Case Summaries Estate of Margot Stewart v. Commissioner, 106 AFTR 2d 2010-XXXX , vacating and remanding, T.C. Memo. 2006-225

Steve R. Akers

Aug 01, 2010

Five months after being diagnosed with pancreatic cancer, decedent transferred a 49% interest in a Manhattan brownstone to her son, who lived with her on two floors of the five-story residence. Decedent and son continued living on those two floors (she lived another six months) and the top three floors were leased to a commercial tenant. All income and expenses with respect to the rental portion were paid to and borne by decedent for the rest of her lifetime, although the son argued that there was an agreement to reconcile the income and expenses of the brownstone and another property that was co-owned by decedent and son. The Tax Court judge (Judge Foley) concluded that there was no such agreement, finding the son’s testimony lacking credibility. The Tax Court found that there was an implied agreement of retained enjoyment, and included the transferred 49% interest in the gross estate under § 2036. (The major impact of that decision was to avoid applying any fractionalization discounts [stipulated by the parties to be 42.5%], because 100% of the property was included in decedent’s estate.)

The Second Circuit vacated and remanded the lower court opinion, holding that even under a clear error standard, the trial court erred in finding that an implied agreement of retained enjoyment extended to all of the 49% interest transferred to the son. The court stated that although the taxpayer has the burden to prove the absence of an implied agreement of retained enjoyment, “co-occupancy of... residential premises by the related donor and donee is highly probative of the absence of an implied agreement and has repeatedly been held to satisfy the taxpayer’s burden.” The son “manifestly enjoyed, and Decedent did not, the benefits of the residential portion of the 49%,” and even as to the rental portion, “it seems likely that Decedent retained the benefits of less than the total 49%.” The case was remanded so the trial court can determine the extent to which there was an implied agreement of retained enjoyment in the 49% transferred interest.

A dissenting opinion found no clear error for upsetting the trial court’s finding of an implied agreement as to the entire transferred interest. The dissent pointed to the fact that decedent’s relationship to the property changed “in not one significant respect” after the transfer. The dissent argues that the majority opinion misread cases and that mere co-occupancy should not be treated as “highly probative” of the absence of an implied agreement, observing that the majority opinion in effect shifts to the IRS the burden of proving the existence of an implied agreement, and that the majority’s reasoning “makes it near impossible for the Commissioner to meet his new burden.” The dissent believes the opinion “opens a new loophole that will vitiate to a considerable degree” § 2036 and invites “easy dodges by future tax avoiders.”

From a numbers standpoint, this is a major victory for the taxpayer. The primary impact of finding that not all of the transferred interest is included in the estate under § 2036 is that substantial fractionalization discounts are allowed. The property appreciated relatively little over the six months after the transfer; therefore, very little will be added to the estate with respect to the portion of the 49% transferred interest that is included in the gross estate. It is conceivable that the parties will come to an agreement at this point rather than fight over an almost meaningless issue (from a dollars and cents standpoint) for another two years.

The opinion raises the practical planning scenario of making transfers of fractional interests in real estate to donees in order to take advantage of significant fractionalization discounts. If co-occupancy (or other co-uses, consistent with the rights of the co-tenants) of the property avoids § 2036, the transfer will result in a significant decrease in the value that is included in the gross estate.

Basic Facts

Since 1989, decedent and her adult son (Brandon) have co-owned an East Hampton home (the “East Hampton property”) as joint tenants with right of survivorship, which they rented out in the summers. The tenants would deal with and pay one or the other of them, and they would evenly split the income (net of expenses) every several months.
Decedent and her son for years lived in the first two floors of a five-story brownstone in Manhattan (the “Manhattan property”). In 1999, Decedent rented the top three floors for $9,000 per month (yes, it was in Manhattan) to a commercial tenant.
In October 1999, decedent met with an “estate planning specialist” to review the commercial lease. The planner suggested that decedent give part of the property to her son. As corroborated in the planner’s contemporaneous diary, decedent said she wanted “to give son one-half of a building and rent.”
Decedent was diagnosed with pancreatic cancer in December 1999, and she began chemotherapy in January 2000.
On May 9, 2000, decedent and her son signed a deed conveying 49% of the Manhattan property to the son. They were tenants-in-common. (The deed was not recorded until April 4, 2001 after decedent died. In the Tax Court, the IRS argued that the gift was not complete because the deed had not been filed. The Tax Court disagreed, and the IRS did not appeal the Tax Court finding that there was a completed gift of the 49% interest on the date the deed was signed.)
From the time of the deed until decedent’s death about six months later (Nov. 27, 2000), decedent and the son continued to live in the bottom two floors. The rent payments for the top three floors were erratic and there were abnormally high repair expenses. The rent payments were made to decedent and she paid most of the expenses ($21,791 vs. $1,963 paid by the son).
Discussed in the Second Circuit opinion but not even mentioned in the Tax Court opinion is that during this same seven-month period, the son received all of the rent payments on the East Hampton property, and unlike in prior years, he did not split the income with decedent.
Decedent died on November 27, 2000.
Decedent’s executor filed a gift tax return reporting the gift of the 49% interest in the Manhattan property. Decedent’s estate tax return reported all of the East Hampton property (100% was included in her estate under §2040 even though it was owned equally by decedent and son as joint tenants with right of survivorship; apparently she provided all the consideration for acquiring the property), but only the 51% interest in the Manhattan property that she kept after making the gift of 49% to the son. The IRS maintained that decedent retained possession or enjoyment of the transferred 49% interest in the Manhattan property and that therefore all of the Manhattan property was includable in her estate.
Stipulations by Estate and IRS:
1. If all of the Manhattan property is not included in the estate, there is a 42.5% discount for lack of control and marketability. (Footnote 9 of the circuit court opinion expresses no opinion as to the correctness of this stipulated amount or whether the IRS is still bound by this stipulation on the remanded case.)
2. The appreciation in the entire Manhattan property from the date of the gift to the date of death was $125,000
Tax Court (October 24, 2006 by Judge Foley):
1. Completed Gift. The transfer of the 49% interest was a completed gift on the date of the deed.
2. Section 2036. There was an implied agreement of retained possession or enjoyment of the transferred 49% interest in the property. In reaching this conclusion, the court pointed to (i) the decedent’s receipt of all the rental income, and (ii) the son’s lack of credibility as to a purported agreement to split the net income of the East Hampton and Manhattan properties and reconcile the receipts and payments at the end of the year.
3. Property Tax and Debt Deductions. The court disallowed a deduction for property taxes on the Manhattan property (because they were not owed by decedent at the time of her death) and a debt deduction for the amount decedent owed the son for his one-half of the net income from both properties under a year-end reconciliation. (The court found that there was no such reconciliation agreement.
Only the § 2036 issue was appealed to the Second Circuit. The oral argument was delayed for two years until November 20, 2008, and there was another almost two year delay in issuing the opinion.

