Section 162 Plan: How It Works, Taxes, and Setup Steps

A Section 162 executive bonus plan is a compensation arrangement in which an employer pays a cash bonus to a selected key employee, who then uses the money to fund a personally owned permanent life insurance policy. The company deducts the bonus as ordinary compensation under IRC Section 162(a), and the executive owns the policy, its cash value, and the death benefit from day one.¹ Private employers use these plans to reward specific individuals without the nondiscrimination testing, government filings, and fiduciary rules that come with qualified retirement plans.

How the Plan Works

The employer identifies a key employee and agrees to pay them an annual cash bonus sized to cover the premium on a permanent life insurance policy. The executive personally applies for and owns the contract. They pick the beneficiary, they control the cash value, and they keep the policy if they leave the company.²

Most plans use whole life or universal life insurance because those products accumulate cash value alongside the death benefit. Under a standard (non-restricted) plan, the executive’s ownership is unconditional and the employer has no claim on the policy or its proceeds. That clean ownership is what lets a 162 plan sidestep the complications of split-dollar arrangements and corporate-owned life insurance, where the question of who owns what can create tax problems later.

Single Bonus vs. Double Bonus

The employer can pay the bonus two ways, and the choice changes what the arrangement actually costs the executive.

A single bonus equals the policy premium. The executive pays income tax on that amount out of pocket. If the annual premium is $30,000 and the executive’s combined marginal rate is around 40%, they owe roughly $12,000 in tax and have to fund that separately.

A double bonus, often called a gross-up, adds extra cash to cover the tax on the whole payment. Using the same numbers, the employer pays a bonus large enough that after taxes the executive nets exactly $30,000 for the premium. The gross-up costs the company more, but the executive owes nothing out of pocket. Most 162 plans use the double bonus structure, because the point is to deliver a benefit rather than hand someone a tax bill.

Tax Treatment for the Employer

The employer deducts the full bonus, including any gross-up, as ordinary compensation. Section 162(a) allows deductions for reasonable compensation paid for services actually rendered, and the deduction flows through on the company’s tax return for the year the bonus is paid.¹

The bonus is also wages for payroll tax purposes. The employer owes the employer share of FICA: 6.2% for Social Security on wages up to $184,500 in 2026, plus 1.45% for Medicare on all wages with no cap.³⁴ FUTA applies to the first $7,000 of each employee’s annual wages, which a highly compensated executive has typically exhausted from regular salary well before the bonus is paid.

The Reasonable Compensation Requirement

The deduction turns on one condition. Total compensation paid to the executive, counting salary, bonus, and everything else, must be reasonable for the work they actually do. The IRS looks at the full picture: the employee’s experience and qualifications, the nature and scope of their duties, the size and complexity of the business, and what comparable companies pay for similar roles.⁵

Closely held businesses see the most trouble here. When the executive is also a major shareholder, the IRS may argue the bonus is really a disguised dividend. If total compensation exceeds what’s reasonable, the excess loses its deductibility. A company paying its owner-executive $500,000 in salary and adding a $100,000 bonus plan should be able to document why that combined figure reflects fair pay for the services provided.

The Section 162(m) Cap for Public Companies

Publicly traded corporations have an added ceiling. Section 162(m) caps deductible compensation for each covered employee at $1 million per year.⁶ Covered employees currently include the CEO, CFO, and the next three highest-paid officers disclosed in proxy filings, along with anyone who was a covered employee in any prior year after 2016. For tax years beginning after December 31, 2026, the group expands to include the five highest-paid employees beyond the CEO and CFO.

The $1 million cap applies to all forms of compensation combined. A 162 bonus layered onto a large salary can push a covered employee past the limit, making some or all of the bonus nondeductible for the company even though the executive still owes tax on it. Private companies are not subject to this cap.

Tax Treatment for the Executive

The full bonus, including any gross-up, is taxable income to the executive in the year it’s paid. The employer reports it as wages on Form W-2, and the executive pays federal and state income tax on the entire amount.

High earners should also plan for the 0.9% Additional Medicare Tax, which applies to wages above $200,000 for single filers or $250,000 for those married filing jointly.⁷ An executive already earning well above those thresholds will see the bonus land entirely in the surtax zone.

That upfront tax cost is the trade-off. The executive pays now on the bonus so that the value building inside the policy can grow and eventually be accessed on favorable terms.

Tax Advantages Inside the Policy

Once premiums are paid, the payoff of a 162 plan sits inside the insurance contract itself. Three features drive it.

Cash value in a permanent life insurance policy grows without being taxed year to year. A brokerage account triggers capital gains and dividend taxes annually; the policy’s internal earnings compound untouched for as long as the contract qualifies as life insurance under IRC Section 7702.⁸⁹

If the executive dies while the policy is in force, the beneficiary receives the full death benefit free of income tax.¹⁰ For a policy funded over many years with substantial employer-bonused premiums, that benefit can be sizable.

Accessing Cash Value Through Policy Loans

During the executive’s lifetime, they can borrow against the policy’s cash value. Loans from a life insurance policy that is not a modified endowment contract are not treated as taxable income, which gives the executive a way to tap accumulated value in retirement or for other needs without generating a tax bill. If the policy lapses or is surrendered with an outstanding loan, the loan becomes taxable to the extent it exceeds the executive’s cost basis in the contract.¹¹

The practical warning: an executive who borrows heavily and then lets the policy lapse can face a large, unexpected tax bill. Anyone using policy loans as a retirement income strategy needs to keep enough cash value in the contract to sustain it.

