Knetsch v. United States

PETITIONER:Knetsch
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.

Question

Did the transaction between Knetsch and the insurance company create an indebtedness within the meaning of the Internal Revenue Code?

Earl Warren:

Number 23, Karl F. Knetsch et al., Petitioners versus United States.

Mr. McLane.

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.

Earl Warren:

Mr. Wiprud.

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 —

Potter Stewart:

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.

Grant W. Wiprud:

Now in form, this transaction involves the purchase of very large face amounts of annuity contracts with a very large loan from the insurance company issuing the contract.

The face amount of these contracts aggregated $8,388,000.

This was supposed to be the guaranteed cash value of these contracts at maturity.Maturity was 30 years after date of purchase.

The taxpayer was 60 when he purchased them so, in theory at any rate, if he lived to be 90 and held these contracts, enforced until he was 90, he would then have contracts with a guaranteed cash value of $8 million and with annuity payments from age 90 of $90,000 per month.

In purchasing these annuity contracts, there was an exchange between the taxpayer and the insurance company of obligations.

In fact, the instruments which represent this exchange were integrated instruments which expressly refer to each other.

The insurance company issued the annuity bonds that which I have described, and the annuity bonds themselves recited that they were issued at consideration of cash payments by the taxpayer aggregating $4,000 and the execution by the taxpayer of loan notes against these annuity bonds out of the cash value of the annuity bonds of $4 million.

In short, in form he was paying one tenth of 1% of the purchase price in cash and executing notes against the loan value of the very contracts he was purchasing for the remainder 99 plus percent of the purchase price.

The loans that’s — loan of $4 million was a collateral loan.

He assigned the bonds to the insurance company which issued them forthwith on the same date that he purchased them.

The obligation to repay the loan of $4 million was to write them at the same time that the obligation of the insurance company to pay the annuity amounts was to write them under the annuity contracts, unless he — his indebtedness under the loan wherever to exceed the cash or loan value of the policies and the loans were nonrecourse loans.

Therefore, you would have a situation where at the outset and on the same day, annuity contracts in very large face amounts are issued in exchange for loan notes, of course, no money changes hands reciprocal and offsetting obligations are set up both to ripen 30 years from date.

Thirty years from date, the insurance company guarantees a cash value and 30 years from date, the taxpayer guarantees to pay $4 million.

John M. Harlan II:

Can I ask you a question.

Grant W. Wiprud:

Yes, Your Honor.

John M. Harlan II:

Before the Code of 1954, was this specific type of transaction an infrequent one or was it — or there are lots of these contracts?

Grant W. Wiprud:

There is quite a few of these, Your Honor.

There were so far as we know, the two — two insurance companies which specialize in this kind of thing were the Sam Houston Company 99% of whose resource are allocated to this kind of contract and who advertised this kind of thing as a tax sheltered investment in the Wall Street Journal and other trade journals.

And the Standard Insurance Company of Indiana which promoted variations of this scheme in the same way.

There are a lot of variations, some of them bring in window dressing in the form of a temporary bank loan which is — it exists for 24 hours.

You’d take the money from the bank, 24 hours later, the insurance company pays the taxpayer the amount of the loan, pays the bank and they end up with within that effect very like that here.

This is the simplest form of the transaction which this Court has before it, where you simply have reciprocal obligations which are reflected and integrated documents, the bonds on the one hand and the annuity loans on the other.

John M. Harlan II:

If you’re right — if you are right on your position here, I would suppose the injection of a bank into this situation.

Grant W. Wiprud:

We argue that it was of no consequence in the — in the cases involving that which Weller and Emmons which are pending here on petitions for cert did involve temporary bank loans and the Third Circuit agreed with us that taking an integrated view of the transaction and those temporary bank loans were of no consequence.

John M. Harlan II:

The Diggs case in the Second Circuit involved a bank.

Grant W. Wiprud:

Yes, I believe he ran to a bank too.

Yes, Your Honor.

