Knetsch v. United
States (1960)
KNETSCH ET UX. v. UNITED STATES
No. 23
SUPREME COURT OF THE UNITED STATES
364 U.S. 361; 81 S. Ct. 132; 5 L.
Ed.
2d 128; 60-2 U.S. Tax Cas. (CCH)
P9785; 6 A.F.T.R.2d (P-H)
5851; 1961-1 C.B. 34
October 17-18, 1960, Argued
November 14, 1960, Decided
PRIOR HISTORY:
CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR
THE NINTH CIRCUIT.
DISPOSITION: 272 F.2d 200, affirmed.
SYLLABUS: In 1953, a 60-year-old taxpayer purchased
single-premium 30-year
maturity deferred annuity savings bonds with an
aggregate face value of
$4,000,000 from a life insurance company, paying only
a nominal sum in cash,
giving nonrecourse notes secured by the bonds for the
balance and paying a
substantial amount as "interest" in advance
on that "indebtedness." A few days
later, he borrowed from the company nearly all of the
excess of the
cash-surrender value which the bonds would have at the
end of the first contract
year over the amount of the existing
"indebtedness" and again paid in advance
the "interest" on such additional
"indebtedness." These borrowings and
"interest" payments were repeated in 1954
and 1955, and the bonds were
surrendered and the indebtedness was cancelled in
1956. Held: The amounts paid
as "interest" in 1953 and 1954 were not
deductible from the gross income of the
taxpayer and his wife in their joint income tax
returns for those years as
"interest paid . . . on indebtedness,"
within the meaning of @ 23 (b) of the
Internal Revenue Code of 1939 and @ 163 (a) of the
Internal Revenue
Code of 1954. Pp. 362-370.
(a) On the record in this case, it is patent that the
transaction between the
taxpayer and the insurance company was a sham which
created no "indebtedness"
within the meaning of those sections of the Codes. Pp.
362-366.
(b) Congress did not authorize deduction of such
payments by enacting @ 264
(a)(2) of the Internal Revenue Code of 1954, which
expressly denies a deduction
for amounts paid on indebtedness incurred to purchase
or carry a single-premium
annuity contract, but only as to contracts purchased
after March 1, 1954. Pp.
367-370.
COUNSEL: W. Lee McLane, Jr. argued the cause for
petitioners. With him on the
brief was Nola M. McLane.
Grant W. Wiprud argued the cause for the United
States. With him on the
brief were Solicitor General Rankin, Assistant
Attorney General Rice and Harry
Baum.
Richard H. Appert, Converse Murdoch and Douglas W.
McGregor filed briefs, as
amici curiae, urging reversal.
JUDGES: Warren, Black, Frankfurter, Douglas, Harlan,
Clark, Brennan, Whittaker,
Stewart
OPINIONBY: BRENNAN
OPINION: MR. JUSTICE BRENNAN delivered the opinion of
the Court.
This case presents the question of whether deductions
from gross
income claimed on petitioners' 1953 and 1954 joint
federal income tax returns,
of $ 143,465 in 1953 and of $ 147,105 in 1954, for
payments made by petitioner,
Karl F. Knetsch, to Sam Houston Life Insurance
Company, constituted "interest
paid . . . on indebtedness" within the meaning of
@ 23 (b) of the Internal
Revenue Code of 1939 and @ 163 (a) of the Internal
Revenue Code of 1954. n1 The
Commissioner of Internal Revenue disallowed the
deductions and determined a
deficiency for each year. The petitioners paid the
deficiencies and brought
this action for refund in the District Court for the
Southern District of
California. The District Court rendered judgment for
the United States, and the
Court of Appeals for the Ninth Circuit affirmed, 272
F.2d 200. Because of a
suggested conflict with the decision of the Court of
Appeals for the Fifth
Circuit in United States v. Bond, 258 F.2d 577, we
granted certiorari, 361 U.S.
958.
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n1 The relevant words of the two sections are the
same, namely that there
shall be allowed as a deduction "All interest
paid or accrued within the taxable
year on indebtedness . . . ."
