Review employee-owned policy bonuses, payroll tax treatment, gross-up cost and ongoing funding. Compare the benefit with cash and deferred compensation.
March 17, 2025 · Financial Forte Staff
Historical article: prepared retrospectively using information available as of March 17, 2025.
An executive benefit funded through life-insurance premiums can sound more complicated than its basic compensation idea: the employer pays a current bonus connected to a policy owned by the employee. The details become important when the employee expects the premium to be tax-free or the employer expects ownership of a policy it does not own.
Identify the owner, beneficiary, payment obligation and tax treatment before comparing the proposal with a cash bonus or deferred compensation. A current executive-bonus arrangement can support a specific employee need, but the insurance contract and compensation decision should each make sense on their own.
Follow ownership before following the premium
In the employee-owned arrangement considered here, the executive owns the individual policy and controls rights under its terms, subject to any valid restrictions. The employer pays or bonuses the premium as current compensation. That is different from an employer-owned key-person policy intended to protect the business.
It is also different from a promise to pay deferred compensation later. A current bonus should not be described as tax-deferred merely because the employee uses it to fund a policy. Any restrictions, repayment provisions or delayed compensation features need separate legal and tax review rather than assumptions based on the arrangement's name.[1]
Employer-provided benefits are generally taxable unless a specific exclusion applies. For this illustration, assume the individual-policy premium is taxable compensation and the appropriate wage reporting and employment-tax treatment apply. Do not borrow the exclusion rules for qualifying group-term life insurance and apply them automatically to an individual executive policy.[2]
If the employer owns the policy or retains an interest, the analysis changes. Employer-owned life insurance can involve separate notice, consent, reporting and tax requirements. Changing the owner or beneficiary is not a small administrative variation to an otherwise identical employee-bonus arrangement.[3]
Show the employee's tax cost as well as the premium
Suppose an employer proposes a $10,000 annual taxable bonus used to pay an executive's policy premium. Assume a simplified combined incremental employee tax effect of 30%. The employee would need $3,000 for the tax associated with that bonus, in addition to directing the full $10,000 to the premium.
If the employee expected a benefit requiring no personal cash, that difference needs to be discussed before implementation. Paying the premium directly to the insurer does not itself remove the assumed taxable compensation. Payroll needs clear instructions and a way to handle the required withholding.
Suppose the employer wants to provide enough total taxable compensation for the employee to retain $10,000 after the assumed 30% tax effect. The gross amount would be approximately $14,285.71: $10,000 divided by 70%. The assumed employee tax would be approximately $4,285.71. Adding only $3,000 to the original bonus would leave $9,100 after a 30% tax effect on the full $13,000.
These are simplified gross-up illustrations, not payroll calculations. Actual federal, state and employment-tax effects, wage limits and withholding can differ. Employer-side taxes and administrative costs would also need to be included in the business budget.
Compare the grossed-up benefit with a cash bonus of the same employer cost. The employee may value the insurance, or may prefer flexibility to address debt, savings or another need. A policy-based benefit should not be assumed more valuable merely because it is presented as an executive program.
Evaluate the contract beyond the first year's funding
Review the insurance need, underwriting, guaranteed and nonguaranteed elements, premium schedule, fees, surrender values and consequences of stopping payments. A policy illustration should not be treated as a guarantee of every future value. Confirm which amounts are contractual and which depend on assumptions.[4]
If the employer intends to pay premiums for several years, distinguish a present intention from an enforceable commitment. Put the expected funding period and any enforceable commitment in writing. The employee needs to know what happens after termination, retirement, a business sale or a change in the employer's willingness to fund the benefit.
The owner may be able to keep the policy after employment ends, but continued coverage and value depend on the contract and future funding. “Portable” should not be used to suggest that premiums disappear or that the policy can never lapse.
Restrictions designed to encourage retention need careful review. An employee-owned arrangement with current access may provide less retention leverage than the employer expects, while additional restrictions can introduce legal and tax complexity. Measure the employee's understanding and the business objective instead of promising a guaranteed retention result.
Document the compensation decision and oversight
Have the tax advisor confirm reporting, deductibility and any limits based on the actual arrangement, including reasonable-compensation and ownership considerations. A marketing reference to a tax-code section is not a substitute for that review. Keep the agreement, payroll instructions and policy records consistent.
Determine which ERISA or other benefit-plan obligations, if any, apply to the arrangement as actually structured. Do not label every executive bonus a qualified retirement plan or assume that a selective benefit has no governance requirements. The applicable duties depend on the substance of the promise and administration.[1]
Ask the employee to acknowledge the explained tax and funding obligations, then assign responsibility for premium confirmation, payroll reporting and periodic review of the contract. Confirm how a missed premium, employee departure or policy change reaches the people who need to act. Those controls can reduce avoidable lapse and reporting risk.
Start with the employee's need and the employer's total budget. Then compare a current insurance-funded bonus with cash compensation and any separately evaluated deferred arrangement. The strongest proposal is one both parties can explain in terms of ownership, tax cost, continuing obligations and the benefit it is intended to provide.
Related reading
- Key-Employee Benefits: Check the Gaps in Group Coverage
- Key-Person Coverage and Buy-Sell Funding Serve Different Purposes
Have more questions about executive benefits and compensation design? Email Dave at dave@financialforte.com to discuss your questions and next steps.
The contact invitation is current; it does not imply this contact path existed on the historical reference date.
Educational information, not personalized investment, tax, legal or benefits advice. Examples use hypothetical assumptions. Verify current rules and your circumstances before acting.
Sources
- [1] IRS Publication 5528: Nonqualified Deferred Compensation Audit Technique Guide — March 20, 2024; 26 CFR 1.409A-2: Deferral elections — GovInfo 2023 package serves pages headed April 1, 2021 edition; 2007 rule
- [2] IRS Publication 15-B: Employer’s Tax Guide to Fringe Benefits — December 20, 2024 cover; 2025 edition
- [3] IRS Notice 2009-48: Employer-owned life insurance — June 15, 2009 IRB
- [4] NAIC Life Insurance Buyer’s Guide — 2018; copyright and catalog confirmed