Holdings

There was a 2-1 split in the three-judge panel, with a very strong dissent.

The factual findings are reviewed under a clear error standard. There was no clear error in the Tax Court’s determination that there was an implied agreement of retained enjoyment, but “it was clearly erroneous for the Tax Court to find that the terms of the agreement were such that Decedent would enjoy the substantial economic benefit of 100% of Brandon’s 49% interest in the Manhattan property.”
The circuit court gave guidance to the Tax Court regarding how to determine what part of the 49% interest should be included in the estate under § 2036. As to the residential portion (the bottom two floors), the son received all of the economic benefit of his 49% by his co-occupancy. As to the commercial portion (the top three floors), “it seems likely that Decedent retained the benefits of less than the total 49%.”
The Tax Court’s opinion was vacated and the case was remanded to the Tax Court for determination of the amount of the Manhattan property includable under §2036.

Analysis

Review Standard and Burden of Proof. The general characterization of a transaction for tax purposes is a question of law subject to de novo review. The meaning of retaining “possession or enjoyment of, or the right to the income from, the property” under §2036 is determined de novo by the circuit court. However, the “particular facts from which the characterization is to be made” are fact questions subject to a clear error review standard. Thus, whether there was an implied agreement of retained enjoyment and the terms of such agreement are fact questions subject to the clear error standard.

In determining whether there is an implied agreement of retained enjoyment under § 2036, “the burden is on the decedent’s estate to disprove the existence of any adverse implied agreement or understanding and ‘that burden is particularly onerous when intra-family arrangements are involved.’”

(Some of the discussion in the dissent is based on the clear error review standard and the “onerous” burden on the estate to disprove the existence of an implied agreement.)
Statute. The Tax Court concluded that decedent “retained... the possession or, or the right to the income from, the property.” I.R.C. § 2036(a)(1).

Section 2036 provides, in pertinent part:
1. General Rule. — The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer ...under which he has retained for his life... —
  1. the possession or enjoyment of, or the right to the income from, the property…
General Determination of § 2036 Retained Interest Requirement.
1. “Possession or Enjoyment” is Applicable, Not “Right to Income.” The “right” to income means a legally enforceable power (citing Byrum) and decedent did not have a legally enforceable power to receive the income from the son’s portion of the property. The issue is whether she retained “actual ‘possession or enjoyment’” of the property.
2. “Property.” The statute’s reference to “property” means what is transferred, and here refers to the transferred 49% interest in the Manhattan property, and not the entire Manhattan property. “Therefore, our inquiry is limited to whether Decedent ‘retained . . . the possession or enjoyment of’ the transferred 49% interest in the Manhattan property.”
3. Substance Over Form; Substantial Present Economic Benefit. Look to substance, not to form, in applying the “possession or enjoyment” language. The Supreme Court in Byrum, stated that the terms “use” and “enjoy” connote “substantial present economic benefit.”
4. Real Property. This determination “may be difficult” for property that is “wholly inhabited by a decedent and/or family members.” However, for income producing property, “it is quite easy... All we have to do is follow the money. Whoever is, in substance, receiving the net income... [is] possessing and enjoying the property.”
5. Extent of Retained Interest. The regulations address situations in which the decedent does not retain possession or enjoyment of all of the transferred property:
  If the decedent retained or reserved an interest or right with respect to all of the property transferred by him, the amount to be included in his gross estate under section 2036 is the value of the entire property, less only the value of any outstanding income interest which is not subject to the decedent’s interest or right and which is actually being enjoyed by another person at the time of the decedent’s death. If the decedent retained or reserved an interest or right with respect to a part only of the property transferred by him, the amount to be included in his gross estate under section 2035 is only a corresponding proportion of the amount described in the preceding sentence. Treas. Reg. §20.2036-1(c)(1)(i).
  
  Revenue Ruling 79-109 also addresses a retained interest in only a portion of transferred property: “When 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, the amount includible in the gross estate is that portion of the transferred property that would be necessary to yield the retained income.” Rev. Rul. 79-109, 1979-1 C.B. 297.
6. Implied Agreement. Possession or enjoyment of property may be retained by an implied agreement (and, as described above, the burden is on the estate to disprove the existence of such an implied agreement). The terms of the agreement also matter — as to whether the retained interest is in only a portion of the transferred property.
Implied Agreement for Residential Property. Two factors are particularly significant in determining whether there is an implied agreement for retained possession or enjoyment of residential property: (1) continued exclusive possession by the donor; and (2) withholding of possession from the donee.

If both factors are present, the taxpayer has lost every case (citing Estate of Maxwell; Estate of Reichardt; Estate of Kerdolff; Estate of Linderme; and Estate of Rapelje (donor’s occupancy is “almost exclusive”).)

If neither factor applies (i.e., if there is joint occupancy by the donor and the transferee) the taxpayer has won every case “despite the great burden faced by the taxpayer in all these cases” (citing Union Planters Nat’l Bank v. U.S.; Estate of Binkley v. U.S.; Diehl v. U.S.; Stephenson v. U.S.; Estate of Roemer; Estate of Gutchess; Estate of Weir; and Estate of Burr). Most of these cases involved interspousal transfers where one spouse transferred the residence to the other spouse and continued to live in the residence with the transferee-spouse; the courts held that such occupancy with one’s spouse is a merely a “natural use” and does not indicate an implied agreement of retained enjoyment. However, Diehl and Estate of Roemer involved familial transfers other than to a spouse where there was co-occupancy. Estate of Roemer explicitly rejected a “spouses only” reading of these cases.