Now, after the taxpayers in the Sam Houston Company had set this transaction up in this fashion with no appreciable change of position or of economic obligations on either side, say for a $4,000 cash outlay by the taxpayer and reciprocal offsetting obligations under the fines and the loan notes.

The taxpayer proceeded within a few days and within a space of a few days to make two — two payments which were labeled as prepayments of interest on the loan.

The first one in fact was made on the same day that he purchased the contracts for $140,000.

Grant W. Wiprud:

The insurance company turned around and then augmented his indebtedness to the company by $99,000 which was the cash or loan value of these policies at the end of the first contract year less a thousand dollars which he left in the city.

And at the same time then the taxpayer turned around again and paid prepaid a year’s interest on this augmentation of $99,000.

So that as of the end of 1943, he had purportedly paid out a $147,000, a down payment of $4,000 at the outset on the policies, the purchase price of the policies and $143,000 in interest.

However, since the insurance company had concurrently loaned back to him $99,000 as an augmentation of his indebtedness on the policies, he was actually out-of-pocket at considerably smaller sum than a $147,000.

John M. Harlan II:

Would you regard this case differently from the Government’s point of view if he hadn’t had his loan-back?

Grant W. Wiprud:

No, he would not, Your Honor, but we think that it is cumulative when we think it’s a very strong showing generally that this trans — transaction was completely devoid of commercial substance.

We would say in any event, that given the way in which they set it up where this reciprocal and offsetting obligations under the bonds on the one hand and the loan notes on the other that he didn’t actually borrow $4 million in the sense of the marketplace which this Court has adopted in its — in its decisions in construing 23 (b).

John M. Harlan II:

You’re going to deal with this argument that even under this — the way this was dealt with that he stood to gain no tax advantage?

Grant W. Wiprud:

Yes, Your Honor.

I — I’m just concluding the form now and I’ll turn then to the substance of it.

In the following year of 1954, the same pattern was followed.

In form, his prepaid interest, aggregating $143,000 to the insurance company.

The insurance company concurrently loaned back to him another second augmentation of his loan of $104,000 which meant that he had then taken down the total cash or loan value of the policy up to the end of the second year less a thousand dollars which he left in.

The net result of this pattern would be as the tax clerk found if he continued it, that at age 90, if he continued this process of prepaying interest and borrowing back the full cash or loan value each year has augmented less a thousand dollars.

At age 90, he would have received an annuity of $43 a month for life.

And for this, he was investing amounts of close to $50,000 a year net to himself even after taking into account these loan-backs to him from the insurance company.

Now in 1956, he washed it out.

He surrendered his policies, the insurance company cancelled his indebtedness as augmented and he received a thousand dollars in cash which was the thousand which he was leaving in each year in augmenting his cash and augmenting his indebtedness against the insurance policies.

Now in the first place, turning to the substance of this transaction, we submit, that there was no real indebtedness created here.

The taxpayer didn’t actually borrow $4 million from the tax — from Sam Houston.

Now by saying this, we don’t mean to say that money has to change hands in order for indebtedness to be created which would serve as a predicate for interest deductions under 23 (b).

But certainly, there must be an advance of dollars or there must be an advance of some tangible economic benefits which the taxpayer receives forthwith which would be the equivalent of dollars.

Now in this case, we think it can be — the difference between this case and a case where economic benefits which are the equivalent of dollars are advanced.

I think I can illustrate best for this Court by two examples.

Take the case where a property owner sells his home and takes back a purchase money mortgage.

Now to the extent of the purchase money mortgage, obviously, no money changes hands.

On the other hand, the purchaser of the home has actually received in advance an immediate possession of tangible economic benefits which are the equivalent of dollars.

He has the possession and the use of the home.

And the other example I would advance is the case where a taxpayer buys stock on margin.

This example is much highlighted in Judge Moore’s dissent in the Diggs opinion in the Second Circuit to which the counsel for taxpayer has referred.

Grant W. Wiprud:

In such a case, the taxpayer receives the ownership of stock and regardless of his indebtedness to the broker.

He stands to profit by the independent fluctuations of value of that stock.

