate employment agreement which requires the insured employee to repay any bonuses if the employee terminates employment for any reason prior to being vested in the bonuses. It is the authors’ opinion that since the policy appears to be subject to a substantial risk of forfeiture, no up-front income tax deduction should be available to the employer for its premium bonuses (and the employee also does not incur up-front taxable income). Instead, the tax consequences associated with this type of arrangement should not occur until such time as the insured employee is vested.

Question – What is a double bonus?

Answer – Some employers pay not only an amount sufficient to pay premiums but also the tax on the bonus. This second bonus to pay the tax on the first payment is often called a double bonus.

To compute the amount that the employer must pay the employee so that he or she will net an amount sufficient to pay both the premium and the tax on it, divide the premium by one minus the employee’s combined income tax bracket. For instance, suppose the covered employee is in a combined federal and state income tax bracket of 30 percent and the premium is $10,000. The employer must bonus out $14,285.71 for the employee to net $10,000 after tax. [$10,000 divided by one minus .30 (.70) equals $14,285.71. Thus, $14,285.71 multiplied by .70 equals $10,000.]

Question – Can a Section 162 Plan be used with business owners in addition to key employees?

Answer – The use of an executive bonus arrangement with C corporation owners is entirely appropriate and can allow them to use business dollars to pay the premiums for personally owned life insurance. However, the use of such arrangements with owners of pass-through entities may not be appropriate, except in situations where it is used to reallocate pass-through income to minority owners in assisting them to purchase personally owned life insurance.

Its use with partners of partnerships and members of Limited Liability Companies (LLCs) that are taxed as partnerships is generally tax neutral, so there is generally no advantage (aside from reallocating income to minority owners) to using such an arrangement as opposed to having an owner utilize his or her distributive share of pass-through income to pay premiums. Its use with S corporation owners can actually cause adverse tax consequences. This is because S corporation owners do not have to pay payroll taxes on their distributive share of pass-through (K-1) income. Thus, paying a bonus to an S corporation owner can unnecessarily cause him or her to incur payroll taxes that would not have been incurred if the owner had simply used pass-through income to pay the premiums for the personally owned life insurance.

Question – What type of life insurance policy is typically used to fund a Section 162 plan?

Answer – Any permanent or even term coverage can be used in a Section 162 Plan although almost always some form of permanent insurance is indicated to pay-up the policy by the time the insured reaches retirement age. Consider a policy on which cash dividends, the surrender of paid-up additional insurance, or there is sufficient cash value that the employee can withdraw or borrow that can be used offset the employee’s tax on the premiums paid by the employer.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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