CURRENT TAX DEVELOPMENTS - Estate Planning Journal, December 2010
Estate of Stewart, 106 AFTR 2d 2010-5710 , 2010-2 USTC 60596 (CA-2, 2010)
In Estate of Stewart
the Second Circuit held that under the facts presented,
Section 2036 did not require the inclusion in the decedent's gross estate of a gift of a 49% interest in a residence used by the decedent along with the donee and a portion of which was also rented to an unrelated third party.
The decedent, 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, the decedent and Brandon rented out the East Hampton property, splitting the rental income evenly. As a matter of convenience, the decedent and Brandon would not both sign the lease; nor did the tenant send one check to the decedent and another check to Brandon. Rather, either the decedent or Brandon would sign the lease, and the tenant would write a single check either to the decedent or to Brandon. Whoever received the rent checks that year would then write a check to the other for that person's share. The decedent and Brandon also evenly split the expenses of maintaining the East Hampton property.
In addition, the decedent and Brandon lived on the first two floors of a five-story brownstone in Manhattan (the “Manhattan property”), which the decedent had bought in 1968. The decedent leased the upper three floors to an unrelated commercial tenant.
On October 1,1999, the decedent and Brandon met with an estate planning specialist who suggested that the decedent make a gift of part of the Manhattan property to Brandon. The decedent was diagnosed with pancreatic cancer in December 1999, and she began chemotherapy treatments in January 2000. On May 9, 2000, the decedent and Brandon signed a deed that transferred a 49% interest in the Manhattan property to Brandon as a tenant in common.
After the gift was completed, the decedent and Brandon continued to live together in the lower two floors of the Manhattan property, and the tenant continued to lease the upper three floors. However, after the gift, the rental payments became erratic, untimely, and sometimes partial. Also following the gift, the Manhattan property underwent thousands of dollars worth of repairs. As a result, the expenses of the Manhattan property were significantly higher than usual—at the same time that the income produced by the property became unreliable.
Subsequent to the gift, the decedent continued to receive the rent payments from the tenant of the Manhattan property, and Brandon received the rent payments from the tenant of the East Hampton property. In contrast to their previous practice, Brandon never wrote a check to the decedent for her share of the East Hampton rent. The decedent, who had previously paid for all Manhattan property expenses, now paid for most of them, with Brandon paying only a small portion of those expenses.
The decedent died on November 27, 2000. Following her death, the estate filed with the IRS a Form 706 that reported the contents of the decedent's estate as including 100% of the East Hampton property but only a 51% interest in the Manhattan property. The IRS issued a notice of deficiency stating that the decedent had retained possession or enjoyment of the transferred 49% interest and that, therefore, under Section 2036 the entire Manhattan property was part of the decedent's estate for federal tax purposes.
The estate filed a timely petition in the Tax Court challenging the IRS's determination of deficiency. The Tax Court found that the decedent continued to receive the rental payments from the tenant and enjoy the economic benefits of the Manhattan property. Because there was no written agreement between the decedent and Brandon stating that they would reconcile the income and expenses of the two properties and because the Tax Court did not find Brandon's testimony credible that there was an oral agreement, the Tax Court found that no such agreement existed. Rather, the Tax Court concluded that the decedent and Brandon had an implied agreement that the decedent would retain the economic benefits of the Manhattan property. For those reasons, the Tax Court held that the full value of the Manhattan property was includable in the decedent's estate under Section 2036 . The estate timely filed an appeal to the Second Circuit.
The court noted that in cases involving transfers of interests in residential property, two factors are significant in determining whether an implied agreement or understanding existed between the parties. Those factors are:
(1) Continued exclusive possession by the donor.
(2) The withholding of possession from the donee.
The court noted that the taxpayer has lost each case where the decedent transfers an interest in residential property but continues to live in it to the exclusion of the donee. The court stated that in this case, however, neither of the two factors was present. The decedent did not have exclusive possession of, nor did she exclude Brandon from, Brandon's 49% interest in the Manhattan property. Therefore, the court concluded that the decedent's residential use of part of the Manhattan property does not indicate an implied agreement that she would retain the economic benefits of the residential portion of Brandon's 49% interest.
With respect to the rental portion of the Manhattan property, the court stated that it was not clearly erroneous for the Tax Court to find an implied agreement that the decedent would enjoy for her life the economic benefit from all or a portion of the rental portion of the Manhattan property. The court noted that the Tax Court found that the decedent continued to receive the monthly rent payments from the tenant. In addition, the Tax Court did not find Brandon's testimony to be credible regarding the fact that he had an oral agreement with the decedent to reconcile the income and expenses of the Manhattan and East Hampton properties. The court held that these two findings were not clearly erroneous and must be upheld. The court stated that the Tax Court's finding of an implied agreement was supported by the fact that the estate had failed to provide a credible explanation as to why the entire rent payments were received and retained by the decedent.
The court did state that it was clearly erroneous for the Tax Court to find that the terms of the implied agreement were such that the decedent would enjoy the substantial economic benefit of 100% of the Manhattan property. The court noted that Brandon clearly enjoyed a portion of the residential portion of the Manhattan property. In addition, the court stated that as to the commercial portion of the Manhattan property, it was likely that the decedent retained the benefits of less than 100% of the Manhattan property. Therefore, the court remanded the case to the Tax Court to decide what portion of the 49% interest transferred to Brandon should be included in the decedent's estate.
In determining the apportionment of Brandon's 49% interest between the portion retained by the decedent and the portion not retained by the decedent, the court stated that the Tax Court should use the approach adopted by the IRS in
Rev. Rul. 79-109 .2
In that Ruling, the decedent conveyed to his adult children a vacation home, but he retained for his life the right to use it or, in the alternative, keep the rental payments, during the month of January of each year. The IRS concluded in that Ruling that the amount includable in the gross estate is that portion of the transferred property that would be necessary to yield the retained income. The court stated that the Tax Court must first determine how much of the economic benefit generated by the 49% interest is attributable to the residential portion of the interest that Brandon enjoyed and how much is attributable to the commercial portion that the decedent retained.
The court stated that the Tax Court should also consider the fact that the decedent and Brandon each paid a portion of the expenses related to the Manhattan property. The court noted that while the payment of expenses by the decedent supports the holding of the Tax Court that an implied agreement existed, the payments also decreased the economic benefit received by the decedent. Therefore, the court indicated that the Tax Court must determine who received what portion of the net income from the 49% interest rather than what portion of the gross income.
Finally, the court stated that the Tax Court should consider the distribution of the income and expenses from the East Hampton property, because consideration of the East Hampton property may be useful to an accurate determination of how the economic benefit of the Manhattan property was shared between Brandon and the decedent.
This case would appear to be a major victory for the taxpayer. The taxpayer may have prevailed earlier in this case, such as at the audit level, if a co-ownership agreement had been prepared specifying the rights and obligation of the parties with respect to the property, the income derived from the property, and the expenses incurred in maintaining the property. The extent to which the holding of this case can be applied to vacation homes in which the donee does not use the home on a regular, continuous, and significant basis is not clear. Applying the holding of this case to vacation homes is, therefore, not without risk.
. 106 AFTR 2d 2010-5710, 2010-2 USTC 60596 (CA-2, 2010).
Frank S. Baldino
is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org