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On December 11, 1953, the insurance company sold
Knetsch ten 30-year maturity
deferred annuity savings bonds, each in the face
amount of $ 400,000 and bearing
interest at 2 1/2% compounded annually. The purchase
price was $ 4,004,000.
Knetsch gave the Company his check for $ 4,000, and
signed $ 4,000,000 of
nonrecourse annuity loan notes for the balance. The
notes bore 3
1/2% interest and were secured by the annuity bonds.
The interest was payable
in advance, and Knetsch on the same day prepaid the
first year's interest, which
was $ 140,000. Under the Table of Cash and Loan Values
made part of the bonds,
their cash or loan value at December 11, 1954, the end
of the first contract
year, was to be $ 4,100,000. The contract terms,
however, permitted Knetsch to
borrow any excess of this value above his indebtedness
without waiting until
December 11, 1954. Knetsch took advantage of this
provision only five days
after the purchase. On December 16, 1953, he received
from the company $ 99,000
of the $ 100,000 excess over his $ 4,000,000
indebtedness, for which he gave his
notes bearing 3 1/2% interest. This interest was also
payable in advance and on
the same day he prepaid the first year's interest of $
3,465. In their joint return for 1953, the petitioners deducted the sum of
the two interest payments, that is $ 143,465, as "interest paid . . .
within the taxable year on indebtedness," under @ 23 (b) of the 1939
Code.
The second contract year began on December 11, 1954,
when interest in advance
of $ 143,465 was payable by Knetsch on his aggregate
indebtedness of $
4,099,000. Knetsch paid this amount on December 27,
1954. Three days later, on
December 30, he received from the company cash in the
amount of $ 104,000, the
difference less $ 1,000 between his then $ 4,099,000
indebtedness and the cash
or loan value of the bonds of $ 4,204,000 on December
11, 1955. He gave the
company appropriate notes and prepaid the interest
thereon of $ 3,640. In their
joint return for the taxable year 1954 the petitioners
deducted the sum of the
two interest payments, that is $ 147,105, as
"interest paid . . . within the
taxable year on indebtedness," under @ 163 (a) of
the 1954 Code.
The tax years 1955 and 1956 are not involved in this
proceeding, but a
recital of the events of those years is necessary to
complete the
story of the transaction. On December 11, 1955, the
start of the
third contract year, Knetsch became obligated to pay $
147,105 as prepaid
interest on an indebtedness which now totalled $
4,203,000. He paid this
interest on December 28, 1955. On the same date he
received $ 104,000 from the
company. This was $ 1,000 less than the difference
between his indebtedness and
the cash or loan value of the bonds of $ 4,308,000 at
December 11, 1956. Again
he gave the company notes upon which he prepaid
interest of $ 3,640.
Petitioners claimed a deduction on their 1955 joint
return for the aggregate of
the payments, or $ 150,745.
Knetsch did not go on with the transaction for the
fourth contract year
beginning December 11, 1956, but terminated it on
December 27, 1956. His
indebtedness at that time totalled $ 4,307,000. The
cash or loan value of the
bonds was the $ 4,308,000 value at December 11, 1956,
which had been the basis
of the "loan" of December 28, 1955. He
surrendered the bonds and his
indebtedness was canceled. He received the difference
of $ 1,000 in cash.
The contract called for a monthly annuity of $ 90,171
at maturity (when
Knetsch would be 90 years of age) or for such smaller
amount as would
be produced by the cash or loan value after deduction
of the then existing
indebtedness. It was stipulated that if Knetsch had
held the bonds to maturity
and continued annually to borrow the net cash value
less $ 1,000, the sum
available for the annuity at maturity would be $ 1,000
($ 8,388,000 cash or loan
value less $ 8,387,000 of indebtedness), enough to
provide an annuity of only $
43 per month.
The trial judge made findings that "there was no
commercial economic
substance to the . . . transaction," that the
parties did not intend that
Knetsch "become indebted to Sam Houston,"
that "no indebtedness of [Knetsch] was
created by any of the . . . transactions," and
that "no economic gain
could be achieved from the purchase of these bonds
without regard to the tax
consequences . . . ." His conclusion of law,
based on this Court's decision in
Deputy v. du Pont, 308 U.S. 488, was that "while
in form the payments to Sam
Houston were compensation for the use or forbearance
of money, they were not in
substance. As a payment of interest, the transaction
was a sham."
