Do you think that split-dollar arrangements (other than premium loans under the split-dollar loan regime) faded away when the Internal Revenue Service tightened the rules on them in the final regulations issued Sept. 17, 2003?1 Think again. New variations of the split-dollar technique keep appearing.

Discount private split-dollar — also known as “three-generation split-dollar” — is one of the popular new techniques. Promoted around the country in recent years, it involves a private split-dollar arrangement that subjects the premium payer's rights to severe restrictions intended to significantly reduce the value of his interest in the arrangement for gift and estate-tax purposes. In essence, discount private split-dollar is supposed to be both a premium financing technique and a wealth transfer technique.

The question is, “Does it work?”

Typical Arrangement

Although there are many variations, a typical discount private split-dollar arrangement looks like this:

A grandparent establishes an irrevocable grantor trust for the benefit of his grandchildren. The trust is the applicant, owner and beneficiary of a life insurance policy on the grandparent's child (or of policies on the joint lives of the child and the child's spouse). The grandparent enters into a contributory non-equity collateral assignment split-dollar arrangement with the trust. Under this arrangement, the grandparent advances premiums to the insurer, while the trust makes a contribution equal to the annual economic benefit for the insurance coverage on the life of the child. The agreement provides that upon termination of the arrangement, the grandparent is entitled to whichever is greater: the policy's (or policies') cash value or the aggregate of his premium advances. In other words, there is no equity in the arrangement for the trust. The trust is entitled only to the death benefit.

The design of the split-dollar arrangement is critical in this technique. It is specifically structured to fall under the final regulations' economic benefit regime rather than the loan regime. If a split-dollar arrangement falls under the economic benefit regime, the economic benefit is the term premium representing the cost of current protection received by the trust (excess of policy face value over cash value).2 Until the IRS provides further guidance, the term premium may be determined from Table 2001 or, in some cases, a lower term premium may be used from the term premium table of the insurance carrier issuing the insurance policy.3

Unless the insured is very elderly, the term premium under the economic benefit regime is almost always lower (sometimes significantly lower) than the applicable federal interest rate (AFR) used for a loan regime split-dollar arrangement.4 With regard to the split-dollar arrangement between the grandparent and the trustee, the economic benefit regime involves smaller payments/gifts than the loan regime. But, to avoid a current gift of cash value of the policy to the trust, the economic benefit regime split-dollar contract must give all of the cash value to the premium payer (the so-called “non-equity split-dollar.”)5

The split-dollar economic benefit regime normally requires the premium payer (the grandparent in our example) to be the owner of the insurance policy with the pure insurance allocated to the insurance trust by an endorsement to the policy (the so-called “endorsement split-dollar.”) Generally, if a person other than the premium payer (for example, the trust) owns the policy, the loan regime with its higher AFR would apply.6 But if the grandparent owned the policy and all of its cash value, the full cash value of the policy, without discount, would be in the grandparent's gross estate at death or would be the value of the sale or gift if the policy were later sold or given by the grandparent to the trust.

Discount private split-dollar solves this problem by taking advantage of a special provision in the split-dollar regulations allowing non-equity private split-dollar collateral assignment arrangements. Under the regulations, even though the life insurance policy lists the trustee as the owner, it's the grandparent who's treated as the owner — so long as the only economic benefit that the arrangement ever provides the trust is life insurance protection.7

Thus, a split-dollar contract between the trust that owns the policy and a grandparent/collateral assignee qualifies as an economic benefit regime arrangement as long as the arrangement gives all of the cash value (a non-equity arrangement) to the grandparent. The favorable basic tax economics of the arrangement then can be strategically customized by (1) obligating the grandparent to pay at least a certain number of premiums, and (2) expressly forbidding the grandparent from unilaterally terminating the split-dollar contract or accessing the policy's cash value. The hope is that these restrictions will result in a steep discount to the value of the grandparent's interest when he dies, or gives or sells that interest to the trust (or to another party.)


Typically, a grandparent advances just a few very large premiums to make the policy quickly self-sufficient. For example, if a universal life policy is involved, the grandparent might front-end load the premium payments just short of the modified endowment contract (MEC) limits of Internal Revenue Code Section 7702A (generally five or six years).8 This front-end loading has the advantage of rapidly increasing the policy's cash value relative to the death benefit, thereby reducing the amount of outside premiums needed over the life of the policy.

