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The restrictive executive bonus arrangement: a bonus with control.

The executive bonus is a familiar technique to recruit, retain and reward key non-owner employees, and is a well-known way to fund a life insurance policy. The significant characteristic of an executive bonus arrangement is that, by handling the premium as additional compensation, the premium becomes tax-deductible for the employer, subject to the reasonable compensation limits in IRC [section] 162(a)(1).


Unfortunately, the arrangement puts only a very weak "golden handcuff" on the employee. As long as the employee stays, the premium payments continue. If the employee leaves, the premium payments end. And if the policy is to be continued, the employee has to take on the obligation. However, if the employee leaves, the policy and its internal values go with the employee.


One way to give the employer more control is with a restrictive executive bonus arrangement. One version of the REBA calls for the employee to place a restrictive endorsement on the policy. The typical restrictive endorsement allows the employee to change the beneficiary without the employer's consent, but that's all. Partial surrenders, loans, complete surrenders, assignments as collateral and so on must have the approval of the employer.

In the case of a variable life insurance policy, the employee might also have the right to change separate account elections without the employer's consent. A restrictive endorsement would typically be released upon the employer's cessation of business. It might also have a stated expiration date. The restrictive endorsement puts more of a hold on the key employee than the standard executive bonus. However, if the employee is patient, the restriction will eventually expire, making all the values available to the employee.

Is there something better? Yes, the document granting the employee the pay raise can also contain a vesting schedule requiring the repayment of some or the entire raise if the employee leaves before the repayment provisions are satisfied.

For example, a 5-year cliff vesting provision would require the employee to repay all of the raises if the employee leaves before 5 years have elapsed. A graded vesting provision might call for the repayment obligation to decrease at the rate of 20% per year.

Vesting in a REBA is handled differently than in a deferred compensation plan. With respect to the latter, the vesting schedule tracks the increase in the employee's rights under the plan. In a REBA, the vesting schedule tracks the decrease in the repayment obligation.

A REBA is a nonqualified arrangement, so no Department of Labor or IRS rules specify or limit the vesting schedule. Instead, vesting is determined based on the agreement between the employer and employee. The vesting provisions, however, can't be too stringent; employees may refuse to accept them. And state laws limit them if they're unconscionably long (similar to non-compete covenants). Anywhere between 5 and 10 years with either graded or cliff vesting would be good starting points.

The vesting schedule shown in the chart would say that (assuming the raise in pay is $10,000 per year) if the employee leaves early these would be the amounts repayable to the employer, depending on when the employee leaves.

Only after 5 years of service is completed will the repayment obligation in this example disappear. Given this vesting schedule example, as of the first day of the 6th year of service the employee will be fully vested.

Typically the REBA policy endorsement has a calendar year expiration date. That expiration date generally coincides with the employee becoming fully vested in the additional compensation.


The additional compensation is a raise in pay, deductible by the employer under [section]162(a)(1) IRC as an ordinary and necessary business expense, subject to the reasonable compensation limitations. One might think that the deduction could be denied under IRC [section]83(a)(2) because the pay raise is a transfer of property subject to a substantial risk of forfeiture.

Fortunately, [section]1.83-3(e) I.T.Regs. specifically excludes transfers of money from the definition of property. Therefore, a raise in pay accompanied by the repayment provision shouldn't run afoul of [section]83(a)(2). It should be deductible in the year paid, not at some future time when the vesting provisions are satisfied. Of course, the additional compensation is includable in the employee's income under [section]61(a)(1) IRC.

What happens if the employee leaves early and has to repay some or all of the additional compensation? This situation is covered in IRC [section]1341. If the employee leaves before being fully vested, [section]1341 allows the employee a deduction for the repayment of the additional compensation. Further, the deduction would be a business expense, deductible from gross income under [section]162. Alternatively, it might be deductible as a loss from a transaction entered into for profit under IRC [section]165(c)(2). On the employer's side the repayment would be taxable in come under IRC [section]61.


Just about anything the two parties negotiate is acceptable. Therefore, if the departure is under friendly circumstances (e.g. a family illness requires the employee to relocate) then the repayment provision could be waived.

The employment agreement granting the raise in pay can mention the raise is to be used to pay for life insurance on the employee. However, to give the employer broader access to sources of repayment, the repayment provision should not specify that repayment is to be from the internal values of the policy. Further referring to policy values might run afoul of IRC 264(a)(1), which disallows the deduction for any life insurance premium under which the taxpayer is a direct or indirect beneficiary.


Even though there is no clear authority, a REBA may be subject to ERISA. Typically REBAs are offered only to select managers and/or highly compensated employees, qualifying the arrangement for the 'top hat' exemption. Given that exemption, it would be necessary to send the Department of Labor a letter stating that there is a plan and that the plan document is available upon request.

The agreement containing the raise and the vesting schedule could constitute the plan document. Under ERISA the plan would have to name a fiduciary, which could be satisfied by appointing an officer, partner or LLC member as the fiduciary. Finally, the plan would need to have a claims procedure, which could be inserted in the employment agreement.


REBA offers 3 critical features: a current income tax deduction; a "golden handcuff;" and relative simplicity. Given those 3 traits, an employer would be wise to consider it as a key component in a program to recruit, retain and reward key employees.

David K. Smucker, CPA, CLU, ChFC, is a senior consultant in advanced sales for Nationwide Financial Services, Inc. in Columbus, Ohio. He can be reached at

Five-Year Cumulative Graded Vesting

leaves           Cumulative   Vested
during year        Raises     Percentage

1                 $10,000     0% after no complete years
2                 $20,000     20% after one complete year
3                 $30,000     40% after two complete years
4                 $40,000     60% after three complete years
5                 $50,000     80% after 4 complete years
6 & thereafter      N/A                    100%

leaves            Unvested      Repayment      Repayment
during year      Percentage      Formula       Obligation

1                   100%      100% X $10,000    $10,000
2                   80%       80% X $20,000     $16,000
3                   60%       60% X $30,000     $18,000
4                   40%       40% X $40,000     $16,000
5                   20%       20% X $50,000     $10,000
6 & thereafter       0%            N/A             $0

* THE VESTING SCHEDULE SHOWN ABOVE would say that (assuming the
raise in pay is $10,000 per year) if the employee leaves early,
these would be the amounts repayable to the employer, depending
on when the employee leaves.
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Title Annotation:insurance policies for executive bonuses management
Comment:The restrictive executive bonus arrangement: a bonus with control.(insurance policies for executive bonuses management)
Author:Smucker, David K.
Publication:National Underwriter Life & Health
Geographic Code:1USA
Date:Dec 1, 2008
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