We first examine the transaction between Knetsch and
the insurance company to
determine whether it created an
"indebtedness" within the meaning of @
23 (b) of the 1939 Code and @ 163 (a) of the 1954
Code, or whether, as the trial
court found, it was a sham. We put aside a finding by
the District Court that
Knetsch's "only motive in purchasing these 10
bonds was to attempt to secure
an interest deduction." n2 As was said in Gregory
v. Helvering, 293
U.S. 465, 469: "The legal right of a taxpayer to
decrease the amount of what
otherwise would be his taxes, or altogether avoid
them, by means which the law
permits, cannot be doubted. . . . But the question for
determination is whether
what was done, apart from the tax motive, was the
thing which the statute
intended."
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n2 We likewise put aside Knetsch's argument that,
because he received
ordinary income when he surrendered the annuities in
1956, he has suffered a net
loss even if the contested deductions are allowed, and
that therefore his motive
in taking out the annuities could not have been tax
avoidance.
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When we examine "what was done" here, we see
that Knetsch paid the insurance
company $ 294,570 during the two taxable years
involved and received $ 203,000
back in the form of "loans." What did
Knetsch get for the out-of-pocket
difference of $ 91,570? In form he had an annuity
contract with a so-called
guaranteed cash value at maturity of $ 8,388,000,
which would produce monthly
annuity payments of $ 90,171, or substantial life
insurance proceeds in the
event of his death before maturity. This, as we have
seen, was a
fiction, because each year Knetsch's annual borrowings
kept the net cash value,
on which any annuity or insurance payments would
depend, at the relative
pittance of $ 1,000. n3 Plainly, therefore, Knetsch's
transaction with the
insurance company did "not appreciably affect his
beneficial interest except to
reduce his tax . . . ." Gilbert v. Commissioner,
248 F.2d 399, 411 (dissenting
opinion). For it is patent that there was nothing of
substance to be realized
by Knetsch from this transaction beyond a tax
deduction. What he was ostensibly
"lent" back was in reality only the rebate
of a substantial part of the
so-called "interest" payments. The $ 91,570
difference retained by
the company was its fee for providing the facade of
"loans" whereby the
petitioners sought to reduce their 1953 and 1954 taxes
in the total sum of
$233,297.68. There may well be single-premium annuity
arrangements with nontax
substance which create an "indebtedness" for
the purposes of @ 23 (b) of the
1939 Code and @ 163 (a) of the 1954 Code. But this one
is a sham. n4
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n3 Petitioners argue further that in 10 years the net
cash value of the bonds
would have exceeded the amounts Knetsch paid as
"interest." This contention,
however, is predicated on the wholly unlikely
assumption that Knetsch would have
paid off in cash the original $ 4,000,000
"loan."
n4 Every court which has considered this or similar
contracts has agreed with
our conclusion, except the Court of Appeals for the
Fifth Circuit in the Bond
case and one District Court bound by that decision,
Roderick v. United States,
59-2 U. S. T. C. para. 9650. See Diggs v.
Commissioner, 281 F.2d 326 (C. A. 2d
Cir.), pending on petition for certiorari (later
denied, post, p. 908); Emmons
and Weller v. Commissioner, 270 F.2d 294 (C. A. 3d
Cir.), pending on petitions
for certiorari (later denied, post, p. 908); Haggard
v. United States, 59-1 U.
S. T. C. para. 9299; Oliver L. Williams, 18 T. C. M.
205. See alsoRev. Rul.
54-94, 1954-1 Cum. Bull. 53, and the dissenting
opinion of Judge Wisdom in Bond.
