A Section 162 bonus plan is the simplest way for a private company to give a key employee a benefit that a 401(k) cannot match. The company pays a bonus. That bonus funds a permanent life insurance policy. The employee owns the policy, names the beneficiary, and builds cash value inside it over time.
Here is the part most articles skip. A plain Section 162 bonus plan creates no retention at all. People call these plans golden handcuffs, and without one added feature, that name is wrong.
What Is a Section 162 Executive Bonus Plan
The short version: an employer pays a bonus to a selected employee, and the employee uses that money to buy a life insurance policy on their own life, all under a written agreement.
The mechanics are short:
- You pick which employees participate. There is no coverage testing and no requirement to include everyone.
- The employee applies for a permanent life insurance policy and owns it.
- Your company pays a bonus equal to the premium, either to the employee or directly to the carrier.
- The bonus shows up as wages on the employee’s W-2.
- Your company deducts the bonus as compensation.
The plan takes its name from Section 162 of the tax code, which is the section that lets a business deduct ordinary and necessary expenses, including reasonable pay for work performed.
Owners like these plans because they are quick to set up. You skip IRS approval and most of the annual administration a qualified retirement plan brings with it.
What Kind of Life Insurance Funds a Section 162 Plan
Most plans use a permanent policy, because the employee gets two things from it: a death benefit for their family and cash value they can reach later. Term coverage builds no cash value, so it delivers only the first half.
Three permanent policy types show up most often:
- Whole life. Fixed premiums and cash value that builds on a schedule the issuing insurer sets. It suits a company that wants the same bonus amount every year.
- Universal life. Adjustable premiums, so the bonus can flex with a strong year or a lean one.
- Indexed universal life. Cash value linked to a market index, with a floor and a cap. It offers more growth potential and needs more monitoring.
Guaranteed universal life usually fits poorly here. It keeps cash value to a minimum, and cash value is the part most employees care about.
The policy type also shapes the vesting schedule. A design that builds cash value slowly needs a longer schedule before the employee has much to vest into.
Who Owns the Policy in an Executive Bonus Plan
The employee owns it. That single fact drives everything else about how these plans behave.
The employee names the beneficiary. The employee controls the cash value. If the employee resigns on a Tuesday and starts at your competitor on Monday, the policy goes with them. Your company has no claim to it and no way to recover the bonuses it already paid.
Portability is a real benefit for the employee, and it is exactly why a plain Section 162 bonus plan works as a reward rather than a retention tool. It buys goodwill. It does not buy time.
Owners who set one up expecting it to keep a manager in the building for five years are usually surprised. The plan does what its design allows, and holding people in place was never part of that design.
How a Restricted Executive Bonus Arrangement Adds the Handcuffs
Adding a vesting schedule to the same structure turns a reward into genuine retention, and the industry calls that version a REBA.
A REBA combines three pieces: the Section 162 bonus plan itself, a restrictive endorsement the carrier records against the policy, and language in the employment agreement. The endorsement is what limits the employee’s access to the cash value until they have vested.
Vesting schedules usually run three to seven years and take one of two shapes:
- Cliff vesting. The employee gets full access to the cash value on one date, and nothing before that date.
- Graded vesting. Access opens gradually, often twenty percent a year across five years.
If the employee leaves before vesting, the unvested portion goes back to the company. In many designs the policy’s own cash value covers that repayment.
The death benefit generally stays available to the employee’s family the whole time. That combination is what makes the arrangement work. The employee gets protection immediately and earns the savings piece by staying.
If retention is the actual goal, the restrictive endorsement is the entire mechanism.
Is an Executive Bonus Plan Taxable to the Employee
Yes. The bonus counts as ordinary income to the employee in the year you pay it, and it appears in box 1 of their W-2 like any other wages.
This trips up owners who present the plan as a gift, because it lands as a tax bill. An employee who receives a $20,000 bonus to fund a premium owes income tax on $20,000, and the money already went to the insurance carrier.
The fix is a structure called a double bonus. Your company pays a second bonus sized to cover the tax on the first one. The employee ends up whole, the carrier receives its premium, and your company deducts both bonuses. If an advisor presents a plan without one, ask why before you sign anything.
How Is a Life Insurance Bonus Calculated
You start with the annual premium and work backward to a bonus large enough to cover both the premium and the tax on the bonus itself.
Take a $20,000 premium for an employee in the 24% federal bracket who also pays Arizona’s flat 2.5% income tax, a combined 26.5%. The example assumes the whole bonus falls inside that bracket, and it leaves out Social Security and Medicare, which push the real number higher.
- The shortcut that comes up short. Add 26.5% of the premium, or $5,300, for a total bonus of $25,300. Tax on $25,300 comes to $6,704.50, which leaves $18,595.50. The employee ends up $1,404.50 short of the premium.
- The full gross up. Divide the premium by 73.5%, the share the employee keeps after tax. That gives a total bonus of $27,210.88. Tax takes $7,210.88, and exactly $20,000 remains for the premium.
The shortcut falls short because the second bonus is taxable too. Your company deducts the full $27,210.88, subject to the reasonableness test below. Your CPA should rerun these figures with the employee’s actual rates before anyone commits to a number.
What a Section 162 Bonus Plan Costs the Company
Your company deducts the bonus in the year it pays it, which is the main financial advantage over a deferred compensation plan.
