This is a popular technique for attracting and rewarding key employees, largely because of its relative simplicity. The employer establishes a life insurance policy on a key employee as a fringe benefit, and pays the premiums in the form of a bonus to the employee. The bonus is a tax-deductible expense for the business (so long as the bonus doesn’t exceed reasonable compensation guidelines under federal tax law) and is tax-reportable income for the key employee. The key employee usually holds all rights in the policy, which can make this a valuable personal asset.
Business owners can install bonus plans for themselves and be very selective in using this type of benefit; there are no federal non-discrimination regulations to worry about, as there are for qualified plans. The main requirement for providing an executive bonus plan is sufficient, consistent cash flow to pay the bonuses for the policy premiums.
The Supplemental Executive Retirement Plan (SERP) is one of the most common examples of a nonqualified benefit plan. As the name indicates, it is meant to supplement the regular retirement benefits of a key executive, such as income from assets accumulated in a 401(k) or other qualified plan.
A SERP can be funded with general assets or annual allocations, but many businesses choose to fund these plans with corporate-owned life insurance.
A SERP is analogous to an old-school pension plan. A business buys life insurance policies for key employees, with the business being the sole beneficiary of the policy proceeds. As these insured key employees retire, the company pays them benefits from operating assets.
When these key employees pass away, the life insurance proceeds reimburse the business – and the business receives those proceeds tax-free.
Split dollar provides business owners with flexibility when funding executive benefits. Rather than having the business pay all premiums, the premium expense can be split between the company and the employee. The ultimate death benefit payout (or policy rollout at the employee’s retirement) can be split as well, to enable the company to recover its costs (hence the name, split dollar).
Either the company or the employee can own the policy, with the two arrangements known as “endorsement” and “collateral assignment,” respectively. Because of the variety of possible arrangements, a written agreement normally governs the use of this technique by an employer (another difference from executive bonus).