Section 162 Executive Bonus Plans: How Corporations Fund Executive Life Insurance Tax-Deductibly
I want to be really straight with you about section 162 executive bonus plans. Honestly, I don't see the value in most of the ones I see sold — it took me a while to understand why a business owner would commit to one, and that's exactly why I've never promoted them the way some agents do. But there are real reasons this plan works for the right situation, from locking in insurability while someone's young and healthy to you, as the owner, wanting this for yourself. So I'd rather you understand exactly what you're considering, what it does and doesn't do, and when it actually earns its place in a compensation package — before you sign anything.
To make this concrete, meet Tara. She owns a 40-person distribution company, and her VP of Operations — the person actually running the warehouse floor and the client relationships — just got a call from a recruiter. Tara's insurance agent showed up a week later with a proposal. Let's walk through what he pitched her, what's true about it, and what he left out.
• Why an employer might use one
• Why group term isn't always the answer
• What the company owns and controls
• Whether a REBA really creates retention
• Other ways to structure the bonus
• Cash value benefits and honest costs
• When a 162 plan actually makes sense
• The reasonable compensation risk
• How entity type changes the answer for owners
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Jump to the Tool ↓What Is a Section 162 Executive Bonus Plan?
A Section 162 executive bonus plan is a simple arrangement: the company pays a bonus to a key employee, and that bonus is used to fund a life insurance policy the employee owns — not the company. The name comes from Section 162 of the Internal Revenue Code, which lets a business deduct "ordinary and necessary" compensation. Because the bonus is treated as compensation, the company deducts it, and the employee owes income tax on it — the same as any other bonus.
There are two common versions:
Single bonus: The company pays a bonus equal to the premium. The employee covers the income tax out of their own pocket.
Double bonus: The company pays the premium plus an additional amount to cover the tax bill, so the employee's net cost is close to zero.
Tara's agent proposed a double bonus: $50,000 a year, funding a policy on her VP, with the company covering the tax gross-up so her VP never writes a check.
Why Would a Business Owner Actually Do This?
Here's the reframe that matters: the real comparison isn't "162 plan vs. doing nothing." Tara had already decided she wanted to reward her VP — that money was leaving the building one way or another. The real question is what happens to that money after it leaves.
Give someone a cash bonus, and it typically goes toward whatever's in front of them that year — a kitchen remodel, a vacation, a car payment. Nothing wrong with that. But a year later, there's usually nothing left to show for it.
Fund a policy with that same dollar instead, and the after-tax cost to the company is identical — but now it buys something that doesn't disappear. A death benefit for the employee's family. Cash value that compounds quietly in the background. It's the same compensation dollar, redirected from consumption into an asset the employee would likely have had to buy themselves, with their own after-tax money, if the company hadn't.
The Payroll Tax Reality Most Pitches Skip
Tara's agent described this as "fully tax-deductible with no strings attached." That's only half true, and the missing half matters.
A 162 bonus is ordinary W-2 compensation. That means it's subject to the same payroll taxes as any other bonus:
• FICA (Social Security and Medicare) — owed by both the company and the employee, just like salary
• FUTA (federal unemployment) — owed by the company
• State unemployment and, in most states, workers' comp — typically calculated off the same payroll base
The company's income tax deduction lowers its income tax bill. It does nothing to reduce the payroll tax the company owes on top of the bonus. Those are two separate systems, and a deduction in one doesn't touch the other.
One real wrinkle here: those payroll taxes have wage bases, and a VP-level salary can already be past them before the bonus is even paid. For 2026, Social Security tax stops applying once an employee's wages for the year hit $184,500 — a real possibility for someone already earning a strong salary. FUTA is even more likely to already be exhausted: it only applies to the first $7,000 an employee earns each year, which most salaried employees blow past in January. So Tara's actual employer-side payroll tax cost on a year-end bonus could be meaningfully smaller than a flat "add 7.65%" estimate would suggest — this genuinely depends on her VP's total pay and when in the year the bonus lands, which makes it a payroll professional's calculation, not a rule of thumb.
None of that makes the plan a bad idea. It just means "100% deductible" isn't the same thing as "free," and any honest conversation about this plan should say so up front.
