The American economy depends on small business, and small business depends on its employees. Specifically, the ability to attract, train and keep talented employees. Since it is difficult for small business to compete with big business in terms of executive pay, they sometimes turn to innovative remunerative strategies to retain the talented people they have in their employ. Life insurance is used in three of these plans; executive bonus, split dollar, and deferred compensation. An extremely simplified overview of each type of plan follows.
Executive bonus (also known as a section 162 plan, after the IRC section that authorizes them) is the simplest of the three. The employer bonuses the premium to the employee, and the employee uses the bonus to purchase a life insurance policy (In practice, most employers make payment directly to the insurance company). The premium is deductible by the employer and taxable income to the employee.
Although that is a great deal for the employee (they get a policy for just the tax on the premium instead of paying the entire premium), some employers will also bonus the tax to the employee so that the employee incurs no out of pocket expense. Example: An employer would bonus $13,889 to an employee in a 28% bracket to pay a $10,000 premium. That tax on that bonus (at 28%) would be $3,889, leaving $10,000 available for the life insurance premium.
Split dollar is a plan whereby the policy values (premium, cash value and death benefit) are shared between two parties, usually an employer and an employee. Without going into the technical specifics, the employee will pay a (small) premium approximating the term cost, and the employer will pay the (much larger) balance. In exchange for his payments, the employer always has a right to the cash value and death benefit equaling the sum of all of his payments, so he will eventually recoup all of his payments.
Deferred compensation involves an employee deferring a portion of her compensation (usually a raise). The employer will fund the plan using life insurance, because the deferral is usually payable whether or not the employee is alive at the specified age. The employer does not receive a tax deduction when the deferral is funded, but does receive one when it is eventually paid. Like split dollar, this can be structured in such a manner so that the employer recoups all payments.
Unlike qualified plans (401(k), pension, and profit sharing plans) these plans don’t have to be offered to all employees. Executive bonus, split dollar, and deferred comp plans are all non-qualified plans, meaning that the employer can offer them to only those employees deemed essential to the business. That makes them extremely flexible tools in the executive remuneration arena.