Business owners
The Executive Bonus Plan: How a Business Keeps a Key Employee Without a Golden Handcuff Nobody Wants
No plan document. No IRS filing. No discrimination testing. The business picks one person, pays a bonus, and that person owns something they would lose by leaving.
By Caleb Bullard · · 7 min read
The short answer. An executive bonus plan, often called a Section 162 plan, is an arrangement where an employer pays a bonus that a selected employee uses to fund a personally owned life insurance policy. The employee owns the policy and names the beneficiary. For the employer, the payment is compensation — 26 U.S.C. 162(a) allows a deduction for "a reasonable allowance for salaries or other compensation for personal services actually rendered." The bonus is taxable income to the employee. Because the employer is not a beneficiary of the policy, the arrangement avoids the rule in 26 U.S.C. 264(a)(1), which disallows a deduction for premiums where the taxpayer is "directly or indirectly a beneficiary under the policy." Employers should confirm treatment with their CPA before implementing.
Every small business eventually has the same problem. One person — the operations manager who knows every account, the estimator whose numbers are always right, the second-in-command who runs the place when the owner is away — becomes genuinely hard to replace. And that person knows it.
The usual answers are a raise or equity. A raise gets absorbed into life within about two months. Equity is permanent, dilutive, and brings someone into ownership decisions forever. Owners often want something in between and assume it requires a complicated retirement plan.
It does not. There is a version of this that fits on one page.
How it works
The mechanics are almost embarrassingly simple:
- The business selects one employee. Just that one, if it wants.
- The business pays that employee a bonus.
- The employee uses the bonus to fund a life insurance policy that they own, naming their own beneficiary.
That is the entire structure. There is no plan document to file, no IRS approval to wait for, and none of the participation testing that comes with a qualified retirement plan. It is called a Section 162 plan because the deduction comes from the ordinary compensation rules rather than from any special benefits provision.
The tax picture, in plain terms
For the business: the payment is pay. The statute allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including… a reasonable allowance for salaries or other compensation for personal services actually rendered.” The word doing the work there is reasonable — total compensation has to make sense for the job.
For the employee: it is income. It shows up on the W-2 and it is taxed that year. Some owners gross the bonus up so the employee is whole after tax; others pay the bonus and let the employee handle it. Both are normal.
The detail owners get wrong: the employer must not be a beneficiary of the policy. Federal law disallows a deduction for “Premiums on any life insurance policy… if the taxpayer is directly or indirectly a beneficiary under the policy or contract.” The moment a business tries to keep a string attached by naming itself, it has built a different arrangement with a different and worse tax answer. Employee owns it. Employee names the beneficiary. That is what makes the deduction work.
What the employee actually gets
Two things, and the second is the one that keeps people.
Their family is protected by a policy that belongs to them and follows them for life — unlike group coverage through work, which ends when the job does.
And if the policy is a permanent one, it builds cash value they own. That is the piece that feels different from a raise. A raise is spent. This accumulates, in their name, because of where they work.
The retention question
Owners always ask the same thing: what stops them from taking it and walking?
By default, nothing. They own it. That is the deal, and it is why the employee values it.
If an employer wants a retention element, there is a restricted version — commonly called a restrictive endorsement, or a double bonus arrangement — where the employee’s access to the cash value is limited for an agreed number of years while the death benefit stays in force. It is a contract between the employer and the employee, and it should be drafted by an attorney, not improvised.
A word of caution on the handcuff instinct: make it too tight and the thing stops feeling like a gift and starts feeling like a leash. The arrangements that actually retain people are the ones the employee is glad to have.
Where this fits, and where it does not
It fits when a business has one or a few people it cannot afford to lose, wants to reward them specifically rather than everyone, and does not want the cost or the administration of a qualified plan.
It does not fit when the real need is a retirement plan for the owner and the whole staff — that is a different set of tools, and if the owner is the one who is behind, there is a better-suited structure. It also does not fit when the business cannot sustain the bonus for years, because starting and stopping does more harm to the relationship than never starting.
None of this is legal or tax advice, and the numbers only mean something against a real business. If you have someone you cannot afford to lose and you want to see what this looks like with your figures in it, book a conversation.
Questions people ask
What is a Section 162 executive bonus plan?
An arrangement where an employer pays a selected employee a bonus, and the employee uses it to fund a life insurance policy they own personally. It takes its name from 26 U.S.C. 162, the section that allows a business to deduct ordinary and necessary expenses including reasonable compensation. There is no plan document to file and no IRS approval required.
Can the employer deduct the bonus?
Generally yes, as compensation, provided it is reasonable for the services actually rendered. The statute allows a deduction for "a reasonable allowance for salaries or other compensation for personal services actually rendered." What makes it deductible is that it is pay. If the employer were a beneficiary of the policy, a different rule would apply and the deduction would be disallowed. Confirm with your CPA.
Is the bonus taxable to the employee?
Yes. It is compensation, so it is taxable income in the year received, and it is reported on the employee's W-2. Some employers gross the bonus up so the employee's take-home is unaffected after tax. Others do not. Both are common; the choice belongs to the employer.
Can a business offer this to only one person?
Yes, and that is much of the appeal. Unlike a qualified retirement plan, an executive bonus arrangement is not subject to the participation and nondiscrimination requirements that apply to qualified plans, so an employer can select one person or a small group. Employers should still confirm how any specific arrangement interacts with their other benefit plans.
What keeps the employee from taking the policy and leaving?
On its own, nothing — the employee owns the policy, which is the point. Employers who want a retention element use a restricted version, sometimes called a restrictive endorsement or double-bonus arrangement, where the employee's access to the policy's cash value is limited for an agreed period. That restriction is a contract between employer and employee and should be drafted by an attorney.
Is this the same as deferred compensation?
No. Nonqualified deferred compensation is a promise by the employer to pay later, and the employee is an unsecured creditor of the business until it pays. In an executive bonus arrangement the employee owns the policy now. That is a meaningful difference if the business ever gets into trouble.
Sources
This article is general education, not advice for your situation. Policy features vary by carrier and state.