Two or three years after the grandparent has paid the last of the front-end loading premiums, he either sells or gives his interest in the arrangement to the trust.9 Either way, this step will terminate the split-dollar arrangement by merger. No new premiums are anticipated, because the grandparent has front-end loaded the premiums. An alternative to selling or giving the split-dollar contract to the trustee is for the grandparent to make a specific testamentary bequest of the split-dollar contract to the trust upon his death.

What's the Play?

The grandparent who has advanced all those premiums has agreed that he won't recover those sums until the arrangement is terminated. Because he has no power to terminate the arrangement unilaterally or access the cash value at any time, the value of his interest in the arrangement for sale, gift or estate-tax purposes should be:

  • the amount due the grandparent (anticipated cash value of the policy or aggregate premiums paid by the grandparent, if greater) discounted back to the date of sale, gift or death from the life expectancy of the insured child;

  • increased by the present value of the annual economic benefit due the grandparent from the trust during the life expectancy of the insured.

Because the insured child isn't expected to die for many years, the discounted present value at the date of sale, gift or death is going to be a very small percentage of the cash value of the insurance policy subject to the split-dollar contract.

If the discount works, the grandparent will have achieved a number of estate-planning objectives. First, he will have transferred a significant amount of cash in the form of large premium payments to the trust with any taxable gifts limited to the low annual economic benefit associated with the insured child's age. Second, if he dies before the arrangement is terminated, only the sharply discounted value of the split-dollar contract will be includible in his estate for estate-tax purposes. On the other hand, if he gives his contract to the trust or sells it, he would do so at that sharply discounted value. If the split-dollar contract is sold to the trust for the discounted value, there is no extra gift at sale unless the grandparent makes a separate gift to the trust to be used for the purchase price. The discounted value also would affect the generation-skipping transfer (GST) tax if a generation-skipping trust is involved.

This technique's results are theoretically so good that one has to wonder: Are they too good to be true?

There are several potential technical challenges, including:

  • Can the arrangement, by design, qualify for economic benefit treatment as a non-equity collateral assignment plan under the final split-dollar regulations?

  • How is the discount itself determined?

  • Does IRC Section 2703 apply to negate the restrictions that underscore the discount?

  • Has the grandparent made a gift on creation of the arrangement?

  • Does the step transaction doctrine apply?

  • Is there a modification of the arrangement under the split-dollar regulations so that the grandparent is deemed to have transferred the policy at its full value?

Design Flaw in the Set-Up?

As we've noted, the final split-dollar regulations require that for the premium payer to be treated as the policy owner under the economic benefit regime, the only economic benefit that can be provided to the trust is current life insurance protection. At first blush, the regulations suggest that as long as the premium payer is entitled to the greater of the policy's cash value or its aggregate premium advances (leaving no equity in the arrangement for the trust), the arrangement should qualify for economic benefit treatment.

But could it be that such a restrictive arrangement that purports to suspend all rights of the collateral assignee in order to set the stage for a discount of the assignee's interest, in fact leaves the trust with more than just a death benefit? Obviously, proponents of the technique would find this question inconvenient at best. Yet some planners are not convinced that all we have to do to qualify for economic benefit treatment is put the cash value entirely on the premium payer's side of the ledger when the arrangement is terminated. They wonder whether a construct that purports essentially to ignore all of the other privileges and immunities of policy ownership for the life of an arrangement constitutes a hyper-technical and overly simplistic reading of the regulations. If the arrangement doesn't qualify under the economic benefit regime, then the IRS would likely apply the loan regime rules and treat the grandparent's premium advances as below-market term loans, with all of the associated negative implications for income, gift and GST tax purposes.

Discount and Potential Attacks

The fundamental underpinning of discount private split-dollar is that the grandparent's collateral assignment interest in the policy is so limited and so restricted that it qualifies for a substantial discount.

At present, there are no authorities telling us whether these restrictive non-equity private split-dollar arrangements qualify for any significant discount should the split-dollar contract be included in the grandparent's gross estate or should the grandparent give or sell it to the trust.

Clearly, though, the IRS could make several possible arguments that the discount should either be eliminated or reduced:

  • Section 2703 — Is there a discount at all? For estate, gift and GST tax valuation purposes, a property's value is determined without regard to any restriction on the right to sell or use such property.10 An exception to this rule is if the restriction is (1) a bona fide business arrangement; (2) not a device to transfer such property to members of the decedent's family for less than full and adequate consideration in money or money's worth; and (3) comparable to similar arrangements entered into by persons in an arm's length transaction.11

    Could the IRS argue that the split-dollar contract is a restriction on the insurance policy that should be ignored under Section 2703? The counter-argument is that the property to be valued is the split-dollar contract and not the insurance policy. Therefore, the split-dollar contract is not just the restriction but the property itself.

