Executive Bonus Plan (Section 162): What It Is and How It Works
An executive bonus plan — also known as a Section 162 bonus plan — is a form of compensation that allows key employees to share in a company’s profits. It’s a popular tool for businesses that want to attract, motivate, and retain top talent.
What Is an Executive Bonus Plan?
A bonus is an addition to regular salary or compensation that lets employees share in the profits of a successful year. Employers often use employee bonus plans as an incentive-based form of compensation tied to the attainment of profit goals or other performance targets during the year.
Bonuses can also help executives fund their share of a split-dollar life insurance plan.
Executive Bonus Plan Example
Here’s a simple bonus plan example that shows how this works in practice:
XYZ Corporation expected each of its sales executives to bring in $100,000 in new business during Year 1. Any executive who exceeded this goal would receive a bonus on January 1 of Year 2, equal to 10% of their new business above $100,000.
Because Joe brought in an extra $50,000 in business, he received a $5,000 bonus check on January 1 of Year 2.
This type of annual bonus structure example illustrates how bonus plans directly tie compensation to individual performance.
When Can an Executive Bonus Plan Be Used?
Employers can use bonus plans anytime they want to attract, motivate, and retain key employees. These plans can be informal or even oral — there are no tax or legal requirements for a written plan, and nothing needs to be filed with the government.
That said, a written plan is often the better choice, for two main reasons:
- It protects the company’s tax deduction. Without a written plan, the IRS may conclude the bonus is simply an excessive discretionary payment. If the payment goes to a shareholder, the IRS could even recharacterize it as a dividend rather than deductible compensation.
- It protects the employee. A written agreement clearly defines the terms of the bonus plan and gives the employee legal grounds to hold the company to that agreement.
Tip: Incentive stock options are another form of deferred compensation that offer many of the same incentive features as cash bonus plans, and may be worth considering alongside an executive bonus plan.
Strengths of an Executive Bonus Plan
Helps attract, motivate, and retain key employees
A major challenge for employers is attracting, motivating, and retaining key employees — especially executives. Executive bonus plans help meet this challenge. Receiving a lump sum of cash for strong performance is a powerful motivator, and it can make one company more attractive than a competitor offering the same base salary.
Promotes increased productivity
Because bonuses closely link performance to reward, they’re an effective incentive-based form of compensation. Bonuses can also serve other purposes, such as helping an executive fund the purchase of a life insurance policy.
Tied to company performance
Bonuses allow flexibility in compensation that reflects how the company is actually performing. Both the employer and employee can benefit when the business does well.
Flexible and easy to design
Executive bonus plans are flexible and relatively easy to design, within certain tax restraints, since they don’t need to be written or filed with the government.
Employee income tax can be deferred
Because employees use the cash method of accounting (rather than the accrual method), a bonus earned in one year isn’t included in taxable income until it’s actually received — usually the following year.
Employers can also allow employees to defer receipt of a bonus to a later date. However, to avoid adverse tax consequences, any deferral arrangement should satisfy the requirements of IRC Section 409A, if applicable.
Tradeoffs of an Executive Bonus Plan
Deductibility is limited to “reasonableness”
Under Section 162 of the Internal Revenue Code, only reasonable allowances for salaries or other compensation (including bonuses) qualify for trade or business expense deductions.
Caution: For publicly held corporations, no deduction is allowed for compensation paid to certain executives that exceeds $1 million in a given year.
How to Set Up an Executive Bonus Plan
Consult with an attorney and an accountant
Setting up a compliant, effective bonus plan starts with the right professional guidance:
- An attorney can evaluate your business goals and financial situation and help you design the most advantageous compensation plan.
- A certified public accountant can help ensure the plan follows proper accounting methods.
Tax Considerations for Executive Bonus Plans
Income tax to the employer
Bonuses are generally deductible by the employer under the same rules as other cash compensation. A bonus can only be deducted if it represents a reasonable allowance for services actually rendered, and no deduction is allowed for compensation exceeding $1 million paid to certain top executives.
Because bonuses are often paid after the close of the year in which they were earned, the 2½ Month Safe Harbor Rule is an important part of bonus planning. Under this rule, an accrual-method corporation can deduct a compensation payment that is properly accrued before year-end, as long as it’s paid no later than 2½ months after the end of the corporation’s tax year.
This rule does not apply to employees who own or control 50% or more of the corporation. For those employees, the bonus must be paid during the same taxable year it’s earned in order to be deducted that year.
Income tax to the employee
A bonus is taxed to the employee as ordinary income. Since employees report taxes using the cash method of accounting, the bonus becomes taxable when it’s actually received.
Frequently Asked Questions
What is an executive bonus plan?
An executive bonus plan, also called a Section 162 bonus plan, is a form of compensation that allows a company to give key employees or executives a bonus tied to performance or profit goals. It can also help executives fund benefits such as a split-dollar life insurance policy.
How does a Section 162 bonus plan work?
A company sets performance or profit-based goals for an executive. When the executive meets or exceeds those goals, they receive a bonus, which is generally deductible to the employer as a reasonable business expense and taxable to the employee as ordinary income when received.
Does an executive bonus plan need to be in writing?
No, but it’s strongly recommended. A written plan helps protect the employer’s tax deduction by clearly showing the bonus is reasonable compensation, and it gives the employee clearly defined, legally enforceable terms.
What is the tax deduction limit for executive bonuses?
Bonuses are deductible to the employer as long as they represent a reasonable allowance for services rendered. However, for publicly held corporations, no deduction is allowed for compensation paid to certain executives that exceeds $1 million in a given year.
Are executive bonuses taxable to the employee?
Yes. A bonus is taxed as ordinary income to the employee. Because employees use the cash method of accounting, the bonus is taxable in the year it’s actually received, not necessarily the year it was earned.
Work With a Fort Myers, FL Financial Planning Team
Designing an executive bonus plan involves important tax and legal considerations. Our Fort Myers, FL-based team at The Art and Science of Successful Planning works with business owners throughout Southwest Florida to help structure compensation plans, including executive bonus plans, that align with their business goals.
The Art and Science of Successful Planning is an independent financial services company helping individuals and businesses utilize a variety of investment and insurance products custom suited to their needs and objectives. Investment Advisory Services offered through The Art and Science of Successful Planning, a Registered Investment Advisor registered in the state of FL. Tyler G. Harrelson, CES, CLTC, CFS, P.A. is a licensed insurance agency doing business as the Art and Science of Successful Planning and is independent of the Registered Investment Advisory.
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