As a business owner, an insurance agent may have at one time or another approached you to discuss the benefits of having a Deferred Compensation Plan commonly known as an “Executive 162 Bonus Plan”. After you ask some questions you finally are told that you are basically buying a cash-value whole life insurance policy, and that you cannot deduct the annual premiums until the employee is taxed on the benefit. You also find out that you have to make the same contribution to the life insurance policy each year regardless of how well (or not so well) your business does. While this plan is viable for some businesses, it’s not the only option available.
What if instead of using a life insurance policy under a Section 162 Bonus Plan, we substituted the life policy with a Deferred Annuity?
The business gets an immediate income tax deduction on the contribution and can bonus out sufficient income to the employee to pay the tax on the income going into the annuity. The annuity, which must be owned by the employee, will grow tax deferred and provide a benefit to the employee in retirement. The business does not have to pay a premium each year and, thus, can make annual contributions based upon the employee’s performance of that year and / or the profitability of the company.
The employee owns the contract, the annuity will be protected from the business’s creditors, and the business will not be able to change its mind and later withhold the benefit. The employee will have full ownership of the annuity but will pay penalties and taxes if the employee surrenders the contract prior to age 59½. If the business is concerned that the employee may access the funds early and start a competing business, a secular trust can be used to keep this from happening.
Since the employee will be fully vested and the owner of the annuity, the contributions made by the business will be fully deductible to the business and fully taxable to the employee when made. The annuity value would be tax-deferred and a portion of each distribution would be non-taxable under the inclusion ratio based upon the employee’s investment in the contract. The business can, if it chooses, use a deductible bonus to reimburse the employee for the tax due on the annuity contribution.
If the business owner feels that the pre-age 59½ withdrawal penalties are not enough of a restriction on the funds in the annuity contract, a trust can own the annuity with the employee as beneficiary and an independent trustee can control access to the annuity until the agreed annuity start date. The employee remains fully vested and entitled to the annuity, but the business is protected from the employee accessing the funds prior to the agreed upon date. For income tax purposes, the employee must create the trust for the annuity income to remain tax-deferred as long as the trust is the agent for the employee.
This is a great way to benefit specific key employees without the restrictions of a qualified plan. This program offers flexibility in that contributions do not need to be made each year but can be made based upon how the employee and/or company performs in any given year. The business gets the deduction it seeks, and the employee can know that the benefit cannot be taken away once given.
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*This blog is strictly the opinion of Michael A. Malleo and not those of
ASH Brokerage Corp., Quest Capital Strategies, Inc., nor any of our affiliates.
Malleo Financial Services LLC cannot and will not give any specific tax or legal advice.
Please consult your tax professional or legal professional for such advice.