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The petitioners contend, however, that the Congress in
enacting @
264 of the 1954 Code authorized the deductions. They
point out that @ 264
(a)(2) denies a deduction for amounts paid on
indebtedness incurred to purchase
or carry a single-premium annuity contract, but only
as to contracts purchased
after March 1, 1954. n5 The petitioners thus would
attribute to
Congress a purpose to allow the deduction of pre-1954
payments under
transactions of the kind carried on by Knetsch with
the insurance company
without regard to whether the transactions created a
true obligation to pay
interest. Unless that meaning plainly appears we will
not attribute it to
Congress. "To hold otherwise would be to exalt
artifice above reality and to
deprive the statutory provision in question of all
serious purpose." Gregory v.
Helvering, supra, p. 470. We, therefore, look to the
statute and materials
relevant to its construction for evidence that
Congress meant in @ 264 (a)(2) to
authorize the deduction of payments made under sham
transactions entered into
before 1954. We look in vain.
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n5 Section 264 (a)(2) provides:
"(a) GENERAL RULE. -- No deduction shall be
allowed for --
. . . .
"(2) Any amount paid or accrued on indebtedness
incurred or continued to
purchase or carry a single premium life insurance,
endowment, or annuity
contract.
"Paragraph (2) shall apply in respect of annuity
contracts only as to contracts
purchased after March 1, 1954." (Emphasis
supplied.)
The substance of the section without the italicized
language was added to the
1939 Code in 1942. 56 Stat. 827.
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Provisions denying deductions for amounts paid on
indebtedness incurred to
purchase or carry insurance contracts are not new in
the revenue acts. A
provision applicable to all annuities, but not to life
insurance or endowment
contracts, was in the statute from 1932 to 1934, 47
Stat. 179. It was added at
a time when Congress was developing a policy to deny a
deduction for
interest allocable to tax-exempt income; n6 the
proceeds of annuities were
excluded from gross income up to the amount of the
consideration paid in by the
annuitant. See H. R. Rep. No. 708, 72d Cong., 1st
Sess., p. 11. The provision
was repealed by the Revenue Act of 1934, 48 Stat. 688,
when the method by which
annuity payments were taken into gross income was
changed in such way that more
would be included. 48 Stat. 687. See S. Rep. No. 558,
73d Cong., 2d Sess., p.
24.
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n6 See @ 23 (b) of the Revenue Act of 1932, 47 Stat.
179, which provided:
"(b) INTEREST. -- All interest paid or accrued
within the taxable year on
indebtedness, except (1) on indebtedness incurred or
continued to purchase or
carry obligations or securities (other than
obligations of the United States
issued after September 24, 1917, and originally
subscribed for by the taxpayer)
the interest upon which is wholly exempt from the
taxes imposed by this title,
or (2) on indebtedness incurred or continued in
connection with the purchasing
or carrying of an annuity."
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Congress then in 1942 denied a deduction for amounts
paid on indebtedness
incurred to purchase single-premium life insurance and
endowment contracts.
This provision was enacted by an amendment to the 1939
Code, 56 Stat. 827, "to
close a loophole" in respect of interest
allocable to partially exempt income.
See Hearings before Senate Finance Committee on H. R.
7378, 77th Cong., 2d
Sess., p. 54; @ 22 (b)(1) of the 1939 Code (now @ 101
(a)(1) of the 1954 Code).
The 1954 provision extending the denial to amounts
paid on indebtedness
incurred to purchase or carry single-premium annuities
appears to us simply to
expand the application of the policy in respect of
interest allocable to
partially exempt income. The proofs are perhaps not as
strong as in the case of
life insurance and endowment contracts, but in the
absence of any contrary
expression of the Congress, their import is clear
enough. There is
first the fact that the provision was incorporated in
the section covering life
insurance and endowment contracts, which
unquestionably was adopted to further
that policy. There is second the fact that Congress'
attention was directed to
annuities in 1954; the same 1954 statute again changed
the basis for
taking part of the proceeds of annuities into gross
income. See @ 72 (b) of the
1954 Code. These are signs that Congress'
long-standing concern with the
problem of interest allocable to partially exempt
income, and not any concern
with sham transactions, explains the provision.
Moreover the provision itself negates any suggestion
that sham transactions
were the congressional concern, for the deduction
denied is of certain interest
payments on actual "indebtedness." And we
see nothing in the Senate
Finance and House Ways and Means Committee Reports on
@ 264, H. R. Rep. No.