Co-occupancy with a related transferee will not necessarily, by that fact alone, mean there is no implied agreement of retained enjoyment. However, if the IRS “points to nothing besides the mere co-occupancy between the donor and the donee, a conclusion based on an implied agreement concerning [residential property] cannot stand.”

Conclusion as to residential portion of the Manhattan property: “Decedent’s residential use of part of the Manhattan property does 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.”
Implied Agreement For Commercial Portion of Property. Decedent received all of the rental income from the Manhattan property after the gift. However, the circuit court noted in its statement of facts that the son received all of the income from the East Hampton property during the same period, and “in contrast to their previous practice, Brandon never wrote a check to Decedent for her share of the East Hampton rent.” The estate argued that
Decedent had not retained the enjoyment or income of the entire Manhattan property but rather, as a 51% owner, had forgone much of the net income from the top three floors by using a setoff to pay Brandon [the son], and had shared the value of the bottom two by living with Brandon. According to the Estate, instead of splitting up the rental income and expenses each month in proportion to their interests in the two properties — a process which would have required Decedent and Brandon to write separate checks for every expense and receive separate checks from both tenants — Decedent and Brandon were keeping track of each person’s net income from both properties and intended to reconcile any differences at the end of the year.

The Tax Court rejected the estate’s argument, looking primarily to the fact that decedent in fact received all of the income from the Manhattan property after the transfer. As to the purported reconciliation agreement, the Tax Court noted that there was no written agreement, it did not find the son’s testimony credible (there was no further explanation as to why the son was not credible), and the accountant testified that “he did not recall being informed about an agreement to reconcile the income and expenses.” [Observation: The Tax Court did not mention the testimony of the estate planning specialist, who initially discussed the gift of a portion of the Manhattan property to the son, that decedent wanted to give the son “one-half of building and rent.” That would seem to support and lend credibility to son’s testimony that the intent was to reconcile the income receipts.]

The circuit court concluded that the Tax Court finding as to the commercial portion of the property that decedent received the rent payment and that the son’s testimony was not credible are not clearly erroneous and must be upheld, but the finding of an implied agreement of retained enjoyment is subject to apportionment, as discussed immediately below.
Apportionment. The Tax Court’s finding of an implied agreement was not clearly erroneous, but it was clearly erroneous for the Tax Court to find that the terms of the agreement were such that Decedent would enjoy the substantial economic benefit of 100% of Brandon’s 49% interest in the Manhattan property. This is so because Brandon manifestly enjoyed, and Decedent did not, the benefits of the residential portion of the 49%. And, as we discuss below, even as to the commercial portion, it seems likely that Decedent retained the benefits of less than the total 49%.

In determining that the implied agreement extended to all of the transferred property, the Tax Court had two findings — decedent’s receipt of all the income from the property and the credibility determination as to the son’s testimony. The circuit court held that does not “provide a complete picture” and “because the Tax Court did not consider ‘all facts and circumstances surrounding the transfer and subsequent use of the property’ [citing Estate of Rapelje], it is appropriate to vacate and remand so that the Tax Court may do so.” [Observation: The court gives some guidance as to how to approach this apportionment, but as discussed below, there may be considerable confusion surrounding this process.]
1. Revenue Ruling 79-109. Under Rev. Rul. 79-109, 1979-1 C.B. 297, the portion of transferred property includable in the estate under § 2036 “is that portion of the transferred property that would be necessary to yield the retained income.”
2. Bifurcate Residential Portion. First, determine how much of the “substantial economic benefit” generated by the entire property is attributable to the residential portion. The court noted that “Brandon received 100% of the economic benefit from the residential portion of that 49% by inhabiting it.” [A clear implication of this statement is that the decedent did not retain any of the economic benefit attributable to the 49% interest in the residential portion of the property. A seemingly simple approach would be to use a “per floor” basis to prorate the “substantial economic benefit” in this situation where two of five floors were inhabited by decedent and the son. A simple possible conclusion from the court’s statement above would be that decedent did not retain any interest in at least 2/5ths of the 49% transferred interest. However, footnote 15 belies that simple analysis by noting that in allocating the net income (discussed below), the court should consider not only the income from the rental portion but also “Brandon’s imputed income from living in the residential portion of the property — that is, the fair market rental value one would have paid to be Decedent’s housemate from May 9, 2000 to November 27, 2000.”]
3. Apportion Based on Net Income. Decedent paid most of the Manhattan’s property expenses ($21,791 vs. $1,963 paid by the son). “This finding is a double-edged sword.” On the one hand it supports the finding of an implied agreement that decedent would retain all of the income from the Manhattan property, including the 49% transferred interest. (However, in footnote 13, the majority points out that a decedent’s payment of substantially all gross expenses after a transfer has, in many cases, not resulted in a finding of an implied agreement (citing Estate of Roemer and Stephenson).) On the other hand, “each dollar of Manhattan property expenses paid by Decedent also decreases the economic benefit she received.” The focus should be on “who received what portion of the net income from the 49% interest, rather than the gross income,” and the clear implication is that decedent’s paying most of the expenses decreased her economic benefit, which might result in the conclusion that decedent did not retain all of the rental portion of the 49% transferred interest. [Observation: Does that make sense? Decedent clearly received 100% of the gross rental income. She received more than 100% of the net rental income, because she did not bear all of the expenses.]
  