The Modified Endowment Contract Risk

Overfunding a policy relative to its death benefit can turn it into a modified endowment contract, or MEC. A policy becomes a MEC when it fails the seven-pay test, meaning cumulative premiums exceed what would have been needed to pay the policy up over seven level annual payments.¹²

MEC status changes the tax treatment of loans and withdrawals. Gains come out first and are fully taxable, and a 10% penalty applies if the owner is under age 59½.¹¹ The death benefit stays income-tax-free, but the living benefits that make a 162 plan attractive lose much of their edge. When the employer funds large premiums over a short window, especially with a gross-up pushing more cash into the contract, the insurance professional designing the policy needs to run the seven-pay test carefully.

Restricted Executive Bonus Arrangements

A standard 162 plan has one weakness from the employer’s side: the executive owns the policy outright and could leave tomorrow with the full cash value. A Restricted Executive Bonus Arrangement (REBA) adds golden handcuffs.

In a REBA, the employer and executive sign an agreement restricting the executive’s access to the policy’s cash value for a set period. The restriction is typically enforced through a restrictive endorsement filed with the insurance carrier, which blocks the executive from surrendering the policy, taking loans, or withdrawing cash until vesting conditions are met. The most common condition is continued employment for a specific number of years.²

The setup works like a vesting schedule in an employer 401(k) match. An executive who leaves before the restriction period ends may have to repay unvested bonus amounts or forfeit access to the cash value. Once vesting completes, the restrictions come off and the executive has full control.

Even under a REBA, the bonus is taxable to the executive in the year it’s paid. They owe tax on money they cannot yet access, which is why nearly every REBA includes a gross-up.

Tax Relief When an Executive Repays a Bonus

If an executive departs early under a REBA and has to repay bonus amounts, they’ve already paid income tax on that money in a prior year. IRC Section 1341 provides relief when the repayment exceeds $3,000.¹³ The executive calculates tax two ways and uses whichever produces the lower bill:

Deduction method: take a deduction for the repaid amount in the year it’s returned, reducing that year’s taxable income.
Credit method: calculate the tax that would not have been owed had the income never been reported in the original year, and apply that amount as a credit against current-year tax.

For a large repayment in a year when income is lower than the original year, the credit method often wins. Repayments of $3,000 or less don’t qualify for Section 1341.

Why ERISA and Section 409A Generally Don’t Apply

Two frameworks that complicate most executive compensation arrangements generally leave a properly structured 162 plan alone.

Department of Labor regulations exempt bonus programs from ERISA’s pension plan rules so long as payments aren’t systematically deferred until termination of employment or later.¹⁴ A 162 plan pays the bonus currently and taxes the executive each year, so it fits within the exemption. No Form 5500, no summary plan description, no ERISA fiduciary obligations for the employer.

Section 409A imposes strict timing and distribution rules on plans that push pay into a future year. A standard 162 bonus is paid in the current year as taxable compensation, so nothing is being deferred and 409A does not reach it. A REBA typically avoids 409A as well, because the restriction sits on the insurance contract’s cash value rather than on the compensation. The executive still receives and is taxed on the bonus in the current year.

This regulatory simplicity is a large part of why employers pick 162 plans over alternatives like nonqualified deferred compensation or split-dollar arrangements, which require careful 409A compliance and often bring ERISA obligations with them.

Steps to Set Up a 162 Plan

Select the executive. The employer picks the individual or small group. There’s no requirement to offer the benefit broadly, and a single person can be chosen.
Set the bonus amount. The figure is driven by the premium needed for the desired policy. A gross-up structure means the bonus is larger than the premium.
Apply for the life insurance policy. The executive applies for and owns a permanent life insurance policy. If tax-free access through loans matters later, the policy should be designed to avoid MEC status.
Execute a written bonus agreement. The document sets out the bonus amount, payment schedule, and any conditions. For a REBA, it includes the vesting schedule and the restrictive endorsement provisions.
Report the compensation. Each year the bonus is paid, the employer includes it on the executive’s W-2 and deducts it on the company’s tax return.

No IRS approval is needed and no government filings are required beyond standard payroll reporting. The plan can be operational as soon as the policy is issued. For a REBA, the restrictive endorsement must be filed with the carrier before the executive has any access to the cash value.

1
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
2
U.S. Securities and Exchange Commission. Management Section 162 Compensation Agreement
3
Office of the Law Revision Counsel. 26 U.S. Code 3121 – Definitions
4
Social Security Administration. Contribution and Benefit Base
5
Internal Revenue Service. Reasonable Compensation
6
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses – Section 162(m)
7
Internal Revenue Service. Topic No. 560, Additional Medicare Tax
8
U.S. Government Accountability Office. Tax Treatment of Life Insurance and Annuity Accrued Interest
9
Office of the Law Revision Counsel. 26 USC 7702 – Life Insurance Contract Defined
10
Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
11
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
12
Office of the Law Revision Counsel. 26 U.S. Code 7702A – Modified Endowment Contract Defined
13
Office of the Law Revision Counsel. 26 USC 1341 – Computation of Tax Where Taxpayer Restores Substantial Amount Held Under Claim of Right
14
eCFR. 29 CFR 2510.3-2 – Employee Pension Benefit Plan