The value may go up and he may sell it for a very handsome profit which he is entitled to retain.

By contrast, in the case at bar, the insurance — this annuity contracts had no independent values, independent of this circular loan transaction.

The interest which the taxpayer was obligated to pay on his indebtedness to the company was 3.5% per annum.

The cash value of the annuity contracts increased only 2.5% per annum.

So that the taxpayer was obligated to pay the insurance company 1% more per year of $4 million or the loan has augmented which began as $4 million, then the insurance or the annuity contracts augmented in value each year.

Now these — since these annuity contracts did not have any insurance features, he could not stand to profit in any way from — from this transaction saved by tax benefits.

John M. Harlan II:

All of these have been taken out by a very young man.

Grant W. Wiprud:

Yes.

John M. Harlan II:

He would have stood — he would have stood to get his annuity contract or his annuity payments at the end of 30 years or he wouldn’t have profited.

Grant W. Wiprud:

No, Your Honor.

Because if we’ve done what this man did here, he would have gotten $43 a month for life — life by spending out-of-pocket about $50,000 a year which is obviously ridiculous.

You see, what this man is doing every year is he is borrowing back against this policy, the augmentation of cash or loan value — and so his indebtedness mounts astronomically every year and he has to pay 3.5% on that indebtedness whereas the cash to loan value is increasing only 2.5% each year, he can’t win.

And there — are no insurance features here.

The debt benefit for example, payable to beneficiaries of — if this taxpayer should die before the maturity date was net cash value which would be the — a thousand dollars, the way this fellow is working.

Because he was borrowing the full cash or loan values each year except for a thousand dollars.

And so also, all of the other payments which are contemplated apart from the annuity payments to him if he lives to age 90 and got these payments, were all in terms — are all couched in terms of net cash value which is — he keeps (Voice Overlap) a thousand dollars.

John M. Harlan II:

That’s in consequence — that’s in consequence of the continued borrowing back.

Grant W. Wiprud:

That’s right, Your Honor.

John M. Harlan II:

So you might have a different situation I would think if — on your premises if you didn’t have the borrowing back.

Grant W. Wiprud:

Right.

But he had to indulge in this borrowing back in order to make this transaction profitable.Given the fact that he was paying 3.5% interest on this very, very large loan and millions of dollars and that the — on the other hand that the policy was only increasing in value by 2.5% per year, he would have a very large out-of-pocket loss each year on this differential in interest, absent tax benefits.

Now, how did he deal with this transaction in order to maximize his tax benefits?

What he did was to purport to pay in 1953 and 1954 interest aggregating in each year in excess of $140,000.

But in each year, the insurance company loans him back a large portion, about two-thirds of that payment, then he claims as a deduction on his return the entire $140,000 per year.

And the tax benefit to him from the deduction if it were allowed of the entire 140, would far exceed his net out-of-pocket outlay after the augmentation is deducted from what he dispersed to the company.

And in fact, it is set forth succinctly on page 26 of our brief and page 27 where we — we show just what the figures would be.

In — for example, in 1953 he purportedly paid out $143,465 in interest and he claimed this as a deduction, the Commissioner disallowed it.

The amount of the deficiency which is not disputed to represent the tax benefit he would have gotten would be $113,000.

Grant W. Wiprud:

That was just as good as money in the pocket, $113,000.

Potter Stewart:

So when you say he can’t win, you mean he can’t win if he can’t win this case?

Grant W. Wiprud:

He can’t win except by tax benefits.

Tax benefits were the only thing he was trying to purchase.

Charles E. Whittaker:

Well, may I ask you (Inaudible).

Grant W. Wiprud:

Yes sir.

Charles E. Whittaker:

Does the Government contend that this was a tax evasion or just tax avoidance.

Do you argue in other words that the taxpayer doesn’t have to comply (Inaudible)?

Would he not buy a recent real estate by not paying the dollars on (Inaudible)

Then one gives more — on that indebtedness and the interest is deductible?

Does he have to make a profit out of it or anything?

