Employee income taxes
Premium payments are treated as compensation to the employee and are subject to income taxation. The premium payments must be reported on the employee’s W-2 form. At the employee’s death, the insurance proceeds are paid out income tax-free. If the employee surrenders the policy, the cash surrender value in excess of the cost of the contract is taxable as ordinary income to the employee.
Employer income taxes
The employer is allowed an income tax deduction for the full amount of the bonus in each year a bonus is paid. The premium payment is deductible as compensation to the employee provided:
- The employer is not directly or indirectly a beneficiary under the policy, and
- The premiums constitute additional reasonable compensation for services rendered by the employee.
To ensure the employer will be entitled to the income tax deduction, the arrangement must not allow the employer to be a direct or indirect beneficiary of the policy.
Therefore, the employer must not be entitled to receive any cash value from the policy, nor any portion of the death benefit. The insurance policy is used merely as an incentive for the employee to satisfy the separate employment agreement.
Social Security taxes
The premium payments are subject to Social Security taxes. The full amount of the premium payment will be subject to Social Security taxes, if the employee’s salary is below the Social Security taxable wage base.
Benefits and considerations for executive bonus strategies
- Little to no administration
- Simple and flexible
- Immediate income tax deduction
- Selective participation
- Not subject to employer-owned life insurance (EOLI) rules; avoids ERISA (For more information about ERISA, see the GEBA Foreword to Counsel and Specimen Documents)
- Cost-effective life insurance protection and choice of beneficiary
- Immediate access to cash value, which can grow tax-deferred
- Supplemental retirement income
- Not subject to employer’s creditors
- Estate planning aspects
- Provides for golden handcuffs
- Potential recovery of costs if employee leaves
- Cost-effective alternative to GEBA through employee payment of premiums
- No control over the policy
- Does not receive policy’s death benefit or have access to cash value
- Employer bears full cost of plan
- No retention of asset or cost recovery if employee leaves unless GEBA is used
- No golden handcuffs unless GEBA is used
- Must be acceptable underwriting
- Death proceeds may be included in estate
- Bonus is taxable income, but employer could pay tax cost via double bonus
- Other limitations and considerations related to owning life insurance
- Golden handcuffs restrict access to cash value and loans of the policy