Section 162 Executive Bonus Plans and Split Dollar: Keeping the People You Cannot Replace
Every employer we work with has a retention problem they describe the same way. It is not the whole staff. It is four or five people whose departure would genuinely hurt, and the standard benefits package treats them exactly like everyone else.
That is not an oversight. It is how qualified plans are built. A 401k has to pass nondiscrimination testing and has contribution limits that cap what a senior earner can put away. Group life caps out at a multiple of salary. None of it can be pointed at a specific person, which is precisely what you need when the concern is a specific person.
Two arrangements solve for that, and they are frequently confused with each other.
Key takeaways
- A Section 162 executive bonus plan is simple: the company pays the premium on a life insurance policy the executive personally owns. The bonus is deductible to the business as reasonable compensation and taxable to the executive.
- Because the executive is taxed now rather than later, it generally sidesteps the deferred compensation rules that make other arrangements complicated.
- You can offer it to one person. There is no requirement to extend it across the workforce.
- A restrictive endorsement adds the retention element, requiring company consent before the executive can access cash value, surrender, borrow against or transfer the policy.
- Split dollar is a different animal, governed by regulations finalized in 2003, and which of two tax regimes applies turns on who owns the policy.
How a Section 162 bonus plan works
The mechanics take about a paragraph to explain, which is most of the appeal.
The executive applies for, owns and controls a permanent life insurance policy. The company pays the premium and treats it as compensation. The company deducts it as reasonable compensation, provided the company is not a beneficiary of the policy and the executive total pay is defensible for the work being done. The executive reports it as income.
The executive gets a death benefit protecting their family, and a policy that builds cash value they can draw on later. The company gets a deduction and a benefit it can point at exactly the people it wants to keep. There is no plan document to file, no trust, and no separate accounting.
Because the executive is taxed in the year the premium is paid, the arrangement generally avoids the deferred compensation rules under Section 409A, which is what makes the alternative structures expensive to administer.
One practical note. Handing someone a benefit that increases their tax bill is a strange gift, so many employers gross the bonus up, paying an additional amount to cover the tax on the first. It roughly doubles the cost and it removes the only awkward conversation in the design.
The part that does the retaining
On its own, a bonus plan is generous but not sticky. The executive owns the policy from day one and could leave tomorrow with it.
A restrictive endorsement changes that. It is an agreement attached to the policy requiring the company consent before the executive can surrender it, take cash value out, pledge it as collateral, or change its ownership, until a date or a service milestone you specify. The death benefit still protects the family throughout. What is restricted is early access to the money.
Structured over a period of years, with restrictions releasing in stages, it gives a senior person a concrete and growing reason to stay that a salary increase does not. Salary resets expectations immediately. A vesting schedule accumulates.
Split dollar, and when it fits instead
Split dollar is an arrangement where the company and the executive divide the cost and the benefits of a policy. It is more flexible than a bonus plan and considerably more technical.
Regulations finalized in 2003 set up two mutually exclusive tax regimes, and which one applies is determined by who owns the contract.
Under the economic benefit regime, the company owns the policy and is treated as providing benefits to the executive, who is taxed on the value of the life insurance protection and any interest they hold in cash value. This generally governs endorsement arrangements.
Under the loan regime, the executive owns the policy and the company premium payments are treated as loans to the executive, secured by the policy. This generally governs collateral assignment arrangements.
The regimes apply to arrangements entered into after September 17, 2003. Anything older sits under prior rules and is worth having someone look at, because a fair number of legacy arrangements have been running unexamined for two decades.
Split dollar tends to make sense where the amount of coverage is large, where the company wants its premium outlay recovered eventually, or where the arrangement is doing estate planning work as well as retention. It is not the right tool for a straightforward retention problem with two people.
Which one fits
Most of the employers we talk to in this region are best served by the simpler structure. A 162 bonus plan with a restrictive endorsement is understandable in one meeting, costs what it costs with no surprises, and does not create an obligation sitting on the balance sheet.
Split dollar earns its complexity at larger numbers, or where recovering the company outlay matters, or where the executive has an estate tax exposure the arrangement can help address. Given Maryland estate tax threshold of 5 million dollars, that last case comes up here more often than it does in most states.
Why this comes up constantly in the DMV
The talent market in Maryland, DC and Northern Virginia is unusual. Associations, federal contractors, professional services firms and life sciences companies are all competing for a relatively small pool of experienced people, often against employers with far deeper pockets. A larger competitor can nearly always beat you on salary.
What a larger competitor struggles to replicate quickly is an arrangement built around one person, with money that accumulates and a reason to still be there in five years. That is the actual argument for these plans, and it is a conversation about retention rather than a conversation about insurance.
We are a brokerage rather than a law or accounting firm. Your CPA should confirm the deduction and your attorney should review the endorsement language before anything is signed. Nothing here is tax or legal advice.
Frequently Asked Questions
What is a Section 162 executive bonus plan?
An arrangement where the employer pays bonus compensation in the form of premium payments on a life insurance policy that the executive personally owns. It takes its name from Section 162 of the tax code, which governs the deduction for ordinary and necessary business expenses including reasonable compensation.
Is the bonus deductible to the business?
Generally yes, as reasonable compensation, provided the business is not a beneficiary of the policy and the executive total compensation is reasonable for the services performed. The same amount is taxable income to the executive in the year it is paid.
Who owns the policy in a 162 bonus plan?
The executive. They apply for it, own it, control it and name the beneficiary. That portability is the point for the executive and the reason a restrictive endorsement is usually added for the employer.
What is a restrictive endorsement and does it really retain people?
It is an agreement requiring the employer consent before the executive can surrender the policy, withdraw or borrow cash value, pledge it as collateral or transfer ownership, until a specified date or length of service. It does not trap anyone, and the death benefit is never restricted. What it does is make leaving early cost something concrete, which is more durable than a raise.
How is split dollar different from an executive bonus plan?
In a bonus plan the company simply pays compensation and the executive owns everything. In split dollar the company and the executive divide both the cost and the benefits, and the company often expects to recover its outlay. Split dollar is governed by regulations finalized in 2003 with two tax regimes, economic benefit and loan, determined by who owns the contract. It is more flexible and materially more complex.
Do we have to offer this to everyone?
No. Unlike qualified retirement plans, these arrangements are not subject to nondiscrimination testing, so you can offer them to one person or to a handful of senior people and to nobody else. That selectivity is usually the whole reason an employer is interested.
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