One type of employee compensation arrangement that is currently advantageous for shareholder-employees is the Sec. 162 life insurance plan. The primary advantage is the ability to avoid the nondiscrimination rules applicable to other fringe benefits.

Sec. 162 plans have the additional advantage of simplicity, which holds down their administrative costs. Because of tax and labor law compliance rules, compensation and fringe benefits planning has become increasingly complex, but the executive bonus plan is refreshingly simple. Shareholder-employees and executives who participate in the plan apply for, own, and name the beneficiary on permanent life insurance policies covering their lives. The personally owned nature of the policy offers them maximum flexibility. The premiums for such policies are provided through a bonus payment by the employer-corporation. The corporation either pays the premium directly to the insurer or gives the amount necessary to pay the premium as a bonus to the employee, who is then billed directly by the insurance company.

The income taxation of the plan is also easy to illustrate to clients. The premium amount paid directly to the insurer (or bonus to the employee) is treated as gross compensation income to the employee under Sec. 61(a)(1). This compensation is treated as ordinary income subject to the employee�s normal individual income tax rate. If the bonus along with the employee�s other compensation represents reasonable compensation, the corporation deducts the amount of the bonus as an ordinary business expense under Sec. 162(a)(1)�thus the origin of the name Sec. 162 plans. Although the tax burden of the plan is immediate to the executive, the bonus can be designed as a zero-tax bonus (making it large enough to pay the tax on the bonus) to reduce the executive�s out-of-pocket costs. Moreover, the executive, as the owner of the policy, can use policy dividends to reduce future premiums (and the need for future taxable bonuses).

The primary advantage of a closely held corporation�s adoption of a Sec. 162 plan is its exemption from the federal nondiscrimination and administrative reporting rules applicable to most other types of fringe benefit plans. The board of directors of a closely held business or professional corporation can pick and choose the participants who will be included and limit the plan to those shareholder-employees who want individual life insurance coverage. In addition, there are no discrimination rules with respect to benefit limits. Theoretically, the plan could provide any amount of life insurance premium to purchase coverage on the life of a shareholder-employee who desires substantial coverage.

However, the corporation should use caution in providing unlimited coverage since the corporate deduction for bonus payments to the plan is limited by the reasonable compensation rules. If the limit is exceeded, the corporate income tax deduction will be lost with respect to the amount of any bonuses to shareholder-employees that are deemed unreasonable, and the excess bonus will be treated as a dividend payment rather than as compensation. It is prudent for the corporation to adopt the Sec. 162 plan by board of directors� resolution and to provide evidence in the minutes to the corporate purpose for establishing the plan (for example, by indicating the need to retain or attract key executives by offering the Sec. 162 plan as a benefit).

Do the substantial individual insurance benefits available under a Sec. 162 plan render the Sec. 79 plan obsolete? The answer to this question depends on many factors. Does the corporation already have a Sec. 79 plan in place that benefits employees? Does the current plan meet the burden of the nondiscrimination rules? Does the corporation wish to continue to provide group term life insurance coverage to nonowner, nonhighly compensated employees? Generally speaking, the group term life insurance plan concept should not be dropped simply because of the popularity of the Sec. 162 bonus plan. If they meet the nondiscrimination requirements, Sec. 79 plans still offer favorable tax treatment. The corporation gets an ordinary business expense deduction for contributions to the plan. The first $50,000 of coverage per employee can be provided tax free to the employee�including shareholder-employees and other key employees. And the corporation may want to avoid lowering employee morale by terminating a popular fringe benefit arrangement covering a broad cross-section of employees and replacing it with a highly discriminatory executive bonus plan limited to a few key employees.

What is generally recommended is that shareholders and other key employees who require (and for whom the corporation wishes to provide) more substantial life insurance coverage participate in a Sec. 162 bonus life insurance plan to supplement a Sec. 79 plan. From the executive�s standpoint, the Sec. 79 plan could still provide each key employee with the $50,000 of tax-free coverage. Additional group term coverage for these key employees would be taxable to the participants and could be deemed discriminatory, which would result in all benefits becoming taxable as income. This excess coverage could instead be "carved out" of the group term life insurance plan through a Sec. 162 bonus arrangement. Thus the executive bonus plan is also commonly referred to as a Sec. 79 executive carve-out bonus plan. The carved-out portion of coverage is actually superior to what could be provided under a Sec. 79 plan even if no nondiscrimination rules were applicable to group term coverage (see table 12-2). Key shareholder-employees participating in the plan receive permanent individual life insurance policies providing them with a tax-free cash surrender value (CSV) build-up and other flexibilities associated with owning individual permanent life insurance.

The executive bonus arrangement is also more favorable to shareholder-employees in their postretirement years. The nondiscrimination rules generally limit the funding of retired lives reserves plans to $50,000 of postretirement coverage per participant. Executive bonus plans provide participating employees with permanent coverage without the $50,000 limitations, and since the plan is held individually by the employee, it is available during his or her retirement years.

It is unclear whether Sec. 162 bonus life insurance plans will be deemed welfare benefit plans under the provisions of ERISA. Since the plan provides

taxable benefits to a select group of highly compensated executives, most of the reporting and disclosure requirements would not apply in any case. However, if the plan is deemed a welfare benefit plan, a written plan document should be made available to the Department of Labor on request. As a precaution, the plan should be adopted through a formal corporate resolution to satisfy the writing requirement. Written notice of the plan in a claims procedure manual or booklet should also be given to every plan participant. Finally, a corporate officer should be appointed as "named fiduciary" of the plan to comply with any potential applicability of ERISA provisions.

The Sec. 162 bonus life insurance plan involves ownership of an individual life insurance policy by an insured-employee. As such, the life insurance proceeds will be included in the insured-employee�s gross estate for federal estate tax purposes under the provisions of Sec. 2042. This may not be a desirable result, particularly since the highly compensated plan participants are probably accumulating substantial estates irrespective of the bonus life insurance plan. If the gross estate inclusion is a concern to the participating executive(s), the plan can be designed with third-party ownership of the individual life insurance policy. For example, the life insurance can be owned by the insured-employee�s spouse or by an irrevocable trust created by the insured-employee. If the third party is the initial applicant and owner of the policy, the proceeds should be excludible from the insured�s gross estate even if the insured dies immediately after the coverage becomes effective. If estate tax problems become a concern at a later date, a plan participant could gift an existing policy to a third-party owner. In this event, the insured must survive the 3-year period following the policy transfer to get the insurance proceeds out of his or her gross estate for federal estate tax purposes (Sec. 2035).

The gift tax consequences of such a transfer depend on the circumstances of the transfer. If an individual third-party owner, such as a spouse, is selected as the donee of the life insurance policy, the original transfer of the policy plus any premiums paid by the employer will be treated as a gift from the insured-employee to the third party. The gift, in this case, will qualify for the $10,000 annual gift tax exclusion as a gift of a present interest. Of course, any premiums paid by the employer will still be treated as taxable income to the insured-employee and as gifts from the insured employee to the policyowner. If the policy is transferred instead to an irrevocable trust created by the insured, the transfer of the policy and any premiums paid subsequently by the employer will be treated as a gift from the insured-employee to the beneficiaries of the trust. However, the gifts under these circumstances will qualify for the annual exclusion only if the beneficiaries are provided with current withdrawal rights to premiums added to the trust.