Estates, Trusts & Gifts
The Second Circuit held that the Tax Court clearly erred in finding that the terms of an implied agreement between a decedent and her son provided that the decedent would retain enjoyment of the entirety of a 49% share in a Manhattan brownstone that she had given to the son and that the entire property should remain in the estate.
Since 1989, Margot Stewart and her adult son Brandon Stewart co-owned, as joint tenants with rights of survivorship, a house in East Hampton, New York (the East Hampton property). Each summer, Margot and Brandon rented out the property, splitting the rental income evenly. They also split evenly the expenses of maintaining the property. The result was that every summer Margot and Brandon each received half of the East Hampton property’s net income.
Margot and Brandon lived on the first two floors of a five-story brownstone in Manhattan (the Manhattan property), which Margot had bought in 1968. On October 1, 1999, Margot leased the upper three floors to an unrelated commercial tenant, Financial Solutions, Ltd. The rent was $9,000 per month, and the term ran through July 31, 2002.
Margot was diagnosed with pancreatic cancer in December 1999, and she began chemotherapy treatments in January 2000. On May 9, 2000, Margot and Brandon signed a deed that transferred a 49% interest in the Manhattan property to Brandon. Although she made the gift after she was diagnosed with cancer, Margot had discussed the gift with Brandon and an estate planner before the diagnosis. The deed provided that Margot and Brandon would be tenants in common.
After the gift was completed, Margot and Brandon continued to live together in the lower two floors of the Manhattan property. Financial Solutions continued to rent the upper three floors, but its rent payments were erratic, untimely, and sometimes partial. In addition, the Manhattan property underwent thousands of dollars worth of repairs. As a result, the Manhattan property expenses were significantly higher than usual, at the same time that the income produced by the property became unreliable.
The financial relationship between Margot and Brandon underwent several significant changes during the period after the gift and before Margot’s death. While Margot continued to receive the Manhattan property rent payments from Financial Solutions, Brandon, who was receiving the rent from in the East Hampton property, stopped sharing it with Margot. Brandon also paid a small amount of the Manhattan property’s expenses, which Margot had previously paid for in their entirety. During this period, Margot paid Manhattan property expenses of $21,790.85, while Brandon paid Manhattan expenses of $1,963.
Background After Margot’s Death
Margot died on November 27, 2000. Following her death, her estate filed an estate tax return that reported the contents of Margot’s estate as including 100% of the East Hampton property but only a 51% interest in the Manhattan property. Because Margot owned only a partial interest in the Manhattan property, the estate claimed a value for the interest that was discounted significantly from a proportionate share of the entire property’s fair market value.
In December 2004, the IRS issued a notice of deficiency to the estate. It contended that Margot had retained possession or enjoyment of the 49% interest in the Manhattan property she had given to Brandon and that the entire property was therefore part of her estate for federal tax purposes. The estate challenged the determination in Tax Court.
Tax Court Opinion
The Tax Court agreed with the IRS that Margot had retained possession and enjoyment of the whole property after her gift of an interest in it to Brandon, and it upheld the IRS’s deficiency determination. The court found that the transfer of interest in the Manhattan property was a completed gift under state law.
However, the court agreed with the IRS that under Sec. 2036, 100% of the Manhattan property’s value was includible in Margot’s estate because she continued to live there and received all the rental income after the May 9, 2000, transfer. Sec. 2036(a)(1) provides that a decedent’s gross estate includes the value of all property interests transferred (other than for full and adequate consideration in money or money’s worth) by a decedent during her life where she has retained for life the possession or enjoyment of the property or the right to the income from the property. The Tax Court held that Margot’s retention of the property’s income stream after the property was transferred was “very clear evidence that the decedent did indeed retain ‘possession or enjoyment.’” Margot’s estate appealed the decision to the Second Circuit.
The Second Circuit’s Decision
The Second Circuit examined the question of what it means to retain “possession or enjoyment” or the right to income from property under Sec. 2036(a)(1). The court noted that retaining the right to income is not the same as retaining the income and found that Margot did not retain the right to income from the property. It was undisputed, the court said, that Margot did not have a legally enforceable power to receive the income from the interest in the Manhattan property that she had legally transferred to Brandon. Therefore, if she retained anything described in Sec. 2036(a)(1), it was the actual “possession or enjoyment” of Brandon’s 49% interest and not any right to income from it.