  One reading of the court’s decision is that all income in the period attributable to the 49% interest from the date of the gift to the date of death must be determined, including the residential portion by including the imputed income of the value of being decedent’s housemate during that period. Next, all expenses should be determined. The amount that each party received or paid of the gross income and expenses should be determined and the each party’s proportionate receipt of the net should be determined.
4. Consideration of Disproportionate Receipt of Income From Other Property. The Tax Court held that there was no agreement to reconcile the income from both the East Hampton and Manhattan properties. The circuit court noted that the Tax Court was under no obligation to accept the son’s testimony of a reconciliation agreement, “but it may be worth considering on remand where the net income from the East Hampton property went.” The IRS argued that the reference to “property” in § 2036 does not allow consideration of decedent’s relationship to other property. However, the court simply notes that “[i]n some cases , consideration of other property may be useful to an accurate determination of who enjoyed the substantial economic benefit of a property.” It leaves to the Tax Court to determine “whether the actual distribution of income from the East Hampton property is among the ‘facts and circumstances surrounding the transfer and subsequent use of the property,’ all of which ‘must be considered.’”
Dissent.
1. Strong Dissent. In a six page one-paragraph opinion (yes, ONE paragraph), the dissent advances a strong dissenting view, decrying the potential for “easy dodges by future tax avoiders.” The strong positions taken by both the majority and dissenting opinions evidence the confusion in this area, and the inherent uncertainty of making transfers and retaining any continuing use or interest in the transferred asset, even for transfers of fractional interests in assets.
2. Burden of Proof. The dissent emphasized that the factual determinations are being reviewed under a clear error standard and that estate has the burden to disprove the existence of an implied agreement retained enjoyment. It views the undisputed facts as supporting the existence of an implied agreement.
3. Focus on Whether Donor’s Relationship Changes; Summary of Dissent.
  The majority does not — and cannot — explain how the Tax Court clearly erred as a factual matter in concluding that Margot Stewart retained all these benefits [receiving all the income from the rent and the substantial economic benefits of residence] given that her relationship to the property changed in not one significant respect from the period preceding transfer to the period after. Instead, the majority, misreading a body of case law that primarily involves transfers of 100% of a family member’s interest in a property to another family member, concludes that post-transfer co-occupancy is near-conclusive evidence that the transferor can no longer enjoy the substantial economic benefits of residence to the extent of the transferred interest. Indeed, the majority finds such co-occupancy dispositive even here, where the transfer concerned only a fraction of the transferor’s interest, created a tenancy in common that guaranteed the transferor continued access to the entirety of her property, and involved a transferor and transferee who the majority agrees were found correctly by a court of law to have reached an agreement undercutting the economic substance of the very transfer under consideration. This turns the proper — and longstanding — construction of section 2036 on its head. It also opens up a loophole that will vitiate to a considerable degree the efficacy of this section… I respectfully dissent. (Emphasis in original).
4. Misreading of Cases; Co-Occupancy Should Not Be Sufficient Evidence to Prove The Absence of An Implied Agreement of Retained Enjoyment. The various cases cited by the majority hold that the mere fact that the donor continued to live in a residence that he conveyed to a family member is insufficient, by itself, to confirm the existence of an implied agreement favoring the donor. However, the majority uses those cases to treat “co-occupancy post-transfer as sufficient to prove the absence of an implied agreement, at least with respect to the residential portion of the property at issue.”(Emphasis in original).
5. Focus on What Donor Retains and Whether Her Relationship Changes, Not What Transferee Received.
  1. Dissent Viewpoint. Section 2036 by its language looks to whether the decedent retained possession or enjoyment of transferred property. “[W]e look to whether the facts and circumstances surrounding a transfer evince an agreement that the transferor’s lifetime possession or enjoyment of the affected property will not be diminished, and if they do, we include the value of the transferred interest in the gross estate.” In this case, “the estate made no showing whatsoever that Margot Stewart’s use of the residential portion of the townhouse changed appreciably between the many years when Brandon lived with Margot as her houseguest and the final months of her life, when Brandon possessed a formal interest in the property.”
    
    This approach is consistent with the statute’s original target, the creation by the decedent of a life estate with a remainder given to relatives. Section 2036 includes the full value of the property because the decedent’s lifetime enjoyment of the property is undiminished — “not because, after the transfer, he somehow enjoys the remainder interest given to his relatives.” The treatment of a transfer of a fractional interest in property is consistent with this understanding. Transferring a co-tenancy interest to the son left decedent, as a co-tenant, with the right to possess and enjoy the whole of the Manhattan townhouse, subject only the son’s right to do the same. Neither the son’s formal interest as a tenant in common “nor his (purported) substantial enjoyment of that interest can, as the majority would have it, be dispositive as to Margot Stewart’s possession or enjoyment of the residential portion.”
  2. Majority Response.
    1. No “Misreading of Cases;” Less Likelihood of Implied Agreement if Co-Occupy After Transferring Only Fractional Interest. The majority responded to this argument in footnote 13 by saying that the dissent treats the “retention of a partial interest as a tenant in common as similar to retention of a life estate, and attempts to distinguish on that ground the numerous cases involving complete transfers of residential property followed by co-occupancy.” However, the majority points out that it would be bizarre to say that a decedent who retains a tenancy in common has a higher burden in disproving an implied agreement than a decedent who gives away the entire property and yet still continues to live on the transferred property without any legal right to be there.
    2. Change in Activities By Decedent Test — Numerous Other Cases Do Not Apply That Test. In addition, the majority (also in footnote 13) responded to the proposed focus on whether the decedent changed any activities after the transfer. Many other cases have found that § 2036 does not apply even though the donor’s activities did not change after the transfer (citing Estate of Gutchess, where the decedent and spouse lived together in the house 17 years before the transfer and 11 years after). [Observation: Of course, most of those prior cases involved interspousal transfers, where the spouses lived together before and after the transfer.
6. Wineman v. Commissioner. One of the few prior cases that have addressed the transfer of a fractional interest in real property is Wineman v. Commissioner, T.C. Memo. 2000-193 (2000). In that case, a mother transferred a 24% interest in the family homestead to her children. The court held that the 24% interest was not included in her estate under § 2036 even though she continued to live with her children at the homestead. The dissent points out that the Wineman court “emphatically did not rely on the mere fact of a tenancy in common, coupled with co-occupancy among family members.” Instead the Wineman court looked at all the facts and circumstances, including that the property consisted of a number of different residences, buildings and structures and that the decedent used only her home, a garden and a small orchard next to her home. Also someone other than the decedent in that case paid the property taxes. The court also relied “heavily” on the credible testimony of transferees that there was no understanding between the decedent and the children.
7. Other Reasons and Facts Supporting Implied Agreement. The dissent pointed to various other factors that support the Tax Court’s finding of an implied agreement of retained enjoyment. These include the following.
  1. The decedent received 100% of the rental income.
  2. The court could draw inferences about how the parties viewed their relationship to the residential portion by how they acted with respect to the rental income.
  3. There is no support in the case law for separating the residential and rental portions of the property; doing so makes receipt of 100% of the rental income irrelevant to whether there was a retained interest in the residential portion.
  4. The majority in effect shifts the burden of proving the existence of an agreement to the IRS without allowing it to consider natural inferences that flow from all facts and circumstances, such as receiving all income.
  5. By treating co-occupancy by the transferee as “highly probative of the absence of an implied agreement,” the majority places a “near impossible” burden on the IRS to prove the existence of an implied agreement. (“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 cohabitating child, the parent reserved for himself its possession and enjoyment...”)
  6. The son’s payment of only 8% of the property’s expenses after he was the 49% owner supports the Tax Court’s conclusion that the transfer was not one of substance.
8. Summary and Strong Words About Potential For Abuse.
  1. Donee Merely “Remained... Houseguest.” “Viewed in its entirety, the history of Margot and Brandon Stewart’s relationships to the Manhattan property, and especially the lack of significant, objective changes in that relationship, strongly supports the Tax Court’s conclusion that Brandon Stewart remained, in essence, Margot Stewart’s houseguest.”
  2. In Effect, Post-Transfer Occupancy by Donee Is Sufficient to Negate Implied Agreement “The majority purports to stop short of holding that, as a matter of law, post-transfer co-occupancy by the transferor and transferee will always preclude a finding of an implied agreement in favor or the transferor. But given the facts present in this case, it is hard to imagine any evidence — short of an admission at trial by the estate — that would be sufficient to demonstrate the existence of an implied agreement regarding a co-occupied residence.”
  3. Planning: Demonstrate Genuine Post-Transfer Tenancy in Common. “Evidence demonstrating the existence of a genuine post-transfer tenancy in common certainly could weigh against the conclusion that the transferor and transferee had an implied agreement that the transferor would continue to possess or enjoy the whole of a property.”
  4. Invites “Sham Transactions” and “Easy Dodges By Future Tax Avoiders.” “Cohabitating family members are all but invited to engage in sham transactions that have no impact upon the transferor’s possession and enjoyment of a property, and whose only purpose is tax avoidance... The majority’s reasoning, by focusing solely on Brandon Stewart’s residence at the townhouse as a tenant in common as dispositive, not only departs from prior case law and contravenes the text of section 2036, but also thoroughly undermines the statute, inviting inequitable disparities among those subject to the estate and gift taxes due to easy dodges by future tax avoiders

