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 162 Executive Bonus Plan
A 162 executive bonus plan is a written agreement where 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.
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. There is no IRS approval, no annual filing, and none of the administration a qualified retirement plan brings with it.
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 already paid.
Portability is a real benefit for the employee, and it is exactly why a plain Section 162 bonus plan is a reward rather than a retention tool. It buys goodwill. It does not buy time.
Owners who set one of these up expecting it to keep a manager in the building for five years are usually surprised. The plan does what it was designed to do. It was just never designed to do that.
How a Restricted Executive Bonus Arrangement Adds the Handcuffs
A Restricted Executive Bonus Arrangement, usually shortened to REBA, adds a vesting schedule to the same structure and turns a reward into genuine retention.
A REBA combines three pieces: the Section 162 bonus plan itself, a restrictive endorsement filed against the policy with the carrier, 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. 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 gets the savings piece by staying.
If retention is the actual goal, the restrictive endorsement is not an optional upgrade. It 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 plans that were sold as a gift and land as a tax bill. An employee who receives a bonus of twenty thousand dollars to fund a premium owes income tax on twenty thousand dollars, and the money already went to the insurance carrier.
The fix is a structure called a double bonus. Your company pays a second, smaller bonus sized to cover the tax on the first one. The employee ends up whole, the premium gets funded, and your company deducts both bonuses.
Most well designed plans now include the gross up. If a plan is presented to you without one, that is a fair question to raise before you sign anything.
What a Section 162 Bonus Plan Costs the Company
Your company deducts the bonus in the year it is paid, which is the main financial advantage over a deferred compensation plan.
The deduction is not automatic. Section 162(a)(1) allows a deduction for a reasonable allowance for salaries or other compensation for services actually performed, and the IRS describes that reasonableness standard in its Section 162(m) Audit Technique Guide. 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 first premium is paid, not after.
Section 162 Is Not Section 162(m)
Searches for these plans often surface material about Section 162(m), which is a different rule that catches a different kind of company.
Section 162(m) caps a publicly held corporation’s deduction at one million dollars per year for compensation paid to certain covered executives. The IRS is explicit that the limit applies only to corporations that are publicly held on the last day of their tax year.
If you own a private company in Tucson, that cap does not apply to 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 it was signed 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 how that policy is owned interacts with your estate plan and with any buy-sell agreement already in place.
When a Section 162 Bonus Plan Is the Wrong Tool
These plans fit a specific situation, and owners sometimes use them where something else works better.
- You want the money to stay on your balance sheet. A Section 162 bonus leaves the company permanently. Non-qualified deferred compensation keeps the asset on your books until it pays out.
- 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 employee is young and the runway is short. Permanent insurance builds cash value slowly. A three year vesting schedule may vest before the policy holds much.
- You need to cover a broad group. These plans work best for a handful of named people rather than a whole department.
The right answer depends on your cash flow, your entity type, and what you are actually trying to prevent.
Frequently Asked Questions
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. There is no IRS filing and no annual administration. The real cost is the premium itself and the tax gross up if you use a double bonus structure.
Can an Owner Participate in Their Own Plan
Sometimes, and it depends on your entity. The reasonableness standard gets more attention when the person receiving the bonus also owns part of the company, so this is a question for your CPA before the plan is written.
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 actually need to be retained, 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.