Grant W. Wiprud:

No, Your Honor but we say that we’re at the very outset, number one, there is no real advance of money or equivalent economic interest.

There is no indebtedness within the meaning of Section 23 (b) and number two where he enters into a transaction which is designed from the outset in such a fashion that he can’t possibly make any profits, same in the way of tax benefits that this is not the kind of thing which is within the intendment of the statute that —

Felix Frankfurter:

Well, if you’re right about —

Grant W. Wiprud:

— Congress did not intend — excuse me.

Felix Frankfurter:

I beg — excuse you — excuse me if I interrupted you.

Grant W. Wiprud:

That Congress could not have intended to setup provisions in the language of Learned Hand which is quoted in the Third Circuit’s opinion in Weller, that statutes are not designed to allow benefits which by their very terms turn out to defeat taxes.

And that in setting up a deduction for interest as all other deductions that Congress was thinking in terms of transactions which had some commercial meaning.

Some purpose apart from simply purchasing tax benefits.

And in a case like this, where it is evident, the taxpayer had no hope of realizing any profit except his tax benefits.

This isn’t a case of just divided motives or divided possibilities but only a possibility of a tax benefit, certainly this is not within the intendment of the statute.

John M. Harlan II:

It says he doesn’t get a tax benefit.

Grant W. Wiprud:

And we say he does not get it, yes, Your Honor.

John M. Harlan II:

Do you disagree with his argument on that?

I don’t want to go through the rigamarole of the — because frankly I have — in the lawsuit, right?

But do you claim that he inevitably does get a tax benefit from this?

Grant W. Wiprud:

He would if his — the deductions were allowed, Your Honor but we say —

John M. Harlan II:

No, no.

Grant W. Wiprud:

— that they should not be allowed.

John M. Harlan II:

I mean if these deductions were allowed?

Grant W. Wiprud:

He would — he would — the money in the pocket, yes, Your Honor.

John M. Harlan II:

He says he doesn’t.

Grant W. Wiprud:

He says —

John M. Harlan II:

He gave some illustrations (Voice Overlap) —

Grant W. Wiprud:

He says–

John M. Harlan II:

— puzzle me (Voice Overlap) —

Grant W. Wiprud:

Yes, he makes (Voice Overlap) —

John M. Harlan II:

I wish you deal with it.

Grant W. Wiprud:

He makes a curious argument that when he entered this transaction, he was doomed to an out-of-pocket loss whether or not the interest deductions were allowed and therefore he had no tax motive.

John M. Harlan II:

Well, can you answer it though?

Grant W. Wiprud:

We say number one (Voice Overlap).

Number one that it is incredible that a taxpayer would enter into a transaction which pretax or after tax, he was doomed to a loss.

And number two, that if this transaction has been carried on over a long period of years, he wouldn’t have been far ahead of the game.

If you will take just the benefits on pages 26 and 27 of our brief which are key to the record that you would realize each year, $113,053 just plain tax benefits.

William O. Douglas:

But don’t some taxpayers in certain high brackets look for opportunities if you’d get to suffer losses?

Grant W. Wiprud:

Yes, Your Honor.

Yes, Your Honor

William O. Douglas:

Is that — there’s any more than that?

Grant W. Wiprud:

Well, Your Honor, it depends.

If there are some substances — if he does what he purports to do, we say this is a sham and the courts so held.

He didn’t do what he purported to do.

Felix Frankfurter:

If you are right about that.

You said there are two answer.

One, this is not intended?

Grant W. Wiprud:

Right and that’s the specific.

Felix Frankfurter:

And two that he buys the tax benefit?

Grant W. Wiprud:

And we think —

Felix Frankfurter:

If you’re right about one, you don’t need two?

Grant W. Wiprud:

Right.

Right, Your Honor.

Grant W. Wiprud:

I see I have only a few minutes left and I have —

Felix Frankfurter:

If you’re right about —

Grant W. Wiprud:

Excuse me.

Felix Frankfurter:

— two is really the usual make of Gregory and Helvering, isn’t it?

