• Court of Appeals Reverses Part of IRS Victory in Gift with Retained Interest Case
  • December 3, 2010
  • Law Firm: Loeb Loeb LLP - Los Angeles Office
  • Gifts that you make during your lifetime may be subject to a gift tax, but they are not included as a part of your estate for estate tax purposes if you really part with the property that is the subject of the gift. The Internal Revenue Code has a few provisions that draw gifts back into a decedent’s estate if he gave them away with “strings” attached. One such provision is Section 2036 which includes in a decedent’s estate assets transferred during the decedent’s lifetime without consideration when the decedent retained the right to possess or enjoy the property or the right to receive income from the property. This was the issue in the case of Estate of Margot Stewart v. Commissioner. Mrs. Stewart owned a five-story building in New York City. She and her adult son lived on two of the floors and the other three floors were rented to a commercial tenant. Mrs. Stewart made a gift to her son of an undivided 49% interest as a tenant-in-common in the building. Following the gift, she still received all of the rent from the tenant and paid most of the expenses associated with the building.

    After Mrs. Stewart died, the Tax Court held in 2006 that the entire 49% interest of the son was includible in Mrs. Stewart’s estate under Section 2036 because she continued to receive the entire income that was produced by the property. Now, four years later, the United States Court of Appeals for the Second Circuit has partially reversed the Tax Court’s decision. The Court of Appeals said that the Tax Court erred in including the entire 49% of the building given to the son. The court said that the building really had two parts: the part occupied by Mrs. Stewart and her son as their residence and the part rented to the tenant. The court said that as to the part rented, it should be included in Mrs. Stewart’s estate because she retained the rent that the tenant paid. Even if she technically had no legal right to receive all of the rent, the fact that she received it and her son permitted her to receive it indicates she retained the possession and enjoyment over the portion of the property that was rented.

    However, as to the two floors used as a residence, Mrs. Stewart did not retain any possession or enjoyment over the 49% she had given to her son. He lived there along with her and had full possession and enjoyment of his 49% interest in the residential portion of the building.

    Even as to the rented portion, the Court of Appeals did not accept the Tax Court’s finding that because the decedent received all of the rent, the entire value of the rented portion of the property should be included in her estate. The correct inquiry is how much of the net income she retained, not how much of the gross income she retained. The court pointed out that while the decedent paid most of the expenses of the property, the son also paid some of them and this must be taken into account in determining the apportionment of the son’s interest in the property. The court also said that the Tax Court should take into consideration another property the decedent and her son owned together and whether the income and expenses from that property might be shared in a way such that between the two properties each party received the share of net income that corresponded with their ownership percentage.

    The Court of Appeals remanded the case to the Tax Court to determine the portion of the value of the building that should be included in her estate for estate tax purposes.