RESPONDENT: United States
LOCATION: Knetsch Residence
DOCKET NO.: 23
DECIDED BY: Warren Court (1958-1962)
LOWER COURT: United States Court of Appeals for the Ninth Circuit
CITATION: 364 US 361 (1960)
ARGUED: Oct 17, 1960 / Oct 18, 1960
DECIDED: Nov 14, 1960
Facts of the case
Knetsch purchased annuity savings bonds from Sam Houston Life Insurance Company. In return, the company gave Knetsch loans and an annuity contract that would produce monthly annuity payments upon maturity. However, Knetsch kept borrowing from the insurance company in amounts that kept the net cash value of the annuity so low that it could produce no financial benefit other than tax deductions. Knetsch claimed payments to the insurance company as interest paid on indebtedness. The Commissioner of Internal Revenue disallowed the deductions and determined a deficiency amount for each of the two years in question. After paying the deficiency, Knetsch brought suit to obtain a refund in the United States District Court for the Southern District of California. The court ruled in favor of United States, holding that the transaction was a sham because it did not create "indebtedness" and, therefore, there was "no commercial economic substance" beyond the tax deductions. The U.S. Appeals Court for the Ninth Circuit affirmed.
Did the transaction between Knetsch and the insurance company create an indebtedness within the meaning of the Internal Revenue Code?
Media for Knetsch v. United StatesAudio Transcription for Oral Argument - October 17, 1960 in Knetsch v. United States
Audio Transcription for Oral Argument - October 18, 1960 in Knetsch v. United States
Number 23, Karl F. Knetsch et al., Petitioners versus United States.
W. Lee McLane, Jr.:
Mr. Chief Justice, may it please the Court.
Since the petitioners only have about 10 or 11 minutes left of their time, I would prefer if I may, to save that time for rebuttal.
In closing the opening statement, the petitioners do ask the Court to note Appendix D of the reply brief wherein the dissenting opinion of Judge Moore in Diggs versus Commissioner is found.
That short opinion states the petitioners' view in succinct and cogent fashion.
Along with the majority opinion in United States versus Bond, Judge Moore sets forth, we think, the proper view in this matter.
Grant W. Wiprud:
If the Court please, the issue here is whether the taxpayer in computing his net taxable income for the years 1953 and 1954, was or was not entitled to deduct certain amounts which he claims were interest payments on a large loan from Sam Houston, a Texas insurance company.
The long-standing statutory provision which authorizes interest deductions in Section 23 (b) of the 1939 Internal Revenue Code which was reenacted without change so far as here pertinent as Section 163 (a) of the 1954 Code.
Both these -- in both Codes the provision says that a taxpayer is entitled to deduct all payments of interest on indebtedness.
Now this Court has been at panes in several landmark decisions to say precisely what constitutes interest on indebtedness within the meaning of this authorizing provision.
The two principal decisions in this area by this Court were the Old Colony Railroad Company case and Deputy versus du Pont, both cited and quoted in our brief.
Suffice it here to say that in both of those decisions this Court took the view that not every enforceable obligation was a proper predicate for interest deductions under the authorizing provision.
That to be deductible, payments purporting to be interest had to be payments for the use of borrowed money.
And this Court observed that that approach to the meaning of the term interest and meaning of the term indebtedness was in concord with the usual ordinary everyday usage of the terms interest and indebtedness in the marketplace.
In this case, the District Court found and the Court of Appeals agreed that the taxpayer never really borrowed $4 million from Sam Houston, the insurance company.
Indeed, the lower courts were in agreement that this entire transaction while in form, it was a purchase of annuity contracts with a very large loan from the very insurance company issuing the contracts was devoid of commercial substance and that it was contrived solely in order to enable the taxpayer, so he hoped to purchase tax deductions.
And that this was the only possible benefit which could accrue to the taxpayer.
Now the taxpayer in assailing this result, well the courts therefore concluded necessarily having reached that view of the facts, that this was not interest on indebtedness within the meaning of Section 23 (b) as this Court has repeatedly defined that provision.
Now, in assailing this result on a -- in this litigation, the taxpayer doesn't deal directly with Section 23 (b) or with this Court's definition of what must constitute an interest to be deductible under that provision.
Rather, he places his reliance upon a provision of the 1954 Code which was not even in existence when he entered into the disputed transaction, a provision which does not authorize deductions but prohibits deductions.
He doesn't say, you contend that the terms of this provision which is a prohibitory rather than an authorizing provision serves to get him to home plate to give him these interest deductions, but he says that if you read the committee report which underlies this amendment to the 1954 Code, that then the only possible conclusion is that Congress in effect as I understand the taxpayer's argument retroactively legislated to modify Section 23 (b) to allow the kind of interest deduction that this taxpayer is claiming here.
We submit that this approach is unsound and we believe that in order to demonstrate this, we think we have demonstrated it on the brief, and in order to show exactly what the impact of this 1954 amendment was, I think that the -- the -- it is necessary first to see exactly what was done in form and what in substance underlay the form of the transaction.
Now in form --
Is your characterization of the petitioners' argument really entirely fair?
It seems to me he does rely on 23 (b), he says this is a -- an interest -- this is interest covered by 23 (b) and to confirm the acquisition, he says the Congress realized that it was too and therefore changed the law in 1954.
Grant W. Wiprud:
Well, Your Honor, he doesn't deal directly with this Court's definition of interest under 23 (b).
He says at page 18 of his opening brief, indeed, that if you read 23 (b) together with 264 (a) (2) that indeed perhaps the Government's position might be correct that it's only -- only if you go to the committee report.
Only if you go to the committee report that you could take the view that 23 (b) extended so far as to allow what we believe and what the courts have held to be a purely sham and contrived transaction which took place here.