Observations

Primary Significance: Transfers of Fractional Interests in Real Estate, Particularly to Co-Occupants. The opinion addresses the uncertainties of how §2036 is applied to transfers of fractional interests in real estate, particularly when the transfer is made to a co-occupant (e.g., the child who has “moved back home” in this terrible economy). Can a fractional interest be transferred to the child, with the parent continuing to use the house as always, without triggering § 2036? If so, the transferred interest and the retained interest may both be valued taking into account significant fractional interest discounts (often 15-25%, stipulated to be 42.5% in this case).
Well Reasoned Analytical Opinions of the Varying Viewpoints. The opinion is very analytical in reviewing the § 2036 uncertainties. The case citations contain an excellent collection of the prior cases that have addressed the § 2036 issues with real estate transfers. The strong differences of opinion in the majority and dissenting opinion reflect the inherent uncertainty regarding the application of § 2036 to transfers with some type of retained interest by the donor, even for transfers of fractional interests.
Major Victory for Taxpayer. From a numbers standpoint, this is a major victory for the taxpayer. As described in Item 4 immediately below, the computation process results in two effects of the court’s decision regarding § 2036: a portion of the appreciation attributable to the transferred 49% interest in included in the estate and fractional interest discounts are allowed. Because all of the property is not includable in the estate, presumably the 42.5% undivided interest discount will apply to whatever portion of the Manhattan property is included in the estate (i.e., of decedent’s 51% and of the portion of the 49% that is includable in the estate, although footnote 9 raises the question of whether the IRS is still bound by that stipulation on the remanded case.) The effect is that the appreciation in the portion of the 49% interest that is includable will be added as a result of the §2036 inclusion. The amount of dollars involved may be rather small. The Second Circuit observed that the added tax, “though not trivial, would probably not be an unduly large amount of money.” The parties stipulated that the appreciation in the entire Manhattan property over the six months from the date of the gift to the date of death was $125,000. For example, if the Tax Court on remand determines that decedent retained a “substantial present economic benefit” in one-half of the 49% interest transferred to the son, the net § 2036 inclusion would be: $125,000 x ½ x 49% = $30,625

At an approximate 50% estate tax rate (remember that decedent died in 2000 before the highest rate was reduced), the additional estate tax would be about $15,000 –and that is before the estate deducts its attorneys fees in the tax litigation.

It is conceivable (indeed, likely) that the parties will come to an agreement at this point rather than fight over an almost meaningless issue (from a dollars and cents standpoint) for another two years. The estate would likely be entitled to a substantial refund, because there will be very little added tax and the estate will be able to deduct all of its attorney fees in the litigation, including any fees that would be incurred in the subsequent Tax Court remand. The IRS would most likely LOSE MONEY by continuing to litigate this case on remand.
Arithmetic of Partial Inclusion Under § 2036. The portion of the gift that is not included in the gross estate under § 2036 is an “adjusted taxable gift” — the value of that portion is added to the value of the taxable estate in computing the “tentative tax.” I.R.C. § 2001(b)(1)B). The tentative tax on the augmented amount is reduced by the amount of gift tax calculated under rates in effect at the date of death on all taxable gifts made during the decedent’s life, as if all of those gifts had been made at the date of death. I.R.C. § 2001(b)(2). If the entire gift is added back as an adjusted taxable gift, the effect is generally just to cause the taxable estate to be taxed in the highest marginal rate brackets, taking into consideration the prior lifetime transfers.

If a portion of the gift is brought back into the gross estate (such as under § 2036), the arithmetic is different. The portion brought back into the estate (at its date of death value, not just the date of gift value) is not also added as an adjusted taxable estate, or else there would be double inclusion of the date of gift amount. I.R.C. § 2001(b)(last paragraph). However, the gift tax at the date of death rates) is still subtracted on all taxable gifts — including the entire gift involved in the § 2036 issue.

