In our currently stressed economic circumstances there may be a parent or two who feels they are not quite enjoying their home as much as before, due to the presence of recently-returned offspring. Whether this was the inspiration for the United States Court of Appeals for the Second Circuit in its decision Re Estate of Stewart v. Comm’r (August 9, 2010), vacating and remanding the US Tax Court’s prior decision, (TC Memo 2006-225) may be known only to the higher court itself.
The immediate practical result, for the Stewart estate, is that a part of the decedent’s 49 percent undivided interest gift made to her son will be excluded from the estate. The implications of Stewart for estate planning and tax practitioners may be quite significant, opening up planning opportunities long considered shut by the courts. Or, to quote the Stewart court’s dissent, the case “opens up a loophole that will vitiate to a considerable degree the efficacy of” Section 2036.
While Section 2036 attacks by the Service have taken many forms, cases involving the continued enjoyment of principal personal residence have repeatedly surfaced. In such cases, when Section 2036 was invoked, the taxpayer had difficulty overcoming the burden of proof that an implied agreement for the decedent’s continued enjoyment of the property did not exist. Noteworthy cases of this nature with Service victories are Maxwell1 (cited by the Stewart court), Disbrow2, and Tehan3. Wineman4 involved a case where a decedent retained a majority interest in real property that she occupied, but paid below market rent that was not negotiated with the transferees. In Wineman, the taxpayer succeeded in proving to the court that no implied agreement was in effect, mostly through objective facts and credible testimony. The court noted that “the decedent’s continued use and possession of parcel 3, of which she owned a controlling interest, is natural in light of the children’s minority ownership.” Revenue Ruling 79-109 followed Uhl5and United States National Bank of Portland6, to address situations where a decedent retained an interest in only a part of the transferred property, or, in the alternative, in a corresponding portion of the income produced by the property. Under the Revenue Ruling, the amount includable in the gross estate is that portion of the transferred property that would be necessary to yield the retained income, which may be particularly useful when the implied agreement terms indicate only partial enjoyment of the transferred interest.
In May 2000, the decedent, Margot Stewart, gave her son Brandon a 49 percent “tenancy-in-common” interest in her Manhattan property, where the two had lived together since 1989. At the time, she was undergoing chemotherapy for pancreatic cancer. The two continued living together at the same property until Margot’s death in November. This case features many of the “estate planning don’ts” commonly seen in section 2036 cases, including deathbed gifting and a lack of respect for the formalities of legal arrangements and titles; and the Tax Court held that the decedent had indeed retained “enjoyment and possession” of the gifted property and pulled the entire amount back into the estate.
Somewhat complicating the narrative of the case, the property had two parts, a residential portion, shared by Margot and Brandon, and a rental portion (the upper three floors) under lease to a third party. This being Manhattan, the rent was $9,000 per month. During Margot’s lifetime, the rent went to her, in its entirety. She also paid the overwhelming majority of the property’s expenses. Brandon testified during the Tax Court hearing that their oral agreement had been to share these cash flows pro-rata (49/51) and that the reason these amounts had been almost all paid to and by his mother was that the amounts would later have been offset against the family’s other (seasonal) rental property in the Hamptons. The Tax Court did not find his testimony credible.
The Second Circuit’s Decision
Section 2036(a), (a)(1), measures whether the decedent has retained “the possession or enjoyment of, or the right to the income from, the property.” Beginning at the end, the Second Circuit first found that two aspects of the statute were “beyond dispute” in this case: the right to income and the definition of the property. The Appeal’s Court noted that the term “right” means a legally enforceable power – and there was nothing in the record indicating the decedent had retained such a right to income from the property, notwithstanding the fact that she had ended up with all of it. More importantly for the result here, as we will see, is that the “property” in question was not the Manhattan property as such, but the 49 percent undivided interest gifted to Brandon.
In determining whether Margot had retained the “possession or enjoyment” of the 49 percent undivided interest, the Appeal’s Court reviewed the lower court’s opinion for clear error only. The “possession or enjoyment” of the property transferred does not refer to legal titles or rights, but rather to a “substantial present economic benefit.” With respect to the rental part of the Manhattan property, the Appeal’s Court noted, “it is quite easy to determine who is using real property that is producing income. All we have to do is follow the money.” The Appeal’s Court found (as did the Tax Court) that there was an implied agreement between the decedent and her son. However, it found that the agreement could not “be read to provide that Decedent would retain enjoyment of the residential portion of Brandon’s 49% interest in the Manhattan property.” In the Second Circuit’s opinion, there are two key factors to this second analysis: “continued exclusive possession by the donor and the withholding of possession from the donee.
“And, if Brandon had not lived in the Manhattan property for the entire time between the transfer and Decedent’s death, it would certainly not have been clear error had the Tax Court found an implied agreement that Decedent could have excluded Brandon from the Manhattan property during her life, and thereby had enjoyed the benefits of the residential part of his 49% interest and of his rights as a residential tenant in common.”
The Second Circuit specified that finding an “implied agreement between two related co-occupants of residential real property” would not necessarily always be clear error. In this particular case, however, the Tax Court had no other finding of fact on which to base its finding of an implied agreement. Thus, it erred. As the dissent points out:
This analysis makes it hard to conceive of a situation in which the Tax Court might properly find that despite the formal transfer of a fractional interest in property to a cohabiting child, the parent reserved for himself its possession and enjoyment”
The Tax Court is now tasked with the rather unenviable job of “bifurcating” the value of a five-story Manhattan brownstone, of which all the rental income from the top three floors went to one owner, with about 90 percent of the expenses paid by same, and with the bottom two floors co-inhabited by mother and son equally. Most importantly for the estate, this also brings back into play a 42.5 percent fractional interest discount, uncontested by the Service during the first hearing.
The dissent, by Circuit Judge Livingston, has a strong focus on the Manhattan property in its totality, and what happened to it before and after the gift. From this standpoint, the question is: was the “transferor’s lifetime possession or enjoyment of the affected property” diminished or not? Clearly, the answer is not. The majority’s laser-like focus on the 49 percent undivided interest (the “property” in question) is likewise instructive. This interest was created at the point in time of the gift, so there is no history, no “before and after.” And a tenancy-in-common interest does not carry the right to exclude the other tenant from the property, only to enjoy co-tenancy. In the majority’s analysis, for the decedent to have continued to enjoy and possess not just her 51 percent interest but also her son’s 49 percent interest, she would have had to kick him out of the house. An unlikely scenario, perhaps. Whether, like the dissent, you would characterize this as a “loophole” or not, it clearly opens new planning opportunities for many families and their advisors. The lesson for the Service might be to always have a back-up plan.
1.Maxwell v. Comm’r, 3 F.3d 591, 593-94 (2d Cir. 1993)
2.Estate of Disbrow v. Comm’r, T.C. Memo 2006-34
3.Estate of Tehan v. Comm’r, T.C. Memo 2005-128
4.Estate of Wineman v. Comm’r, T.C. Memo 2000-193, 79 T.C.M. (CCH) 2189, 2000 Tax Memo LEXIS 233
5.Estate of Uhl v. Comm’r, 241 F. 2d 867 (7th Cir. 1957)
6.United States National Bank of Portland v. United States, 188 F . Supp. 332 (D. Oregon 1960)
Espen Robak, CFA, is founder and president of Pluris Valuation Advisors LLC in New York. Comments or questions are welcome firstname.lastname@example.org.