The court observed that for purposes of Sec. 2036(a)(1), “the property” here refers to the transferred 49% interest in the Manhattan property, not to the entire Manhattan property. The Tax Court has previously recognized that a decedent’s formal and substantial retention of a majority interest in real property does not necessarily require a finding that the decedent retained possession of a transferred minority interest (see, e.g., Estate of Wineman, T.C. Memo. 2000-193).
The court looked to the substance and not the form of the transaction in applying the “possession or enjoyment” language. It said that “while it may sometimes be difficult to determine who is using real property that is wholly inhabited by a decedent and/or family members, it is quite easy to determine who is using real property that is producing income. All we have to do is follow the money.” Whoever receives the income from the property is the person who is possessing and enjoying it.
The court then tried to determine the extent of the retained possession or enjoyment and the terms of the agreement. It reviewed the Tax Court’s determination that there was an “implied agreement” that Margot “would retain the economic benefits” of the entire transferred interest in the Manhattan property. It found, in residential transfer cases, two factors to be particularly significant: (1) continued exclusive possession by the donor and (2) the withholding of possession from the donee.
The court noted that the presence of both those factors is “so damning that in cases where a decedent transfers a residential property but continues to live in it to the exclusion of the donee, the estate taxpayer has lost in every case of which we are aware because the taxpayer could not meet its burden.”
However, the court held that neither of these factors was present in this case. Margot did not have exclusive possession of Brandon’s 49% interest in the Manhattan property, nor did she exclude Brandon from it or, for that matter, the entire property. They continued to live together in the brownstone. Therefore, the court held, Margot’s residential use of part of the Manhattan property did not indicate an implied agreement that she would to any extent retain the substantial economic benefits of the residential portion of Brandon’s 49% interest.
The Second Circuit held that while it was not clearly erroneous for the Tax Court to find an implied agreement, it was clearly erroneous for it to find that the terms of the agreement were such that Margot would enjoy the substantial economic benefit of 100% of Brandon’s 49% interest in the Manhattan property.
The Second Circuit left open the question of what part of the 49% interest should be included in the estate and remanded the case to Tax Court to make the findings necessary to answer that question. It directed the Tax Court to use an approach adopted by the IRS in Rev. Rul. 79-109, which explained that “the amount includible in the gross estate is that portion of the transferred property that would be necessary to yield the retained income.”
The Second Circuit told the Tax Court to first determine how much of the substantial economic benefit generated by the 49% interest is attributable to the residential portion of the interest and how much is attributable to the commercial portion. Such a finding is essential because, at least insofar as gross income is concerned, Margot received 100% of the economic benefit from the commercial portion of the 49% transferred by receiving the rent payments, while Brandon received 100% of the economic benefit from the residential portion of that 49% by inhabiting it. The court was also of the opinion that who paid what expenses must be taken into account in apportioning the 49% interest between the estate and Brandon.
Finally, the Tax Court apparently did not consider the distribution of the income and expenses from the East Hampton property at all. While the Tax Court was clearly under no obligation to credit Brandon’s testimony that he and Margot intended to use the East Hampton income to set off the Manhattan income and then reconcile their accounts at year’s end, the Second Circuit indicated that it might be worth considering on remand where the net income from the East Hampton property went.
The decisions of both courts in this case turn on interpretations of an implied agreement between Margot and Brandon. While the transfer of the 49% interest was evidenced by a deed (albeit a late-recorded deed), the agreements as to the rental income from the top three floors of the brownstone and the East Hampton property, the splitting of expenses, and the right to live in the Manhattan apartment were all oral. Thus, the Tax Court was forced to try to divine the parties’ intentions from their actions and to interpret them in light of a Code section that assumes transfers out of a decedent’s estate are done for the purpose of avoiding transfer taxes.
On remand, the Tax Court may very well find that if Margot did not retain possession and enjoyment of all of Brandon’s share of the property, she did retain possession and enjoyment of a large portion of it. After all, she continued to receive all the income from the property and paid almost all the expenses. As evidence for an agreement, the courts were faced only with after-the-fact testimony, which the Tax Court found to be not credible, and the fact that Brandon continued to live in the brownstone, to which the Second Circuit gave great weight but that arguably did not affect Margot’s economic enjoyment of the property.
If the parties truly wished to split the possession and enjoyment of the property, a well-drafted and clear written agreement between the parties, spelling out their rights and obligations, might have avoided this result.
Estate of Stewart, No. 07-5370-ag (2d Cir. 8/9/10)