The only computational difference between the two situations of no § 2036 inclusion vs. partial or full § 2036 inclusion is that the portion includable under § 2036 is included at the date of death value rather than the date of gift value. The net difference between the two situations is that the appreciation in the portion includable under § 2036 is also added to the taxable estate. If there is little appreciation, that may be a nominal difference.

Another important valuation impact is that if only a fractional interest is included in the estate (including both the retained interest and the portion of the transferred interest included under § 2036), fractional interest discounts will apply to both the retained interest and the § 2036 interest.
Practical Planning Considerations Regarding Transfers of Fractional Interests
1. Overview. Estate inclusion under Section 2036 has been argued in many cases involving continued use of a transferred residence by the donor. The cases have generally tended to require more than just continued possession of a residence in order to find that an agreement existed at the time of the transfer. See Stephens, Maxfield, Lind & Calfree, Federal Estate And Gift Taxation, ¶4.08[4][c] (2001). In fact, the IRS concedes that continued co-occupancy for interspousal transfers will not of itself support an inference or understanding as to retained possession or enjoyment by the donor. Rev. Rul. 78-409, 1978-2 C.B. 234; Ltr. Rul. 200240020. However, the IRS is not as lenient where the residence is given to family members other than the spouse. E.g., Estate of Trotter v. Comm’r, T.C. Memo. 2001-250 (residence transferred to trust for children, decedent continued to pay all occupancy expenses and lived in residence without paying rent).
  
  If only fractional interests are transferred, rather than the entire interest (as discussed in the preceding paragraph), it is more natural that the transferor would continue to use the property in some manner. The Stewart case deals with this fractional transfer situation.
2. Generally: Follow Formalities; Avoid Sloppiness in Recognizing Co-Owners. The § 2036 area has inherent factual and legal uncertainties. Do not compound the difficulty of the argument by sloppiness in following formalities. For example, in Stewart, the deed was not recorded until after decedent’s death, income was received entirely by decedent and she paid all expenses. The trial court judge understandably had reservations about the bona fides of the transaction. The dissent pointed specifically to the decedent’s receipt of all rental income and payment of most of the expenses as evidencing an implied agreement of retained enjoyment. Disbrow (discussed in Item 6 below) is another case where § 2036 was applied partly because of the parties’ failure to respect formalities (frequent late payments, etc.)
3. Income Producing Property. This is the easiest situation to gather evidence demonstrating the absence of an implied agreement for the donor to continue receiving income from the transferred fractional interest. Simply plan the transaction so that donor, in fact, does not receive income attributable to the transferred fractional interest. In light of the inherent uncertainty surrounding § 2036, it is MOST inadvisable for the donor to continue receiving all of the income and paying all of the expenses, as was done in the Stewart case.
  
  Do not rely on using other transactions as an offset against decedent’s retention of a disproportionate part of the income. The IRS made the argument that the effect of transactions involving other property could not be considered at all as a legal matter under § 2036. The court suggested that all of the facts and circumstances should be considered, but relying on using offsets from other transactions is not wise.
  
  How is the income mechanically apportioned and paid among the co-owners? It would be burdensome (and in most cases totally unworkable) to have every receipt and every expense paid to and from separate accounts of the co-owners. Having a clear co-ownership agreement, reflecting the express agreement of the parties to share the income and expenses, should suffice (as long as the parties actually periodically split the income and expenses in accordance with that agreement). The receipts and disbursements could be paid from an account in the name of one of the co-owners, with an agreement to make net payments among the co-owners on a periodic basis. A nominee agreement could be filed with the income tax return of the account owner to document why all of the account income is not taxed to the account owner.
4. Occupancy Property. The much more difficult issue is how to plan for occupancy property. Whether there is an implied agreement for the donor to retain the right to use and enjoy the transferred fractional interest is a factual matter, to be determined from all the “fact and circumstances surrounding the transfer and subsequent use of the property.” Therefore, there are no absolutes. What can be done to help build the best case for the absence of an implied agreement?
  
  Both the majority and dissent agree that merely having co-occupancy among the various co-owners is not necessarily enough to establish the lack of an implied agreement. However, the majority opinion (as pointed out by the dissent with some disgust) suggests that co-occupancy by the various co-owners is “highly probative of the absence of an implied agreement and has repeatedly been held to satisfy the taxpayer’s burden.” The majority points out that where the donor does not have exclusive possession and does not exclude the transferees from occupying the property (i.e., where there is co-occupancy after the transfer), the cases have all found that no implied agreement of retained enjoyment existed, and that the donor’s continued occupancy “is a natural use which does not diminish [the] transferee’s enjoyment and possession and which grows out of a congenial and happy family relationship.” The majority held that where the Tax Court made no specific findings regarding retained enjoyment and the IRS “points to nothing besides the mere co-occupancy between the donor and the donee, a conclusion based on an implied agreement concerning the residential portion cannot stand.” The dissent strongly objects, noting that the majority’s reasoning “in effect shifts the burden of proving the existence of an implied agreement” and “makes it near impossible for the Commissioner to meet his new burden with the astounding claim... that such residence is ‘highly probative of the absence of an implied agreement.’”
  
  The Wineman case (T.C. Memo. 2000-193) is discussed at some length by the dissent. That is the case that has been cited over the last ten years for the proposition that § 2036 does not apply to the transfer of a fractional interest as long as the donor merely retains proportionate use of the property consistent with the retained ownership. The dissent attempts to distinguish Wineman by pointing out that there were various structures on the homestead property in which she gave her children a 24% interest, and that she only used a limited number of those structures (including much of the larger house). The dissent points out that the court said (like the majority in Stewart) that limited personal use or using less than all of the property does not prove the absence of an implied agreement. Instead, like the majority in Stewart, the court said to look at all the circumstances surrounding the transfer and subsequent use of the property. The court looked at two factors, in particular, in finding the absence of an implied agreement. First, the court “heavily” relied on the decedent’s son’s testimony that there was no understanding between the decedent and her children. That will be key — whether the estate can convince the trial judge to believe the remaining co-tenants that they did not have an understanding allowing the donor to have full use of the transferred interest if he or she wanted it. (The Stewart estate beneficiary was not able to convince Judge Foley at the Tax Court that he was credible. The issue, then, is what can be done in the planning stage to build evidence that will support the credibility of that testimony.) In addition, the Wineman court looked at the natural expectation of continued co-occupancy in these situations in strong language (that the dissent neglected to mention):
  Unlike the authority that has been cited in respondent’s brief, this case involves a transfer of less than a fee simple interest in property. The majority owner’s continued use and possession of real property, following transfer of a minority interest is not unusual [citing Gutchess]... In this case, 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. It is not surprising that the children did not seek to partition the property, since they also used the property regularly and they had only a minority interest in the property.
  
