Section 162 Executive Bonus Plans: A Simple Way to Keep Key People

Your best person got a call last week.

Maybe it was a recruiter. Maybe it was a bigger company out of Frisco or Plano with deeper pockets and a shinier benefits page. Either way, you found out the way owners usually do: secondhand, and late.

If your stomach just dropped a little, keep reading.

You can’t match every raise a big company dangles. But you can give your key people something built around them, paid for by the business, that they’d think twice about walking away from. One of the simplest ways owners do that is a Section 162 executive bonus plan.

I’m Harvey Baker Jr., a licensed Texas agent in McKinney. Here’s how it works in plain English, who it tends to fit, and what to run past your CPA before you sign anything.

What a Section 162 executive bonus plan is

The name comes from Section 162 of the Internal Revenue Code, the section that generally lets a business deduct ordinary and necessary expenses, including reasonable compensation.

In plain English:

• The business pays a bonus to a key employee you choose.

• The bonus is used to pay the premium on a life insurance policy.

• The employee owns the policy and names the beneficiary.

That’s the core of it. No trust to set up. No plan document the size of a phone book. It’s a bonus with a job.

Because the employee owns the policy, it can go with them if they leave. That’s part of the appeal and part of the trade-off. More on that below.

Tax treatment depends on your entity type, how the bonus is paid, and your specific facts. Talk with your CPA or attorney before you set one up.

How it works, step by step

1. You choose who’s in. Usually it’s the people you’d hate to lose: the ops lead, the top estimator, the rainmaker, the office manager who actually runs the place.

2. The employee applies for and owns a life insurance policy. Coverage, eligibility, and rates vary by carrier and health.

3. The business pays a bonus. Often it goes straight to the carrier for the premium, or to the employee, who pays it.

4. The bonus is generally taxable income to the employee. The business generally may deduct it as compensation if total pay is reasonable. Confirm with your CPA.

5. Some owners add a little extra to help cover the employee’s tax on the bonus. This is sometimes called a “double bonus.” Same rule: run it by your CPA.

Why owners like it

• Simple to run. Generally a written agreement and a payroll entry, not an administrative project.

• You pick who participates. These arrangements are generally selective, unlike many retirement plans that have to include broad groups of employees. Confirm any ERISA or plan-document questions with your attorney.

• The business may get a deduction. Generally, if compensation is reasonable. Your CPA decides what fits your facts.

• It means something to the employee. A death benefit for their family and, depending on the policy design, potential cash value they may be able to access later. Cash value features and access rules vary by policy and are not guaranteed in every design.

• It’s easy to explain. “The company is paying for a policy that protects your family” lands better than another line on a benefits sheet.

The honest trade-offs

• Portability cuts both ways. A plain executive bonus plan doesn’t stop anyone from leaving. The policy is theirs. If keeping people is the goal, structure matters.

• The employee pays tax on the bonus. That can surprise people if nobody explains it upfront. Grossing up the bonus helps, but it costs the business more.

• The money is spent. The business generally doesn’t get the premium back, unlike some other arrangements.

• Owner-only plans can look different. If you’re an S-corp or LLC owner looking at this for yourself, the math and tax treatment can look very different than they do for a non-owner employee. That’s a CPA conversation, not a blog answer.

• The premium has to keep going. If the bonus stops, the employee may need to fund the policy on their own, or it could lapse, depending on the design.

Adding “golden handcuffs”

If the real goal is to keep someone, many owners look at a restricted version, sometimes called a restricted executive bonus arrangement.

The idea: the business pays the bonus, but a written agreement (sometimes paired with an endorsement on the policy) limits the employee’s access to policy values for a set period or until certain conditions are met. Stay, and the restrictions come off on schedule. Leave early, and the employee may have to repay part of the bonus or wait longer for access, depending on the agreement.

These designs need careful drafting. Your attorney and CPA should be in the room, and the rules should be clear to the employee from day one. Done right, it turns a nice perk into a real reason to stay.

Who it often fits

In North Texas businesses with 5–50 employees (trades and contractors in Collin County, professional services in Frisco and Plano, family-owned shops in McKinney), a Section 162 plan tends to come up when:

• One or two non-owner employees carry a big share of revenue, relationships, or know-how

• You can’t, or don’t want to, offer equity

• A retirement plan for everyone isn’t the right fit right now, or you already have one and want something extra for a few people

• You want something you can start, adjust, or stop without a lot of paperwork

• Cash flow is steady enough to keep the bonus going

It may not fit if cash flow is tight, if the key person’s health makes coverage hard to get, or if what you really need is key person coverage the business owns. Key person coverage protects the company. An executive bonus plan protects the employee’s family. Different jobs. Different policies. Some owners use both.

Hypothetical example for illustration only: Picture a Frisco HVAC company with about 20 employees. The service manager knows every big commercial account and every technician’s strengths, and a competitor has been circling. The owner can’t offer equity, so the company sets up a restricted executive bonus plan: a yearly bonus funds a policy the manager owns, with access to policy values restricted for several years under a written agreement reviewed by the company’s CPA and attorney. The manager’s family gets protection now. The owner gets a real reason for the manager to stay.

Common mistakes

• Skipping the CPA. The tax treatment depends on your entity and facts. Don’t guess.

• Not explaining the tax to the employee. A surprise on their W-2 can sour the whole thing.

• Calling it retention when nothing restricts it. If you want golden handcuffs, they have to be in writing.

• Confusing it with key person coverage. Key person protects the business. Executive bonus protects the employee’s family.

• Sizing it to sound generous instead of to what the business can keep paying. A bonus you have to stop in a slow year sends the wrong message.

• Never revisiting it. Roles change. Pay changes. The plan should too.

Questions to ask before you set one up

• Who are the two or three people we’d most hate to lose, by impact, not by title?

• Is our goal reward, retention, or both?

• How does our entity type affect the deduction and the employee’s taxes? (Ask your CPA.)

• Should we gross up the bonus to help with the employee’s tax?

• Do we want restrictions or a vesting schedule, and who drafts the agreement? (Ask your attorney.)

• What happens if the employee leaves, is let go, or the business is sold?

• Can the business keep funding this through a slow season?

• How does this fit with our key person coverage and buy-sell plan?

Coverage, eligibility, and rates vary by carrier and health. Cheap is a price. Right is a fit.

Get your Gap Map (free, 20 minutes)

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Call or text 430-373-7752 with the word MAP for a free one-page Gap Map. Or learn more at bakerlegacypartners.com.

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Insurance products involve costs, limitations, exclusions, and suitability considerations. This article is educational and is not tax, legal, or financial advice.

Harvey Baker Jr., Licensed Texas Life, Accident & Health Agent, TX License #3470534. Coverage, eligibility, and rates vary by carrier and health.