There's a separate calculation worth knowing if Tara's agent runs a double bonus for her — and it's asking a different question than the employer-cost math above. The employer-cost question is "what does a stated bonus amount actually cost the company." This next question is "what gross bonus is needed so the employee nets a specific dollar amount after their own withholding." The gross-up itself is also taxable wages, so a double bonus isn't just "premium plus taxes" — it has to cover the tax on the gross-up too. The clean way to solve for it:
For illustration only: if Tara wants her VP to net a full $50,000 after withholding, and the combined withholding rate is roughly 30%, the actual gross bonus required is closer to $71,000 — not $65,000, which is what a simple "premium plus 30%" estimate would suggest. The real number depends on the VP's actual wages, filing situation, state, and where she sits relative to the Social Security wage base — this is a payroll and tax professional calculation, not a rule of thumb.
Why Not Just Buy Group Term Instead?
This is the question Tara asked first, and it's a good one. If her VP just needs a death benefit, why not skip the bonus plan entirely and give her group term life insurance — which comes with its own tax break?
Under IRS rules governing group-term life insurance, the first $50,000 of employer-paid group coverage is completely tax-free to the employee. Above that, the imputed cost of the excess coverage — not the actual premium — gets added to taxable wages.
That works well for modest, company-wide coverage. It falls apart the moment you try to use it to deliver a large death benefit to one specific person. Section 79 has a nondiscrimination rule: if a plan gives "key employees" — officers over a compensation threshold, or owners above certain ownership levels — more coverage than everyone else gets, the plan is discriminatory. And when that happens, the key employee doesn't just lose the exclusion on the amount over $50,000. They lose it entirely — the full cost of their coverage becomes taxable, using whichever is higher: the IRS's formula value or the actual cost — and that full amount gets hit with FICA (Social Security and Medicare), the same as wages.
One correction to make here, because it's a common mix-up: group-term imputed income isn't taxed exactly like a cash bonus, even when a plan is discriminatory. By statute, it's specifically exempt from federal income tax withholding and from FUTA — only FICA applies. So it's not quite "identical to salary." It's more accurate to say it loses its main advantage (the free exclusion) and picks up a real cost (FICA on the full amount) without ever fully becoming ordinary wages. The actual dollar cost varies quite a bit depending on the employee's age and coverage amount, since it's calculated off the IRS's formula table, not the real premium — either way, it's taxable, and it's not designed to travel with the employee, which is the bigger problem, covered next.
A large, single-executive carve-out is about as clear an example of a discriminatory plan as exists. So the group-term shortcut mostly evaporates exactly where it would be most useful — a substantial policy for one key person.
Does the Company Get Anything Back?
No — and this is worth saying plainly, because most of what's written about this plan doesn't. Once the policy is issued, the employee owns it outright. If they leave for a competitor next year, the company has no claim on the policy, the cash value, or the death benefit. The insurance company doesn't even know or care who's paying the premium — if a new employer wants to fund the same policy as part of hiring the employee away, nothing stops that. The policy doesn't belong to Tara's company. It belongs to her VP.
If what you actually want is a claim that survives the employee walking out the door — some cost recovery, some control over the asset — a 162 plan isn't built for that. The table below maps what you might actually be after to the structure built for it. A basic 162 plan is only one row on this list, not the default answer.
| What you actually want | Structure to investigate | Why |
|---|---|---|
| Reward one employee, no interest retained in the policy | Basic Section 162 executive bonus plan | Simple, selective, employee-owned from day one |
| Restrict access to cash value for a period | 162 plan + REBA | Adds a vesting condition, but only has teeth with real cash value behind it |
| Recover contributions or retain a collateral interest | Split-Dollar | Built around divided interests and repayment rights, not a bonus |
| Protect the business itself from an employee's death | Key-person insurance | Company owns the policy and is the beneficiary — but the premium isn't deductible under IRC §264 |
| Future benefit only if the employee stays through specific dates | Nonqualified deferred compensation / SERP | Ties the payout directly to continued service, with real compliance overhead |
| Basic death-benefit coverage, broadly offered | Group-term life insurance | Efficient for company-wide baseline coverage under $50,000 |
| Flexible current compensation, employee decides how to use it | Cash bonus or salary increase | No restrictions, no insurance product required at all |
These aren't mutually exclusive. A company might offer $50,000 of group-term coverage broadly, then layer a 162 bonus on top for a handful of key people — the stacking approach covered below.
Does This Actually Retain Anyone? The REBA Reality Check
Tara's agent called this a "golden handcuff." Here's where that claim needs real scrutiny.
Without any restriction added, a vanilla 162 plan has zero retention power. The employee owns the policy the day it's issued. There's nothing stopping them from taking the job across town next month and keeping the policy, fully vested, with no obligation to anyone.
