Retention Bonus Plans

If you own a business, large or small, you may be worried about your ability to recruit, reward and retain the key employees that are critical to your long-term success.

Like many successful business owners today, you may feel that the ideal solution would be one where you offer a benefit that would enable you to gain the loyalty of your top performers — without being subject to ERISA regulations, or having to include all your employees in the plan.

One effective way to ensure loyalty from your top performers is by implementing a Retention Bonus Plan. You can design a plan so that the reward it ultimately offers is within the reach of the top performers you select to participate — a reward that they feel they have a chance of staying long enough to earn. A Retention Bonus Plan is ordinarily created through the use of a Retention Bonus Arrangement — and it can be funded with a life insurance policy, which can help to make it a more affordable solution.

Why is it so important to retain key employees?

Key employees are important because:

They tend to possess:
- unique skills, experience, and leadership;
- valuable relationships with key clients and centers of influence; and
- specialized training that can make them difficult, time consuming and expensive to replace.
They may play a critical role during a period of change after an owner’s death, disability, or retirement — assisting a new owner to effectively transition and improve the company’s chances of future success.

How does a Retention Bonus Plan work?

With the key employee’s written permission, the business owner purchases a whole life insurance policy that is owned by the business and insures the key employee.¹ If the key employee remains with the company after the time specified in the Retention Bonus Arrangement (generally no more than ten years), the key employee will receive, from the policy’s cash value, the amount of the bonus that is specified in the Retention Bonus Arrangement.²

In a Retention Bonus Arrangement, the business agrees to pay the specified employee a bonus if the employee stays for an agreed-upon period of time or until a triggering event, such as the retirement, disability, or death of the owner. The employee will have more incentive to stay until the end of the period because otherwise, the employee will forfeit the bonus.

The owner and employee can negotiate the bonus amount and the stay period. For example, a bonus amount can be a set dollar amount ($100,000) or some multiple of salary (two times salary). The retention period can be one or two years, or some other time frame, although the stay period is not ordinarily longer than ten years in order to make the benefit more attainable. The plan is very flexible and after the initial stay period is achieved, a new stay period can be added.

For example:

Let’s consider how a 10-Year Retention Bonus, funded with a whole life insurance policy, could help one employer who wanted to retain an extremely valuable employee.

Our hypothetical employer, Bob Archer, owns a successful scientific and technical consulting services firm. Kate Breslin is one of his top consultants and she’s been instrumental in the success of the firm. Bob wants to ensure that Kate will stay with the company for many years to come. So, Bob and Kate enter into a Retention Bonus Arrangement, where Bob agrees to pay Kate a $250,000 bonus, in a single lump sum, if she stays with his company for ten years.

With Kate’s written permission, Bob purchases a whole life policy on Kate to fund the plan. At the end of ten years, Bob pays Kate the bonus and uses the policy cash value to recover his cost. At that time, he offers her an additional bonus of $500,000 if she stays another ten years. That bonus, too, is funded from the life insurance policy’s cash value.

As the above table shows, the policy provides both the funding for after-tax cost of the bonus from the policy cash values, as well as the death benefit that can be used to recover plan costs.

How much insurance coverage would be needed?

The amount of the whole life policy that funds your Retention Bonus Plan should be enough to:

protect your business in the event that the key employee should die;
generate sufficient cash value for your business to pay the key employee his or her stipulated bonus at the end of the “stay” period(s); and
enable cost recovery of plan benefits and administration through the life insurance death benefit proceeds.

Advantages for the employer

The plan builds loyalty

Key employees who participate may be more likely to stay with your company in order to earn the bonus.

It’s flexible

You can choose which employee(s) will participate — and even offer each participant a different bonus amount. You can also design the plan to offer additional stay periods — and corresponding rewards — after the initial stay period has been achieved.

It’s valuable

Policy cash value can be listed as an asset on your business’s books, and can be tapped in case of an emergency.³

It’s cost-effective

If properly structured, the policy death benefit can ultimately provide your business with recovery of plan costs. And when funded by life insurance, this plan can have less of an effect on your bottom line in the long term.

It’s easy to implement and administer

The simplicity of the plan makes it easy for you (and employees) to understand — and easy for your business to implement.