    The IRS has used the Section 2703 argument to ignore family limited partnership (FLP) agreements so as to directly value the assets transferred to the partnership. Courts have rejected the Section 2703 argument in the FLP context.12 In recent cases, the IRS seems to have abandoned this argument.

    Perhaps, instead of ignoring the entire split-dollar contract under Section 2703, the IRS might argue that only the restriction in the split-dollar contract that prohibits the grandparent from terminating the split-dollar contract should be ignored under Section 2703. If the IRS were to prevail with this argument, there would be little discount — as the grandparent would be deemed to have a unilateral right to terminate the split-dollar agreement at any time and to access the entire cash value.

    Even if the IRS prevailed in this argument, the safe harbor exception might save the restriction — but only if it could be shown under the facts and circumstances that there is a bona fide business arrangement, not a testamentary device, and the arrangement is comparable to similar arm's length transactions. Yet, these three safe harbor conditions could prove to be a bridge too far for a court that would likely wonder why a grandparent would knowingly enter into this transaction with real money if not to make a testamentary transfer.

    Would the arrangement stand up as a bona fide business arrangement and meet the comparable arm's length test? Many split-dollar agreements between employers and employees contain a prohibition against the employer unilaterally ceasing premium payments for a fixed number of years or before termination of employment or even after retirement. On the other hand, many such agreements allow the employer to terminate the arrangement and recover its advances at any time. In the private split-dollar context, a trust with little other assets would want to guarantee future premium payments and ensure the cash value stays in the policy. Does the fact that the private split-dollar restriction continues until the death of the much younger insured remove the arrangement from bona fide business and comparable arm's length tests? Would the grandparent enter into one of these arrangements with you or me if we weren't relatives?

  • Step transaction doctrine — A successful step transaction doctrine argument also could kill the discount. If the grandparent sells or gifts the split-dollar contract to the trust, there may be exposure to a step transaction argument that the split-dollar contract was not a real restriction because, at the contract's inception, the grandparent had intended to sell or give it away. Of course, such an argument depends heavily upon the facts and circumstances of each case. Negative factors would include the donor selling or gifting shortly after creating the split-dollar contract as well as the absence of any change in circumstance between the time the contract was created and the time it was sold or gifted. There should be less chance for a successful step transaction argument if the split-dollar contract is held until the grandparent dies — unless the grandparent was very elderly or ill when the contract was created.

  • Modification under the split-dollar regulations — Under the split-dollar regulations, such a sale or gift might be treated as though the grandparent transferred the entire life insurance policy to the trust.13 If so, the undiscounted value of the insurance policy cash value would be a gift — reduced by any money received from any sale.

    As we've noted, for the economic benefit regime to apply, the premium payer normally has to be the owner of the life insurance policy.14 Discount private split-dollar is based upon an exception to that rule when the trust owns the policy subject to a non-equity split-dollar contract. In such a case, the donor (grandparent) is treated as the owner for economic benefit regime purposes.15

    But in these “treated” or “deemed” ownership situations, the split-dollar regulations provide that, if the split-dollar arrangement is modified and immediately after such modification the donor (the grandparent) is no longer the owner under the split-dollar arrangement, the grandparent “is treated as having made a transfer of the entire life insurance contract to the” trust “as of the date of such modification.”16

    The sale or gift of the split-dollar contract to the trust by the grandparent certainly would end the grandparent's being treated or deemed as the owner. Would the sale or gift then be a “modification” as defined under the regulations? If modification means a change, the answer would be “yes.” But proponents of discount private split-dollar argue that the gift or sale terminates the split-dollar contract by merger and therefore does not modify the arrangement. If the termination is not a modification, arguably there would be no transfer under the regulations. On the other hand, termination of the split-dollar arrangement might be the ultimate modification. There are no authorities concerning whether a termination is a modification.

    Do the regulations apply to a transfer of the split-dollar contract to the trust by a testamentary bequest upon the grandparent's death? As death is involuntary and ownership would have to change upon the grandparent's death, perhaps a transfer at death is not a modification causing the transfer provisions of the regulations to apply. Again, there are no authorities on point.