The fix agents propose is a Restricted Executive Bonus Arrangement (REBA) — a written agreement, usually paired with a restrictive endorsement the carrier actually places on the policy, that limits specified policy rights until the employee has stayed a set number of years. Depending on how it's drafted, that can cover loans, withdrawals, surrender, assignment, or ownership changes — but the common thread across almost all of it is the ability to actually get money out of the policy. What it doesn't do is delay ownership itself: the employee owns the policy from day one, restricted rights and all.
Which means most of a REBA's real leverage only exists when there's cash value to restrict — loans, withdrawals, and surrender rights are all about accessing money that a term policy simply doesn't have. Attach a REBA to a term policy, and you can still restrict things like assignment or ownership changes, but you lose the part that actually functions as golden handcuffs — there's no growing asset sitting there that the employee doesn't want to walk away from. The most you can add on top of term is a separate clawback clause requiring the employee to repay premiums if they leave early — a much weaker hook, enforced only if the company is willing to chase the money.
This is the detail that got glossed over in Tara's pitch, and it's the detail that should drive the funding decision, not the other way around.
Term or Cash Value — Which Should Fund the Plan?
Here's the honest version of the choice, laid out the way Tara eventually put it to her VP directly: "You're an important part of this company. I want to do something extra for you. I can pay for $5 million in term coverage and give you another $45,000 in salary this year — no strings, spend it however you want. Or, I can put the full $50,000 into a permanent policy with a real vesting schedule attached — you'd own the policy from day one either way, but with this option, you'll get a smaller death benefit that builds cash value, and you'd need to stay ten years before you have full access to that cash value. Which sounds better to you?"
That's a genuinely fair question to ask, and reasonable people land in different places. Someone with a mortgage and young kids may take the extra $45,000 in liquid cash without hesitation. Someone further along, with protection needs already covered, may prefer the compounding asset. Neither answer is wrong.
Before you run the numbers, there's actually more than one caution here.
The first is the obvious one: $50,000 a year does not buy anywhere near $5 million of permanent death benefit. Term is cheap for two separate reasons, and it's worth knowing both. First, it's pure insurance — none of the premium builds cash value, so every dollar goes toward mortality cost alone. Second, the odds are genuinely in the insurer's favor. If Tara's VP is young and healthy, the actual probability she dies during the term is low. Not zero — but low, which is exactly why a large amount of term coverage is inexpensive to begin with.
That "not zero" is the second caution, and it cuts the other way. Low odds aren't the same as no odds, and if the unlikely happens, the size of the death benefit is the only part of this plan her family will ever actually feel. A larger death benefit may matter more to them than a smaller one attached to a compounding cash value account — or it may not. I honestly don't know, and neither does an agent who's never met her. That's exactly why this isn't a decision to make in the abstract: ask her, understand what she's actually worried about, and design the bonus around her situation — not around whichever product happens to pay the larger commission.
Get an actual carrier illustration before comparing numbers side by side, regardless of which way you lean. The two options aren't apples to apples on coverage amount, even at the same premium budget.
The Decision Tree Insurance Section 162 Decision Tool
Section 162 Executive Bonus Plan Decision Tool
Find out whether an employee-owned executive bonus plan matches the job—or whether cash, group coverage, Split-Dollar, deferred compensation, or key-person insurance fits better.
Other Ways to Structure the Bonus
Single, double, and REBA get most of the attention, but the actual design space is bigger than that. A few variations worth knowing before you settle on one:
Leverage bonus. Instead of gifting the tax gross-up outright, the company loans that amount to the employee, who collateral-assigns the policy back to the company to secure the loan. The employee still owns the policy and still gets a full double-bonus-style result, but the company now holds a lien against the cash value for the loan balance — real cost recovery, at least up to what's been loaned. This is worth knowing mainly because it's the bridge structure: push a leverage bonus far enough and you've effectively built your own version of Split-Dollar — which also means the simple "company deducts, employee owns" deduction story from earlier in this article needs a second look once the company holds any real interest in the policy (more on that below). If you find yourself wanting more of this, that's the sign you're pricing the wrong plan.
Stacked with Section 79. Give every employee the free $50,000 of group term as a baseline benefit, then layer a 162 bonus on top to fund additional, permanent coverage just for the specific people you want to reward. The base layer can often be structured as a nondiscriminatory, company-wide benefit — though "offered to everyone" isn't automatically enough on its own; it still has to satisfy the actual eligibility and benefit tests, which is a design detail for whoever sets up the group plan, not a given. The bonus layer sits outside Section 79 entirely, so it can be as selective and as large as you want without tripping those rules. This is genuinely a clean way to get the "give everyone something, give a few people more" outcome without forcing it all through one group plan.
