A Section 162 executive bonus plan is a relatively simple strategy compared to many executive compensation tools, which is exactly why mistakes slip through — the simplicity leads people to skip steps that actually matter. Most of the problems we see in existing plans trace back to a handful of recurring issues, almost all of which are avoidable with the right planning upfront.

Mistake 1: No Written Bonus Agreement

This is the single most common issue with informally set up plans. Without a written agreement specifying the bonus amount, timing, and any restrictions, the arrangement is difficult to defend as a deliberate, documented business decision. If the IRS ever questions the deduction, or if a dispute arises with the employee later, an undocumented section 162 bonus plan offers very little protection for either party.

Mistake 2: Underfunding the Policy

Setting the bonus amount too low relative to the policy’s actual premium requirements is a frequent design error, often the result of trying to hit a specific budget number rather than working backward from what the policy actually needs to perform as illustrated. An underfunded policy can still be issued and put in force, but it may require increasing premiums later or risk underperforming its original death benefit projection, sometimes without anyone noticing until a review years later.

Mistake 3: Ignoring Reasonable Compensation Rules

For the bonus to be deductible, it needs to qualify as reasonable compensation for services actually rendered. This becomes a particular concern for owner-employees, where the IRS pays closer attention to whether total compensation, including the bonus, is proportionate to the work performed. Businesses that layer a large executive bonus on top of an already substantial owner salary without documenting the rationale are creating unnecessary audit risk.

Mistake 4: Not Involving the CPA From the Start

Some plans get designed entirely on the insurance side, with the company’s accountant brought in only after the policy is already in force — or not at all. This backwards sequencing means tax treatment questions get resolved after the fact rather than being built into the plan design. A CPA involved from the beginning can flag reasonable compensation concerns, confirm payroll treatment, and make sure the deduction is properly documented from year one.

Mistake 5: Choosing the Wrong Policy Type for the Situation

Not every permanent life insurance product fits every executive. A policy chosen primarily because it was the provider’s preferred product, rather than because it matched the executive’s age, health, and the business’s funding goals, often underperforms expectations. This is particularly common when an indexed universal life policy with variable, non-guaranteed elements is sold as though its illustrated projections were guaranteed, setting unrealistic expectations from the outset.

Mistake 6: Never Restricting the Benefit When Retention Was the Goal

If the actual business goal was retaining a specific employee, an unrestricted bonus plan doesn’t accomplish that. Because the employee owns the policy outright from day one, there’s no financial incentive tied to staying with the company. Businesses that skip the restrictive endorsement (REBA) step, either to save on legal costs or because it wasn’t explained clearly, often end up with a plan that rewards the employee without actually protecting the business’s retention goal.

Mistake 7: No Ongoing Policy Reviews

Plans set up correctly at inception can still drift off track without periodic review. Interest crediting rates change, cost of insurance charges rise with age, and a policy that looked fully funded at issue can become underfunded years later. Businesses that never request an updated in-force illustration are effectively flying blind on whether the plan is still on track.

Mistake 8: Failing to Plan for Employee Departure Scenarios

Plans that don’t clearly address what happens if the employee resigns, is terminated, or retires create ambiguity exactly when clarity is needed most. This is especially problematic for restricted plans, where vague endorsement language can turn a straightforward departure into a dispute over who actually controls the policy’s cash value.

Mistake 9: Treating the Plan as a One-Time Setup Instead of an Ongoing Commitment

A Section 162 plan isn’t a transaction that’s finished once the policy is issued — it’s an ongoing financial commitment that needs periodic attention from the business, the employee, and their advisors. Businesses that treat the initial setup as the finish line, rather than the starting point of a multi-year relationship with the plan, are the ones most likely to encounter one of the mistakes above down the road.

Most of these mistakes share a common root cause: moving too quickly through plan design without full documentation, or without bringing in the right advisors early enough. A properly structured section 162 executive life insurance plan, reviewed periodically and documented thoroughly, avoids nearly all of them.

Frequently Asked Questions

What’s the single most damaging mistake a business can make with a Section 162 plan?

Skipping a written bonus agreement. Without documentation, the plan is difficult to defend from a tax standpoint and difficult to resolve fairly if a dispute arises later, particularly around an employee’s departure.

How can I tell if my existing plan is underfunded?

Request a current in-force illustration from your provider and compare it against the original illustration from when the policy was issued. A meaningful gap between projected and actual performance is a sign the funding level needs to be revisited.

Is it a mistake to set up the plan without an attorney?

It’s a risk, particularly for restricted plans. An attorney isn’t always strictly required for a simple, unrestricted plan, but is strongly recommended whenever a restrictive endorsement or more complex vesting structure is involved.

Can a mistake made at setup be fixed later?

Many can. Missing documentation can often be created retroactively (though it’s stronger when contemporaneous), and an underfunded policy can typically be adjusted with updated premium levels. Some mistakes, like an unrestricted plan for an employee who has already left, are harder to unwind after the fact.

How common are these mistakes really?

Quite common, particularly in plans set up by generalist agents without deep Section 162 experience, or in plans that haven’t been reviewed in several years. Documentation gaps and missed policy reviews are the two most frequent issues in practice.

What’s the best way to avoid these mistakes from the start?

Work with a provider who specializes in executive bonus plan design, involve your CPA and, when appropriate, an attorney from the beginning, and commit to periodic reviews rather than treating the initial setup as the end of the process.