An Executive Benefit with an Immediate Tax Deduction / The nonqualified executive bonus plan in a nutshell

Steve Parrish for Forbes writes: With the recent tax changes of the American Tax Relief Act of 2012 (ATRA), your nonqualified executive benefit packages should take into account the higher income tax rates that affect you and your business as taxpayers. Typically one thinks of nonqualified deferred compensation or nonqualified stock options as the answer for executive benefits, but neither offers an immediate income tax deduction for your company. However, thenonqualified executive bonus concept does.

The nonqualified executive bonus plan in a nutshell

The beauty of this technique is its simplicity and effectiveness. An executive bonus plan is available for key employees of all entity types (S or C corporations, LLCs, etc.).  An executive bonus plan typically involves the purchase of life insurance on one or more key employees. The employer has total discretion to select which employees to cover and the amount of the bonus provided to each. The employer generally pays the premiums on the policy, and the employee is charged with taxable income equal to the amount of the premiums. In some instances, the employer will “double bonus” the employee to pay for any income taxes due. The bonus amounts are tax deductible to the employer as a business expense (as long as the bonuses are considered reasonable).

Many such plans also include a separate employment agreement. Such agreements are used to specify terms of the bonus arrangement, including the employee’s obligation to repay bonuses if employment is terminated early. In addition, a separate endorsement may be added to the insurance policy to limit the employee’s access to policy values for a period of time without the written approval of the employer.

Interested? Intrigued? Read on for benefits and considerations in choosing this plan design.

Benefits for you as an employer:

• Provides the ability to recruit, reward and retain the key employees who contribute the most to your business.
• Unlike profit sharing and other qualified plans, you can choose which key employees to benefit and the amount to reward each.
• Your business receives a current income tax deduction. If you are a flow through entity, this provides you with an immediate personal tax benefit.
• Agreements may be added to tie the key employee closer to the business and can be tailored to meet business objectives.
• Simple, yet flexible, plan design is easy to communicate and administer.
• The plan is exempt from annual reporting and ERISA requirements.

Some considerations before you go this route:

• The life insurance policy is not corporately owned.
• The death benefits will be paid to the employee/insured’s beneficiary, not your company.
• The nature of life insurance is such that this should be intended as an ongoing executive benefit, versus a one-time bonus.

Benefits for your employee(s):

• Overcomes the government limitations on the amount highly compensated employees can save on a tax-advantaged basis for retirement (e.g. a 401(k)).
• The retirement benefit (i.e. the cash value of the life insurance policy) grows on a tax-deferred basis.
• If properly designed, withdrawals and loans can be distributed from the insurance policy income tax- free (as long as the policy remains in force).
• If the employee dies, the death proceeds usually will be received income tax-free by the employee’s beneficiary.

Some considerations for your employee(s):

• There’s an additional tax if the employer’s bonus doesn’t cover 100% of the tax.
• The bonus may be contingent on continued employment.
• The employee must be insurable.

We all want to recruit, reward and retain key employees, but we also want tax deductions where possible.  The nonqualified executive bonus plan is a great blend of employee incentive and tax deductibility in one, easy to understand benefit package.