Formula-based bonus. Instead of picking a flat dollar figure, tie the bonus to a percentage of the employee's salary or the company's profit for the year. The advantage is that it scales on its own — a raise or a strong year automatically increases the benefit without you having to revisit the agreement. The tradeoff is unpredictability: in a formula tied to profit, a bad year shrinks or eliminates the bonus right when the funding gap could matter most for a permanent policy that's counting on level premiums.
Performance-contingent bonus. The bonus is paid only if specific, named goals are hit — a revenue target, a retention milestone, a completed project. This gives the company real leverage without the formality of a REBA agreement, and it ties the benefit directly to the reason you wanted to reward the person in the first place. The catch: if the goal is missed, the funding gap hits the policy the same way a skipped bonus would under any other structure, so it's worth pairing with a policy design that tolerates an occasional lighter year.
Single bonus for owner-employees. If the person you're rewarding is a shareholder-employee, the sizing conversation gets tighter — and if that shareholder-employee is you, entity type matters even more than sizing. More on that below.
Cash Value — Benefits and the Honest Costs
What permanent coverage adds:
• Coverage that doesn't taper or expire the way term does
• A real, growing asset — which is what actually gives a REBA something to restrict
• Potential supplemental retirement income down the road through loans or withdrawals
• Locks in insurability while the employee is young and healthy — insurability itself is a financial asset that gets more expensive, or disappears, with age and health changes
What it costs — stated just as plainly:
• Far more expensive per dollar of death benefit than term
• Early cash value typically lags total premiums paid in the first several years
• If a rough year means skipping the bonus, an underfunded permanent policy can lapse or shrink in ways a simply-dropped term policy never would
• Illustrated projections aren't guarantees — for indexed products, insurers can adjust caps and participation rates, which moves the numbers
• Funding it meaningfully usually requires a real gross-up, which stacks genuine payroll tax cost on top of the premium itself
When a 162 Plan Actually Makes Sense
After walking through all of this with Tara, here's where it actually landed:
It made sense when the goal was narrow and specific — rewarding one person, quickly, without extending a benefit to the whole staff or taking on a long-term liability. Her VP wasn't a founder or an owner; a SERP or deferred comp plan would have been overbuilt for the situation, with legal costs that didn't match the size of the reward. A 162 plan, funded with cash value and a REBA, gave Tara something genuinely simpler to put in place than a deferred-comp or Split-Dollar plan — underwriting and drafting still take real time, but there's no compliance department required to get there.
It also made sense as an insurability play. Her VP was 42, in good health, with no existing coverage of her own. Locking in a policy now — while healthy — meant her insurability and the policy's contractual guarantees were locked in before some future health change could make coverage expensive or impossible to get at all. Whether the ongoing cost stays exactly level from there depends on the product — worth remembering from the cost section above, since indexed products in particular can still move on the insurer's end.
It would not have made sense if Tara wanted her company to have any claim on the policy if her VP left early — that's a Split-Dollar conversation, not this one. And it wouldn't have made sense if the real goal was pure death benefit at the lowest possible cost — in that case, a straight raise and a term policy the VP buys herself accomplishes the same protection without any of the plan's paperwork or restrictions.
Underneath all of that, there's one test that matters more than any of the mechanics above: a 162 plan makes sense when what the employee actually wants lines up with what you, as the owner, are trying to accomplish. If Tara's VP genuinely values a long-term asset and family protection over cash in hand this year, and Tara genuinely wants to keep her for the long haul, the plan is doing real work for both sides — that's not a coincidence, that's the whole point of asking the "term or cash value" question directly instead of assuming the answer. If those two things don't line up — if she'd rather have the cash, or Tara doesn't actually care whether she stays ten years — no amount of clever structuring fixes that mismatch. The plan is a vehicle for an agreement that already needs to make sense on its own; it isn't a substitute for having that conversation.
The Reasonable Compensation Risk
One more thing worth knowing before you set an amount: the deduction only holds up if the total package — salary, bonus, and everything else — counts as "reasonable compensation" for the role. If the IRS successfully argues that a bonus is unreasonably large relative to the employee's actual duties and market pay, the company's deduction can be disallowed, and for a shareholder-employee, the excess can be recharacterized as a dividend instead of compensation — taxed a second time, with no offsetting deduction for the company.
