To recruit and retain talented executives, many companies offer significant perks. One fairly common benefit is for the company to pay for a life insurance policy that builds cash value, which the executive can then draw on in retirement. This life insurance benefit often is referred to as a Section 162 executive bonus, after the section of the federal tax code that covers such benefits.
Role of Section 162
Several employee benefit programs are named after the specific sections of the Internal Revenue Code that authorize them and give them special tax treatment. That's the case with 401(k) plans, for example, as well as 403(b) and 457 plans. However, Section 162 doesn't actually describe the life insurance benefit that has come to bear its name. It simply allows companies to take tax deductions for "all the ordinary and necessary expenses" of running the business, including "reasonable" compensation paid to its employees. Section 162 executive bonuses are called that because they don't get any kind of special tax treatment -- they are treated as just another business expense.
How the Insurance Benefit Works
In a Section 162 bonus plan, the company pays the premiums on a life insurance policy for an executive — typically a "permanent" policy with an investment component that builds up a cash value. The executive then owns the policy, can name the beneficiary and has full rights to cash it in, borrow money from it or receive income from the investments. The premiums are a compensation expense for the company, deductible under Section 162 and are taxable income for the executive. They'll be reported on the executive's W-2, the same as salary.
Some Section 162 arrangements not only pay the premiums for the executive's insurance policy but also kick in an additional cash bonus to cover the taxes on the premiums. These are called "double bonus" plans.
The $1 Million Limit
Section 162 does restrict some "excessive" compensation. Under Section 162(m), a publicly held corporation cannot deduct more than $1 million worth of compensation for the CEO or for any of its four highest-paid officers. That includes salary as well as taxable bonuses and benefits, including life insurance premiums. This doesn't prohibit corporations from paying an executive more than $1 million in compensation in a year; it just limits the deduction for that compensation. Even when the $1 million cap applies, the tax effect on the executive is unchanged: The premiums are taxable income.