Grant W. Wiprud:

Yes, Your Honor where they characterized a — what purported to be recapitalization as devious and elaborate masquerade as a — the disguise for —

Felix Frankfurter:

But that isn’t — but Helvering — he said these no longer stand for the proposition, but you can’t be very contriving in getting a benefit out of a taxing structure.

Grant W. Wiprud:

No, Your Honor.

Felix Frankfurter:

That’s brought in the dictum.

Grant W. Wiprud:

Oh no, Your Honor, that’s perfectly correct.

Felix Frankfurter:

You reject to that (Voice Overlap) —

Grant W. Wiprud:

That’s correct.

Felix Frankfurter:

Reject that and many relies on it.

Grant W. Wiprud:

That’s correct.

Felix Frankfurter:

Let me — isn’t that true?

Grant W. Wiprud:

Yes, it’s correct, Your Honor.

Felix Frankfurter:

(Voice Overlap) of his opinion.

Grant W. Wiprud:

I think that’s correct.

Felix Frankfurter:

He first rejects it and then relied on it.

Grant W. Wiprud:

But a taxpayer must do what he purports to do in the first instance, i.e. —

Felix Frankfurter:

Well, if you’re right about that then you don’t have to say this is a — if this is a sham — this is a non-reality.

Grant W. Wiprud:

Right.

Felix Frankfurter:

If this is a fiction.

If this is an artifact whatever word you use, then you don’t have to say you can’t get a benefit by monkeying around with the tax structure?

Grant W. Wiprud:

Right.

Felix Frankfurter:

It’s done everyday all over the United States.

Grant W. Wiprud:

Right.

But we —

Felix Frankfurter:

Perfectly honest people and if you can do it without sham, you can do it, isn’t that right?

Grant W. Wiprud:

That’s correct, Your Honor.

Felix Frankfurter:

Alright.

Grant W. Wiprud:

We say that as merely cumulative in this case and that is —

Felix Frankfurter:

But something that isn’t so can’t be cumulative, something that is nothing isn’t cumulative?

Grant W. Wiprud:

We — we submit it so in this case, Your Honor.

Having only a moment or two left, I would like to turn to the committee report upon which the taxpayer plays virtually his sole reliance.

In that committee report, the Congress was enacting a prohibition respectively only to disallow deductions of interest under the various circumstances of this case and of similar cases.

In the committee report, there are two sentences which are critical.

The first is, existing law allows the deduction of interest paid on an indebtedness incurred to carry or continue an annuity contract.

We say surely, Congress had in mind a genuine indebtedness in saying that.

It could not have meant to say that mere labels would suffice.

It has never said so and it surely was aware of this court’s opinions in Deputy versus du Pont and other decision to that affect.

Secondly, in going on to sketch the transaction, which it did, doubtless that Congress had in mind schemes of this kind although it wasn’t exactly the scheme, but schemes along this line doubtless as they were informed about the Sam Houston Insurance Company.

But what Congress was doing to or was to say, we are going to bar for the future all payments of this kind whether genuine or not, whether there’s a genuine indebtedness or not.

This area is so thought with tax avoidance possibilities that we are not going to allow transactions of this nature.

Now in enacting that kind of a sweeping prohibition, we submit that no intention can be attributed to Congress that it turned around and retroactively legislated into 23 (b), a limitation or a new extension of the provision which will allow a taxpayer to claim a sham interest deduction simply by affixing that label to a payment.

John M. Harlan II:

Did the commissioner asked the legislation — 1954 legislation be made retroactive?

Grant W. Wiprud:

Yes he did, Your Honor.

John M. Harlan II:

And the Congress didn’t do it?

Grant W. Wiprud:

The Congress did not do it.

But I think in that respect, the language in this Court’s opinion in the Haggard Company is relevant.

If we are to draw inferences, it would seem as probable that Congress was content to leave the problems of the past to be solved by the courts where they were then pending and there are a lot of these cases in the pipelines rather than to preclude their solution there and we think that that is the answer here.

We don’t think Congress was saying, for the past any payment labeled interest, however phony, it’s going to be allowed as a deduction?