There's a second, related rule worth knowing: a basic 162 deduction assumes the company isn't a beneficiary of the policy in any way. Under IRC Section 264(a)(1), premiums on a policy where the payer stands to collect are generally not deductible. That's the baseline reason the employee has to own the policy outright for the simple version of this plan to work as advertised. The moment the company keeps a real interest in it — a collateral assignment, repayment rights, anything beyond a plain bonus — the deduction analysis gets more complicated, not automatically zero. That's exactly the territory the leverage bonus above starts to enter, which is why that structure needs its own professional review rather than an assumption that the same simple deduction still applies.
Practically, this means documenting why the total compensation makes sense for the role — board minutes, a short written agreement, comparison to what similar businesses pay similar positions. It's not complicated, but it's not optional either.
What About Business Owners? Why Entity Type Changes Everything
Everything above assumes you're funding this for someone else — an employee like Tara's VP. If you're considering this for yourself as an owner, stop before you talk to an agent and talk to your CPA first, because the answer depends entirely on how your business is taxed, not on anything insurance-related.
C-corporation: this works exactly as designed. A C-corp is its own separate taxpayer. A bonus to an owner-employee is a real deduction against income the corporation is taxed on separately from your personal return — the same mechanics as for any other employee.
S-corp, partnership, or sole proprietorship: it usually doesn't help, and it can actively cost you money. These are pass-through entities — the business itself pays no federal income tax. To be precise about the mechanics: an S-corp can deduct reasonable wages paid to a shareholder-employee, that part is real. But because the S-corp doesn't pay its own separate income tax, that deduction just reduces the pass-through income that flows to your personal return on the K-1 anyway. If you're the sole or majority owner, you're on both sides of that transaction — the deduction and the income hitting your return are close to a wash, dollar for dollar. You're not shrinking some separate corporate tax bill the way a C-corp owner would.
And it can genuinely cost more, not less: a bonus is wages, which means it's hit with FICA — Social Security and Medicare, roughly 15.3% between the employer and employee share (subject to the same wage-base rules covered earlier). A distribution of that same dollar, up to your basis in the business, isn't subject to any of that. This is precisely why S-corp owners generally try to keep salary reasonable-but-modest and take the rest as distributions — running extra money through a bonus structure instead works against that, adding payroll tax cost on money that could have come out cleaner. It can also shrink your qualified business income deduction, since that's calculated off pass-through income, not wages. Your CPA needs to run the actual comparison, not just eyeball it.
Partners in a partnership face the same pass-through mismatch, plus a more basic one: partners generally aren't treated as employees of the partnership for federal tax purposes at all, so a W-2-style bonus doesn't cleanly apply in the first place.
One more piece worth knowing: the Section 79 group-term workaround we ruled out earlier for large single-executive coverage is closed off for owners too — the $50,000 exclusion doesn't apply to shareholders who own more than 2% of an S-corp, regardless of nondiscrimination testing.
A sole proprietor faces the most basic version of this problem: you can't create an employer-employee relationship with yourself just by writing yourself a W-2. There's no separate "employer" to pay the bonus. You can still buy yourself a life insurance policy — you just can't fund it through this structure.
And "LLC" doesn't actually answer the question, even though it's probably the most common structure among the business owners reading this. An LLC isn't a federal tax category by itself — it can be taxed as a disregarded sole proprietorship, a partnership, an S-corp, or a C-corp, depending on elections you or your CPA have made. Which one applies determines which paragraph above actually describes your situation. If you don't know which box your LLC checks for tax purposes, that's the first question for your CPA, before anything else in this article.
Who Actually Brings This to the Table?
If you're reading this because an agent just proposed one, you're in good company — that's overwhelmingly how these plans get started. Agents identify a business owner, pitch the tax deduction and the retention story, and build the plan around a policy sale. Employers occasionally raise it on their own, usually after a CPA flags it during comp planning. Employees almost never ask for a "162 plan" by name — they ask for more compensation or mention wanting life insurance, and someone shapes that into this structure.
None of that makes the plan wrong for your situation. It just means the person who brought it to you probably has a reason to want you excited about it. Worth checking your own math before you sign.
Frequently Asked Questions
This article is for general educational purposes and isn't tax or legal advice. Compensation and insurance decisions should be reviewed with your own CPA and attorney before implementation.
Written by Kevin Wenke, CFP®, CLU®