  Consider these planning possibilities:
  1. The clients must realize there are no guarantees. This is an inherently uncertain area of the law (except for interspousal transfers), and ultimately, the judge will decide whether to believe the estate beneficiaries that there was no understanding allowing the decedent to do anything he or she wished to do with the property, including interests transferred to them.
  2. Continue (or begin) co-occupancy so that the decedent is not the sole occupant. The majority points that there are two important factors, exclusive possession and withholding of possession from the donee. Satisfy both of those facts by having co-occupancy. (It should be possible, on the right facts, to avoid § 2036 even if the donor is the sole occupant, because he or she has the right as a co-tenant to occupy the property, as long as he or she does not deny occupancy rights to the other co-tenants. However, that would be a tougher argument to win; the estate would have to convince the court that the donor, at least by implied agreement, did not have an understanding that he or she could keep the other co-tenants from using the property.)
    
    A case illustrating the difficulty of retaining exclusive occupancy of a residence is Estate of Tehan, T.C. Memo 2005-128. In that case, the IRS included the value of the decedent’s condominium ($275,000) in his gross estate under §2036 even though he had transferred the condo to his children in a series of three fractional gifts during three years prior to his death. The decedent had an agreement that as long as he owned any interest in the home, he would pay all of the expenses in return for the exclusive rights to use and occupy the property. However, that arrangement was continued for the two months after the decedent had transferred his entire interest up to his death. The IRS argued that the following facts proved the existence of a retained interest: The decedent retained possession of the condo, paid all expenses (even as the children’s percentage ownership increased to 35%, then 72%, then to 100%), did not pay any rent, and at trial it was established that the children would not have evicted him even if he had not paid expenses.
  3. The question arises as to how much “co-occupancy” is needed. If both the decedent and co-tenant are living at the residence, that should be sufficient. However, except for the situation where children are living with their parents, it is likely that there will be less than full residential use of the property. For example, for a vacation home (and many fractional interest transfers of property are made in secondary homes rather than the taxpayer’s primary residence), consider keeping track of use of the home by the various co-tenants. If the decedent used the secondary home frequently, and children only visited several times a year, there may be more of an implication that the decedent could use the home in any way desired. In that circumstance, consider having formal agreements laying out very clearly the children’s right to use the secondary home whenever desired, perhaps with just the requirement of giving notice to the other co-owners of when they were going to use the property.
  4. Use a “co-ownership agreement” to spell out expressly each co-tenant’s right to use the property (and pay the expenses of maintaining the property), and that no-co-tenant could be excluded from use of the property by any other co-tenant. (For an example of a “Tenancy in Common Agreement” for vacation property, see Wendy S. Goffe, Keeping Vacation Property in the Family, 41st U. Miami Heckerling Inst. on Est. Pl. ¶1811 (2007).) Give the co-ownership agreement to the accountant and other planners so they can assist in seeing that the operation of the property is consistent with the agreement. (In the Tax Court opinion, Judge Foley made note of the fact that there was no written agreement and that the accountant did not know of a “reconciliation agreement” between decedent and her son regarding income and expenses from the property. Having a formal written agreement would seemingly have helped significantly in supporting the son’s credibility.) The agreement could specify that there is no understanding among the co-tenants to the contrary. Such an agreement could help document that the transferees do not merely have the right to be a “houseguest” in decedent’s house. Even the dissent in Stewart observed that “evidence demonstrating the existence of a genuine post-transfer tenancy in common” could rebut an implied agreement “that the transferor would continue to possess or enjoy the whole of a property.”
  5. It would be best (but not absolutely required) if the donor’s use of the property changed in some fashion after the transfer. The dissent suggests a test (not accepted by the majority) looking to whether the donor’s relationship to the property changed in any way after the transfer, noting that decedent’s “relationship to the property changed in not one significant respect from the period preceding transfer to the period after.” The dissent noted “especially the lack of significant, objective changes in that relationship.” The dissent cited Estate of Thompson, 382 F.3d at 376 (upholding inclusion of interest in gross estate where the “practical effect of . . . changes [imposed by the transfer] during decedent’s life was minimal”). One significant change may be that the co-tenants begin sharing the maintenance expenses, including property taxes and insurance, proportionately rather than having all of those expenses paid by the older generation co-owners.
  6. Realize that avoiding § 2036 may be more difficult if the transfer is being made, with continued occupancy, by a terminally ill individual (as was likely the case in Stewart, where the decedent had been diagnosed with one of the deadliest cancers six months before the transfer, and died later that same year.) The transaction will have more of a testamentary feel and it may seem more likely to the judge that the transfer is just being made for tax avoidance purposes and that the decedent will continue to be able to do anything with the property that he or she wants during the terminal illness period.
5. Combined Rental and Occupancy Property (as in Stewart). If the property involves both rental and occupancy aspects, follow the planning suggestions in both of the preceding sections, including a clear agreement to share the income and expenses proportionately. Just as the rental property case is easier than the occupancy property case, a situation involving both rental and occupancy may be easier to establish the absence of an implied agreement of retained use than with just occupancy property alone. The dissent takes the position that paying rent entirely to the decedent helps established an implied agreement of retained enjoyment even as to the occupancy portion of the property. Conversely, paying the rental income proportionately could help establish the understanding of the parties to recognize and respect each co-owner’s rights as a co-tenant, including occupancy rights.
Planning Considerations Regarding Transfers of All Interests But Continuing to Occupy Property In Return for Paying Rent (Not at Issue in Stewart). If the donor retains use of the transferred property under a lease agreement that provides for fair rent, it is not clear whether § 2036 applies. See generally Dodge, Transfers with Retained Interests and Powers, 50-5th T.M. at 162-163 (2002); Stephens, Maxfield, Lind & Calfree, Federal Estate And Gift Taxation, ¶4.08[6][c] (2001). Applying the statute is problematic, because the statute only applies to transfers for less than full and adequate consideration, and the donor would be paying full consideration for the right to use the property. It is ironic that paying rental payments would even further deplete the donor’s estate. However, the trend of the cases is not to apply § 2036 where adequate rental is paid for the use of the property. E.g., Estate of Barlow v. Comm’r, 55 T.C. 666 (1971) (no inclusion under §2036 even though decedent stopped paying rent after two years because of medical problems); Estate of Giselman v. Comm’r, T.C. Memo 1988-391. The IRS has ruled privately in several different rulings that the donor of a qualified personal residence trust may retain the right in the initial transfer to lease the property for fair rental value at the end of the QPRT term without causing estate inclusion following the end of the QPRT term under Section 2036. E.g., Ltr. Ruls. 200825004, 200822011, 199931028. In the QPRT rulings, there is no §2036 inclusion as long as “there is no express or implied understanding that Grantor may retain use or possession of Residence whether or not rent is paid.” However, the IRS has not always conceded that renting property for a fair rental value always avoids application of Section 2036. See Tech. Adv. Memo. 9146002 (Barlow distinguished). Most of the cases that have ruled in favor of the IRS have involved situations where the rental that was paid was not adequate. E.g., Estate of Du Pont v. Comm’r, 63 T.C. 746 (1975).

