Business · 5 min read
Section 162 executive bonus plans
A simple way for a business to reward key people with a life insurance policy they own: single bonus, double bonus, REBA, and the tax picture.
Section 162 executive bonus plans
A simple way for a business to reward key people with a life insurance policy they own: single bonus, double bonus, REBA, and the tax picture.
Pillar: Business · Reading time: 5 min
In plain words
A Section 162 executive bonus plan is a business paying an extra bonus to a chosen employee or owner, who uses it to pay the premium on a life insurance policy they own. The name comes from Internal Revenue Code section 162, which lets a business deduct reasonable pay as a business expense.
The company gets a deduction for the bonus. The employee owns a policy with a death benefit for their family and, if it is permanent, cash value they can use later. Small businesses like these plans because they are simple: no IRS approval and no filings like a qualified retirement plan.
How it works
- The business picks who is in the plan. Unlike a 401(k), it does not have to include everyone. It can choose one person.
- The employee buys a policy and names their own beneficiaries.
- The business pays a bonus, either straight to the insurer or to the employee, equal to the premium.
- The business deducts the bonus as compensation, as long as total pay is reasonable.
- The employee reports the bonus as taxable income and pays the income tax on it.
- The employee owns the policy outright, including any cash value, and keeps it if they leave (unless a REBA applies; see below).
The three main designs
Single bonus
The business pays only the premium. The employee pays the income tax on that bonus out of their own pocket. Simplest, but the employee feels the tax.
Double bonus
The business pays the premium plus a second bonus large enough to cover the employee's income tax on both. The employee pays nothing out of pocket. It costs the business more, but the whole amount is generally deductible.
Restricted executive bonus arrangement (REBA)
The employee still owns the policy, but signs an agreement, often with a restrictive endorsement on the policy, that limits access to the cash value for a set number of years. If the employee leaves early, they may have to repay part of the bonus. This gives the business what planners call "golden handcuffs": a reason for the key person to stay. REBAs need careful drafting by an attorney.
The tax picture, in general terms
Under current U.S. federal law: - For the business: bonus payments are generally deductible as compensation if total pay is reasonable. For C corporations, the deduction is worth the corporate rate (21%). For pass-through businesses, it reduces the income passed to the owners. - For the employee: the bonus is taxable wages, subject to income tax and payroll taxes. - For the policy: cash value grows tax-deferred, and policy loans are generally not taxable while the policy stays in force and is not a modified endowment contract (MEC). The death benefit is generally income-tax-free to beneficiaries.
Owners of S corporations, partnerships and LLCs can use the plan, but the deduction may simply move income from one line to another on their own return. It works best when the person in the plan is an employee other than the owner, or when the owner is in a C corporation.
Section 162 vs other executive benefits
| Plan | Who owns the policy | Business deduction | Complexity |
|---|---|---|---|
| Section 162 bonus | Employee | Yes, when paid | Low |
| Split dollar | Shared by agreement | Usually no | Medium to high |
| Nonqualified deferred comp | Business (informal funding) | Later, when paid out | Medium to high |
A worked example (illustrative)
Grace, 50, owns a C corporation dental practice. Her office manager, Luis, 44, has run the practice for twelve years and she wants to keep him. She sets up a double bonus plan for a policy Luis owns.
| Item | Amount per year |
|---|---|
| Premium on Luis's policy | $10,000 |
| Extra bonus to cover his tax (about 30% bracket) | about $4,300 |
| Total bonus | about $14,300 |
| Corporate tax saved at 21% | about $3,000 |
| Net cost to the practice | about $11,300 |
Luis pays nothing out of pocket. After 20 years his policy, designed for cash value, could have an illustrative cash value well above the total premiums paid, which he could later borrow against for retirement income. Grace adds a five-year REBA restriction so the plan encourages Luis to stay. All figures are illustrative, not a quote or projection.
Common mistakes
- Unreasonable pay. If total pay looks excessive, the IRS can challenge the deduction.
- Forgetting payroll taxes. The bonus is wages, so withholding and payroll taxes apply.
- An underfunded policy. A permanent policy funded at too little can lapse, especially if loans are taken.
- Overfunding into a MEC. Too much premium too early changes how loans are taxed.
- Using a REBA without a written agreement. Restrictions need clear documents to hold up.
FAQs
Can I set up a plan for just one employee?
Yes. Executive bonus plans are not bound by the nondiscrimination rules of qualified retirement plans.
Can a business owner be in their own plan?
Yes, but for pass-through owners the tax benefit is often small, because the deduction and the income land on the same return. It is most useful in C corporations.
What happens if the employee leaves?
Without a REBA, they keep the policy and can keep paying it themselves. With a REBA, the agreement decides what happens.
Is this the same as key person insurance?
No. In key person cover the business owns the policy and is the beneficiary. In a Section 162 plan the employee owns it and their family benefits.
Related strategies
- Key person insurance — protecting the business from losing the same person.
- Buy-sell agreements after Connelly (2024) — planning for an owner's exit.
- Tax-free retirement buckets — where policy cash value fits in retirement.
Next step
Get a quote at /quote for an illustrative policy cost, or take the Wealth Strategy Score at /score to see how a bonus plan fits your business.
Education only, not personal financial, tax, legal or insurance advice. VeraLife.ai is not a registered investment adviser, broker-dealer or insurance agency. All numbers are illustrative.