Tread Carefully

Clearly, reports of the death of split-dollar arrangements after 2003 were greatly exaggerated. Split-dollar lives on — particularly in the loan regime. These arrangements can be excellent short-term premium financing techniques. But be careful of certain aggressive split-dollar arrangements, including discount private split-dollar. Before a client gets involved in such deals, consider the lack of authorities approving such arrangements; the extraordinary (perhaps too extraordinary) tax benefits; the arsenal of potential grounds for IRS attack; and the concerns associated with Section 6694 for those preparing “grandparents'” tax returns.

The views expressed herein are those of the authors and do not necessarily reflect the views of The University of Texas System or Ernst & Young LLP. This article should not be construed as legal, tax, accounting or any other professional advice or service. No one should act upon the information contained herein without appropriate professional advice after a thorough examination of the facts of a particular situation.


  1. Treasury Regulations Sections 1.61-22 and 1.7872-15.
  2. Treas. Regs. Section 1.61-22(d)(3).
  3. Notice 2002-8, 2002-4 I.R.B. 398. Notice 2002-8 states that the interim government Table 2001 (originally published in Notice 2001-10, 2001-5 I.R.B. 459) may be used to value cost of current protection. For split-dollar arrangements entered into before Jan. 28, 2002, the taxpayer may use, as an alternative, the current published premium rates charged by the insurance company issuing the policy for a one-year term premium available to all standard risks if lower than Table 2001. The phraseology of Notice 2002-8 would appear to be a grandfather provision against future changes by the Internal Revenue Service for these pre-Jan. 28, 2002, policies. But, many insurance companies have ceased publishing the old alternative premium table. For split-dollar arrangements entered into after Jan. 27, 2002, the alternative term rate of the insurance carrier, if lower than Table 2001, still may be used — but the IRS reserves the right to change or abolish the alternative term valuation rate. For these post-Jan. 27, 2002, arrangements, the insurance carrier's rate must meet two additional requirements: The availability is known to persons who apply for the term insurance coverage from the insurer, and the insurer regularly sells term insurance at such rates to individuals who apply for term insurance through the insurer's normal distribution channels.
  4. Internal Revenue Code Section 7872(f)(2).
  5. Treas. Regs. Sections 1.61-22(d)(2)(ii) and (4)(ii).
  6. Treas. Regs. Section 1.7872-15(a)(2)(A).
  7. Treas. Regs. Section 1.61-22(c)(1)(ii)(A)(2).
  8. In order not to be a modified endowment contract (MEC), the premium payments must meet the seven-pay test of IRC Section 7702A: The accumulated amount paid under the policy at any time during the first seven contract years does not exceed the sum of the net level premiums that would have been paid on, or before such time if the policy provided for paid-up future benefits after the payment of the seven level premiums. If the seven-pay test is not met, the policy becomes a MEC and withdrawals, distributions, dividends and loans will be taxed under the tax-deferred annuity rules of IRC Section 72(e)(10). But, if there is no intent to access the cash value of the policy during the lifetime of the insured, MEC status is irrelevant.
  9. If a sale is involved, in order to avoid a transfer for value subject to Section 101(a)(2), the grandparent structures the trust to be a grantor trust under Sections 671-679. See Revenue Ruling 85-13, 1985-1 C.B. 184 and Rev. Rul. 2007-13, 2007-11 I.R.B. 684.
  10. IRC Section 2703(a)(2).
  11. IRC Section 2703(b).
  12. Church v. United States, 85 AFTR2d 804 (W.D. Tex. 2000), aff'd without published opinion, 268 F.3d 1063 (5th Cir. 2001) (per curiam); Estate of Strangi v. Commissioner, 115 T.C. 478 (2000), aff'd in part and rev'd in part on other grounds, sub nom, Gulig v. Comm'r, 293 F.3d 279 (5th Cir. 2002), on rem'd jgmt ent'd, Estate of Strangi v. Comm'r, T.C. Memo 2003-145, aff'd, 417 F.3d 468 (5th Cir. 2005).
  13. Treas. Regs. Section 1.61-22(c)(1)(ii)(B).
  14. Treas. Regs. Sections 1.61-22(b)(3)(ii)(B) and 1.7872-(15(a)(2)(i)(A).
  15. Treas. Regs. Section 1.61-22(c)(1)(ii)(A)(2).
  16. Treas. Regs. Section 1.61-22(c)(1)(ii)(B)(2).

Donald O. Jansen is the Austin, Texas-based senior tax attorney in the Office of the General Counsel at the University of Texas System. Charles L. Ratner is the Cleveland-based national director of Personal Insurance Counseling for Ernst & Young LLP