It may be tax deductible

As long as it is reasonable compensation,⁴ the bonus may qualify for a tax deduction when it is paid out.⁵

Advantages for the employee

It’s valuable

The employees you select to participate will receive a lump-sum cash benefit if they stay with your business for the time frame specified in the Retention Bonus Arrangement.

It’s attainable

The benefit will come within a reasonable time frame, compared to qualified pension plans or other benefits that aren’t accessible until retirement.

Why a Retention Bonus Plan may be right for your business

A Retention Bonus Plan can help your business be more protected for the long term, since it can help you retain one of your most valuable business assets — your top performers. This type of plan could be a valuable solution for your company if you:

Have key employees with unique skills, experience, and leadership; valuable relationships with key clients; and/or specialized training that would make it difficult, time consuming and expensive to replace them.
Have executives, managers, or sales people on staff who make substantial contributions to your business’s bottom line — and are concerned about what would happen to your company should any of these key people leave.
Can’t afford to lose any of your top performers to the competition.
Have a business that’s stable and well positioned for the future.

Tax considerations⁵

Once you recognize the need for this type of plan and determine the life insurance coverage to fund it, the following are important tax considerations and some general guidelines you should consider with your tax advisor:

Life insurance premiums are not deductible by the business.
Insurance proceeds are generally received income tax-free by the business.
In pass-through entities such as S corporations, LLCs and partnerships, the death proceeds increase the basis of the owner’s business interest. Premium payments, policy cash values and policy dividends may also impact an owner’s basis.

Protecting the income tax exclusion for the death benefit<sup>6</sup>

Protecting the income tax exclusion for the death benefit⁶

In order to protect the income tax exclusion for the death benefit, there are four general requirements:

Notice must be given to the insured, and her or his consent for the coverage obtained;
Either the insured must fit into certain categories, or the proceeds must be used for certain purposes;
There must be record-keeping; and
Reporting to the IRS concerning these policies must be completed using IRS Form 8925.

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1 The notice and consent requirements for employer-owned life insurance, set forth in IRC § 101(j), should be followed prior to the policy being issued so that the death benefit is not subject to income tax.
2 The bonus should be paid within 2½ months after the close of the company’s tax year in which the employee is required to stay. Otherwise, the agreement may be considered a nonqualified deferred compensation agreement subject to stringent rules and regulations, which could cause unfavorable tax consequences if certain requirements are not met. If IRC § 409A requirements are not complied with, which include having a formalized written plan, the employee may have to recognize all of the deferred compensation, whether received or not as taxable ordinary income, in addition to paying a 20% excise tax and interest in the year there is noncompliance.
3 Policy benefits are reduced by any outstanding loan or loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest. Withdrawals above the cost basis may result in taxable ordinary income. If the policy lapses or is surrendered, any loans considered to be gain in the policy may be subject to ordinary income taxes. If the policy is a Modified Endowment Contract (MEC), loans are treated like withdrawals, but as gain first, subject to ordinary income taxes. If the policy owner is under age 59½, any taxable withdrawal is also subject to a 10% penalty tax.
4 IRC Section 162 requires compensation to be “reasonable” in order for it to be tax deductible to the business.
5 Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation.
6 Life insurance contract death benefits are generally excluded from the income of the recipient. However, if the policy is considered “Employer Owned Life Insurance” (EOLI) under the Internal Revenue Code, the benefit may be considered taxable. Under certain circumstances, this tax treatment applies to individually owned policies as well as employer-owned policies. Your agent can provide you with the form EOLI NOTICE 101J0809 Notice & Consent for Employer Owned Life Insurance. Contact your tax advisor for details about complying with this regulation.
The notice and consent requirements for employer-owned life insurance, set forth in IRC § 101(j), should be followed prior to the policy being issued so that the death benefit is not subject to income tax.
This document is intended for general public use and is for educational purposes only. By providing this content, Park Avenue Securities LLC is not undertaking to provide any recommendations or investment advice regarding any specific account type, service, investment strategy or product to any specific individual or situation, or to otherwise act in any fiduciary or other capacity. Please contact a financial professional for guidance and information that is specific to your individual situation.
All scenarios and names mentioned herein are purely fictional and have been created solely for educational purposes. Any resemblance to existing situations, persons or fictional characters is coincidental. The information presented should not be used as the basis for any specific insurance/investment advice.

Retention Bonus Plans