Anybody who follows college football, especially Big Ten football, knows the names Jim Harbaugh and Urban Meyer. They are the head coaches at the University of Michigan and The Ohio State University, respectively.
Fierce competitors on the field and in the hunt for the best athletes in the country, Harbaugh and Meyer have a lot of similarities to each other as well as to executives in the world of business.
They run multi-million-dollar entities. They manage a staff of assistants. Their success highly depends on recruiting the best talent, developing and implementing superior strategies to their opponents, and motivating their teams to achieve higher levels of success each year.
Because of their talents and previous success, Meyer and Harbaugh are highly sought after, not only by other major universities, but also by professional teams.
Because of the nature of their jobs and to help ensure they remain with their respective employers, Meyer and Harbaugh, along with other successful coaches, receive generous incentive bonuses in addition to their base compensation.
Whether you own a small to medium-sized business or recruit executives for a major corporation, there are key people in important positions critical to your company’s success.
Who are your “head coaches,” those key people and executives critical to your organization’s success? And how can you reward their efforts and provide an appropriate incentive for them to remain with your company?
The answer may be a life-insurance funded executive bonus plan.
Basics of executive bonus plans
Executive bonus plans are fairly simple to implement and administer. The company’s designated key employees own life insurance policies. The premiums on those policies are paid by the employer.
The executive can designate the beneficiary(s) of the policy. The employer cannot be the policy beneficiary. In addition, the executive can access any accumulated cash value inside the policy, and they can take the policy with them if they leave the company.
Unlike employer-sponsored qualified retirement plans like 401(k)s, there is no government oversight or ERISA compliance for an executive bonus plan. In addition, the company does not have to offer this benefit to all employees and can even vary the amount paid to the key executives covered by the plan.
The bonus paid is tax deductible to the employer according to Internal Revenue Code Section 162. This section permits deductions for all ordinary and necessary business expenses, including salaries and other compensation. The premium amount is considered additional compensation to the executive and is therefore taxable income.
Advantages for both employer and executive
Executive bonus plans offer several advantages to the company or organization paying the bonuses and the executives receiving them.
For the employer, the benefits include:
• A way to reward key employees in a tax-deductible way without IRS approval or oversight.
• The ability to select participants without violating ERISA discrimination rules that apply to qualified retirement plans.
• The flexibility to establish a plan that rewards performance, encourages loyalty, and/or provides for retirement.
• Simple implementation and administration.
• Having a plan that is discretionary; you can increase, decrease, or even eliminate the bonus payments at any time.
• Encouraging key employees to remain with the company for the long-term because they would be losing a valuable benefit (a life insurance death benefit and potentially the cash value of the policy) if they left the company.
Executives who are part of the bonus plan can receive the following benefits:
• Ownership of a life insurance policy that can provide a tax-free death benefit to their designated beneficiaries.
• Policy cash value that accrues tax-deferred and may be accessed on a tax-advantaged basis for a variety of purposes, including funding a child’s college education or supplemental retirement income.
• The ability to save additional money for retirement without the contribution limits that exist on qualified retirement plans.
• Unlike tax-advantaged retirement plans, the life insurance policy can be accessed any time. There are no required distributions at age 70 1/2 as there are for IRAs or other qualified plans, and there are no penalties for removing funds from the life insurance policy prior to age 59 1/2.
• The ability to increase the death benefit amount or accumulate more cash value by contributing premium payments above what the company pays.
Choose a structure that works best for your business
The flexibility of executive bonus plans enables multiple design options:
An incentive-based plan. The employer can base the bonus amount on the executive achieving pre-determined thresholds for revenue, profitability, productivity, or any number of benchmarks.
Meyer’s contract with Ohio State, which is public record because the university is a public institution, includes bonuses for winning conference and national championships, achieving coach-of-the-year honors, and having his players attain a cumulative grade point average. There is also a retention bonus paid after the completion of each season.
Split-dollar plans. Harbaugh’s bonus compensation includes a split-dollar arrangement with the University of Michigan, the details of which are also public record.
In this type of arrangement, the employer and employee share the cash value and death benefit of a life insurance policy. They can also “split” the cost of the insurance premiums or the employer can pay the entire amount. The employer typically owns the cash value and can use it to recoup some of its cost if/when the executive leaves the company.
The arrangement between Coach Harbaugh and Michigan includes payment by the university of six annual premiums of $2 million each. Harbaugh owns the policy subject to a collateral assignment in favor of the university.
If the coach quits or is terminated before the six-year period, the school exercises the collateral assignment, and uses the cash surrender value of the policy to recoup its cost of the premiums. If Harbaugh remains with Michigan through the six years, the agreement can end or be modified.
Double-bonus. This is a simple variation where the employer basically covers the tax obligation of the bonus. For example, if the company wants to offer a $25,000 bonus, it would actually pay the executive $25,000 plus whatever amount is needed to pay income taxes on the bonus so that the executive would net $25,000.
Custodial executive bonus. This variation provides more employer control of the bonus arrangement. The agreement will place restrictions on the executive’s ability to exercise policy ownership rights and will often state that the executive needs the company’s consent to access the policy’s cash value. Typically, the restrictions remain in place either until the executive retires or satisfies a length-of-service requirement. Though the employer has control of the policy’s use, it never actually owns the policy.
Ownership bonus plan. Owners of C corporations can establish an executive bonus plan for themselves. This is a common technique to help business owners catch up on their retirement savings without the contribution limits of qualified retirement plans. Unlike S corporations, partnerships, or LLCs, C corporations can deduct executive bonus structures on their owners.
Why use use whole life insurance
An executive bonus plan can incorporate any type of life insurance policy. In most cases, it makes sense to use a permanent type of policy rather than a term policy.
Although the cost will be greater to the company paying the premiums, permanent life insurance offers the benefit of accumulating cash value. This provides the potential for a greater bonus than just offering to pay the premiums on a term policy.
There are a few types of permanent life insurance you can use, including fixed universal life and indexed universal life. But in most cases, the best option is whole life insurance.
While universal life, especially indexed universal life, can offer a higher potential rate of return than whole life, it does not offer the cash value guarantees of whole life insurance. Also, the premium cost of universal life can and will fluctuate over the life of the policy. This can create a situation where cash values do not accumulate as much as projected on a universal life policy, which may be upsetting to the executive receiving the bonus.
With whole life insurance, you pay the same level premium for as long as you own the policy. There are also options where you can pay 10 premiums, 20 premiums, or any number of payments, and still have coverage for the life of the policy insured. The cash value results from the reserves that insurers set aside to ensure they can pay a death benefit.
Some whole life policies, called participating policies, pay a dividend if the insurance company achieves lower mortality and expense costs than it expected. The dividend is paid out of the insurer’s surplus earnings and is not taxed because the IRS considers it a return of the premium you have already paid.
The best of both worlds
An executive bonus plan provides an easily administered, tax-deductible way for companies to recruit, reward, and retain the talented people most integral to their success. And by using whole life insurance to fund a plan, employers can multiply its benefits and provide executives with a flexible financial tool to meet a variety of future needs.