Several cases have distinguished the Barlow approach. The Second Circuit Court of Appeals held that a sale of property with a retained use of the property accompanied with a lease triggered inclusion under §2036. Estate of Maxwell v. Commissioner, 3 F.3d 591 (2nd Cir. 1993). The court held that the sale-leaseback was not a bona fide sale where the decedent continued to live in the house and the purported annual rent payments were very close to the amount of the annual interest payments the son owed to the decedent. The court observed that the rent payments effectively just cancelled the son’s mortgage payments. The son never occupied the house or tried to sell it during the decedent’s lifetime. The son never made any principal payments on the mortgage (the decedent forgave $20,000 per year, and forgave the remaining indebtedness at her death under her will. The alleged sale was not supported by adequate consideration even though the mortgage note was fully secured; the note was a “façade” and not a “bona fide instrument of indebtedness” because of the implied agreement that the son would not be asked to make payments. The Second Circuit affirmed the Tax Court’s conclusion that
notwithstanding its form, the substance of the transaction calls for the conclusion that decedent made a transfer to her son and daughter-in-law with the understanding, at least implied, that she would continue to reside in her home until her death, that the transfer was not a bona fide sale for an adequate and full consideration in money or money’s worth, and that the lease represented nothing more than an attempt to add color to the characterization of the transaction as a bona fide sale.

The Second Circuit in Maxwell specifically distinguished Barlow:

Barlow in clearly distinguishable on its facts: In that case, there was evidence that the rent paid was fair and customary and equally importantly, the rent paid was not offset by the decedent’s receipt of interest from the family lessor.

Nor is there any merit to petitioner’s contention that the ‘decedent’s status as a tenant’ exempts her from section 2036(a) ‘as a matter of law.’ Barlow itself recognized that where a transferor ‘by agreement’ ‘reserves the right of occupancy as an incident to the transfer,’ section 2036(a) applies. Barlow, 55 T.C. at 670. The court there simply reached a different conclusion on its facts:

[The] substance-versus-form argument, while theoretically plausible, depends upon the facts, and we do not think the record as a whole contains the facts required to give it life. Id. at 670 (emphasis added).

The Tax Court rejected the Barlow approach in a case where the decedent did not pay fair rental value. In Disbrow v. Comm’r, T.C. Memo 2006-34, the decedent transferred her residence to a partnership comprised of herself and family members for no consideration. (She subsequently gave her 28% interest in the partnership to the other partners.) There was an agreement that decedent would continue to live in the residence, and there was a formal lease agreement. However, the court determined that the decedent did not pay fair rental value to the partnership for the residence.

While the presence of a lease may sometimes lead to a finding of a lack of retention for purposes of section 2036(a)(1), see, e.g., Estate of Barlow v. Commissioner, 55 T.C. 666 (1971) (possession and enjoyment of real property pursuant to a lease was not a retention of the possession or enjoyment of the property for purposes of section 2036(a) where the tenant paid FRV), such is not true where, as here, the tenant pays less than FRV as to the lease of the property. Decedent's rights under the lease agreements to the exclusive possession and enjoyment of the residence triggers the application of section 2036(a)(1) to the residence in that decedent did not pay FRV for that possession and enjoyment.

The court also concluded that the annual lease agreements were a subterfuge to disguise the testamentary nature of the transfer for various reasons. (1) The partnership was not a business but was a testamentary device whose goal was to remove the residence from the decedent’s estate. (2) The decedent’s relationship to the residence was not treated by either the decedent or the partnership as that of a tenant to leased property (payments were frequently late, the partnership never sent late notices or accelerated payments, rent was set at an amount under fair rental value that was considered necessary to maintain the residence). (3) The residence transfer occurred when decedent was almost 72 years old and in poor health, and after decedent’s death the partnership never sought to rent the residence but sold the residence to a family member for less than full market value. (4) The donees wanted decedent to continue to reside in the residence as long as she wanted. (5) Decedent transferred the residence to the partnership on advice of counsel to minimize estate taxes. The court rejected the estate’s contention that the rent was fair rental value because she shared the residence with others. The court reasoned that there was no credible evidence that anyone other than the decedent could use the residence without her consent.
Writing Style Observation. Totally as an aside, observe how difficult it is to read the six pages of the dissent contained in a single paragraph. Wading through a single incredibly long paragraph makes it difficult to follow the organization of the dissent, which ultimately impacts the persuasiveness of the opinion.

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This summary reflects the views of Bessemer Trust and is for your general information. The discussion of any estate planning alternatives and other observations herein are not intended as legal or tax advice and do not take into account the particular estate planning objectives, financial situation or needs of individual clients. This summary is based upon information obtained from various sources that Bessemer believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current opinions only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in law, regulation, interest rates, and inflation.

Steve Akers

Stephen R. Akers

Senior Fiduciary Counsel

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