1337, 83d Cong., 2d Sess., p. 31; S. Rep. No. 1622,
83d Cong., 2d Sess., p. 38,
to suggest that Congress in exempting pre-1954
annuities intended to protect
sham transactions. n7
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n7 The Reports are as follows:
"Under existing law, no interest deduction is
allowed in the case of
indebtedness incurred, or continued, to purchase a
single-premium life-insurance
or endowment contract. . . .
"Existing law does not extend the denial of the
interest deduction to
indebtedness incurred to purchase single-premium
annuity contracts. It has come
to your committee's attention that a few insurance
companies have promoted a
plan for selling annuity contracts based on the tax
advantage derived from
omission of annuities from the treatment accorded
single-premium life-insurance
or endowment contracts. The annuity is sold for a
nominal cash payment with a
loan to cover the balance of the single-premium cost
of the annuity. Interest
on the loan (which may be a nonrecourse loan) is then
taken as a deduction
annually by the purchaser with a resulting tax saving
that reduces the real
interest cost below the increment in value produced by
the annuity.
"Your committee's bill will deny an interest
deduction in such cases but only
as to annuities purchased after March 1, 1954."
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Some point is made in an amicus curiae brief of the
fact that
Knetsch in entering into these annuity agreements
relied on individual ruling
letters issued by the Commissioner to other taxpayers.
This argument has never
been advanced by petitioners in this case.
Accordingly, we have no reason to
pass upon it.
The judgment of the Court of Appeals is
Affirmed.
DISSENTBY: DOUGLAS
DISSENT: MR. JUSTICE DOUGLAS, with whom MR. JUSTICE
WHITTAKER and MR. JUSTICE
STEWART concur, dissenting.
I agree with the views expressed by Judge Moore in
Diggs v. Commissioner, 281
F.2d 326, 330-332, and by Judge Brown, writing for
himself and Judge Hutcheson,
in United States v. Bond, 258 F.2d 577.
It is true that in this transaction the taxpayer was
bound to lose if the
annuity contract is taken by itself. At least the
taxpayer showed by his
conduct that he never intended to come out ahead on
that investment apart from
this income tax deduction. Yet the same may be true
where a taxpayer borrows
money at 5% or 6% interest to purchase securities that
pay only nominal
interest; or where, with money in the bank earning 3%,
he borrows from the
selfsame bank at a higher rate. His aim there, as
here, may only be
to get a tax deduction for interest paid. Yet as long
as the transaction itself
is not hocus-pocus, the interest charges incident to
completing it would seem to
be deductible under the Internal Revenue Code as
respects annuity contracts made
prior to March 1, 1954, the date Congress selected for
terminating this class of
deductions. 26 U. S. C. @ 264. The insurance company
existed; it operated under
Texas law; it was authorized to issue these policies
and to make these annuity
loans. While the taxpayer was obligated to pay
interest at the rate of 3 1/2%
per annum, the annuity bonds increased in cash value
at the rate of
only 2 1/2% per annum. The insurance company's profit
was in that 1-point
spread.
Tax avoidance is a dominating motive behind scores of
transactions. It is
plainly present here. Will the Service that calls this
transaction a "sham"
today not press for collection of taxes * arising out
of the
surrender of the annuity contract? I think it should,
for I do not believe any
part of the transaction was a "sham." To
disallow the "interest" deduction
because the annuity device was devoid of commercial
substance is to
draw a line which will affect a host of situations not
now before us and which,
with all deference, I do not think we can maintain
when other cases reach here.
The remedy is legislative. Evils or abuses can be
particularized by Congress.
We deal only with "interest" as commonly
understood and as used across the board
in myriad transactions. Since these transactions were
real and legitimate in
the insurance world and were consummated within the
limits allowed by insurance
policies, I would recognize them tax-wise.
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* Petitioners terminated this transaction in 1956 by
allowing the bonds to be
cancelled and receiving a check for $ 1,000. The
termination was reflected in
their tax return for 1956. It might also be noted that
the insurance company
reported as gross income the interest payments which
it received from
petitioners in 1953 and 1954.
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