The deduction still has a condition attached. Section 162(a)(1) allows a deduction for a reasonable allowance for salaries or other compensation for services actually performed, and the IRS notes in its Section 162(m) Audit Technique Guide that whether pay is reasonable depends on factors that differ from one federal circuit to the next. Total compensation has to hold up as reasonable for the role and the work. A bonus that pushes an employee’s package well past market for what they do can draw scrutiny, and that risk climbs when the employee is also a family member or a part owner.
Your CPA should size the bonus with that standard in mind before the company pays the first premium.
Does Section 162(m) Apply to a Private Company
No. That rule caps a publicly held corporation’s deduction at $1 million per year for pay to certain covered executives, and the IRS states that the limit applies only to corporations that are publicly held on the last day of their tax year.
Searches for these plans still surface 162(m) material, including news about recent changes. Two changes are real, and both stay limited to public companies:
- For tax years beginning after December 31, 2025, the One Big Beautiful Bill Act counts pay from every company in a public corporation’s controlled group toward the $1 million cap.
- For tax years beginning after December 31, 2026, the American Rescue Plan Act adds the next five highest paid employees to the covered group.
If you own a private company in Tucson, neither change reaches you. The reasonableness test under 162(a)(1) does.
Why Key Employee Retention Matters Before You Sell
A buyer is paying for the people who run your company, and a retention agreement only counts if you signed it well before the sale.
Owners tend to reach for retention tools when an offer is already on the table. By then the agreement reads as a reaction to the deal rather than as part of how the business operates, and a buyer discounts it accordingly. A vesting schedule signed three years before a sale carries weight. One signed three weeks before does not.
This is why key employee retention belongs inside business exit planning rather than off to the side. The manager who can run the operation without you is the same manager whose departure would move your valuation. Our guide to Exit Planning for Business Owners covers where this sits on the wider runway.
The policy funding matters too. A Section 162 arrangement uses permanent life insurance, and whoever owns that policy affects your estate plan and any buy-sell agreement already in place.
What Are the Downsides of a Section 162 Bonus Plan
The main downsides are that the employee pays tax on the bonus, the plan holds no one in place without a REBA, and the money leaves your company for good.
- The employee owes tax on money they never touch. Without a double bonus, the plan can feel like a bill rather than a benefit.
- No retention without the endorsement. A plain plan lets the employee walk away with the policy on day one.
- The money leaves your balance sheet. A Section 162 bonus is gone once you pay it. Non-qualified deferred compensation keeps the asset on your books until it pays out.
- The deduction depends on reasonableness. Pay that runs well past market can cost the company its deduction.
- Cash value builds slowly. A young employee on a three year vesting schedule may vest before the policy holds much.
- The bonuses stop when the job does. Once the employee leaves, the employee either pays the premiums personally or adjusts the policy.
- It suits a short list. These plans fit a handful of named employees better than a whole department.
If you want to reward growth in company value, phantom stock and stock appreciation rights tie the benefit to what the business is worth without giving away equity. The right answer depends on your cash flow, your entity type, and what you are actually trying to prevent.
Frequently Asked Questions
What Qualifies as a Section 162 Business Expense
An expense qualifies when it is ordinary and necessary for running your trade or business. Reasonable pay for services an employee actually performs is one of the categories Section 162 names, and a reasonably sized bonus fits inside it.
Can I Choose Which Employees Participate
Yes. A Section 162 bonus plan carries no nondiscrimination testing, so you can select individuals by name and offer different amounts to different people.
What Happens to the Plan if the Employee Retires
The employee keeps the policy. Once vesting is complete, they can access the accumulated cash value, which is why these arrangements often function as supplemental retirement savings for a key person.
Does the Company Get the Death Benefit
No. The employee names the beneficiary, and the death benefit goes to that person. If you want the company to receive a benefit when a key person dies, key person life insurance owned by the business is the separate tool for that job.
How Much Does a Section 162 Bonus Plan Cost to Set Up
Setup is inexpensive compared with a qualified plan because it needs no IRS approval. The real cost is the premium itself and the tax gross up if you use a double bonus.
Does a Section 162 Plan Work for an S Corporation Owner
It usually does less for an owner than for a key employee. In an S corporation, the company’s deduction flows through to the owners’ own returns, so a bonus to an owner mostly moves income from one line to another and can add payroll tax that a distribution would not carry. A C corporation owner sits in a different spot, because the company deducts the bonus while a dividend would face tax at both the company and personal level. The reasonableness test applies either way, so this belongs on your CPA’s desk before anyone writes the plan.
How We Coordinate Key Employee Retention at Global Investment Strategies®
We do not draft the employment agreements or file the tax returns. Your attorney writes the restrictive endorsement language and your CPA sizes the bonus against the reasonableness standard.
Our work is making those pieces agree with each other and with the rest of your plan: which people you actually need to keep, how long the vesting schedule should run given your exit timeline, how the policy ownership interacts with your estate plan, and whether a Section 162 bonus plan or deferred compensation fits your balance sheet better.
We have coordinated this work for Tucson business owners since 2009, alongside the attorneys and accountants they already use.
Start With the Person You Cannot Replace
Name the one or two people whose resignation would change what your company is worth. That list is short for most owners, and it is where this conversation starts.
We work with owners across Tucson, Oro Valley, Marana, and the Catalina Foothills. Request a private conversation and we will work through which structure fits your situation, alongside your existing advisors.
Global Investment Strategies® provides educational planning concepts and works alongside your qualified legal, tax, and financial professionals. This article is educational and is not individualized tax, legal, or financial advice. Review any executive compensation or retention strategy with your attorney and CPA before acting.