They were simply saying, “Existing law does allow a deduction for interest on a genuine indebtedness in this area but this area is brought with tax avoidance possibilities.”

Therefore, we’re just going to say no.

No deduction in this area even if it’s genuine.

John M. Harlan II:

Is the Commissioner’s proposal to Congress of 1954, printed many of these papers?

Grant W. Wiprud:

No, Your Honor.

In fact, I have never — I have never seen any papers containing the written proposals.

John M. Harlan II:

What’s the basis of your answer to my question that the Commissioner did specifically proposed retroactive legislation?

Grant W. Wiprud:

So I understand Your Honor.

John M. Harlan II:

Well, let me — one put his fingers on what (Voice Overlap) —

Grant W. Wiprud:

I can — this is — I have personal knowledge one way or the other but so I understand.

John M. Harlan II:

Not documented?

Grant W. Wiprud:

No sir, it’s not in the record.

John M. Harlan II:

You have to get it by inference or (Voice Overlap) —

Grant W. Wiprud:

Well, the taxpayer is certain.

The Commissioner asked for this and I have — had no — been furnished with no materials to rebut it.

Charles E. Whittaker:

May I ask you please sir with the permission of the Chief Justice.

Is it true that prior to the 1954 Act, the Commissioner had recognized such payments as interest and deductible?

Grant W. Wiprud:

He had on the case of certain individuals who submitted ruling letters which incidentally were very fragmentary and sketchy in the details provided.

Charles E. Whittaker:

Now then next, did the Commissioner seek a change in the law, seek to induce Congress to change it so as to make such interest payments?

I’m using that phrase for (Voice Overlap) —

Grant W. Wiprud:

Yes.

Charles E. Whittaker:

— nondeductible?

Grant W. Wiprud:

We would say he did not seek to change it but to clarify it.

Charles E. Whittaker:

To clarify it —

Grant W. Wiprud:

Yes.

Charles E. Whittaker:

— to make — all right.

To the make them nondeductible?

Grant W. Wiprud:

To make it clear for the future.

Charles E. Whittaker:

And was it in response to that request of the commissioner that the 1954 Act resulted?

Grant W. Wiprud:

That this are of provision was enacted, that is correct, Your Honor.

Charles E. Whittaker:

And does it expressly say that your committee’s build will deny an interest deduction in such cases but only as to annuities purchased after March 1, 1954?

Grant W. Wiprud:

That is correct, Your Honor.

Charles E. Whittaker:

Then how do you get away from that?

Grant W. Wiprud:

Because, we submit, that Congress was dealing in terms of genuine indebtedness and genuine interest payments since it certainly did not intend to allow retroactively sham transactions to qualify under the statute.

It’s not limited to sham transactions.

It says loans on annuity contracts and certainly there can be genuine loans on annuity contracts, we don’t dispute that.

Further argument, are such genuine loans prior to the 1954 code, interest could be deducted, but it can’t be after 1954.

Charles E. Whittaker:

Was the Commission — was the report talking about some other type of transaction or about this very type of transaction in this report which is quoted at page 20 of the petitioner’s brief and page 2 of his reply brief saying “It has come to your committee’s detention et cetera?”

Now as the — were the —

Grant W. Wiprud:

We think that the —

Charles E. Whittaker:

— (Voice Overlap) with this very situation?

Grant W. Wiprud:

We think they were dealing with this scheme and with the live schemes or all kinds of variations on this scheme, yes, Your Honor.

But we don’t think they were meaning to pass judgment on it to say that this kind of a scheme is — is — represents genuine interest payments but they were just simply saying that this area is fraught with tax avoidance possibilities.

Therefore, for the future, we’re going to bar genuine interest payments and a fortiori certiorari, sham interest payments simply to preclude any controversy in the area.

And of course what the later Congress thinks and earlier kinds of statement as this Court has said in its recent price decisions, it’s a hazardous speculation.

John M. Harlan II:

May I ask you one more question?

Grant W. Wiprud:

Yes, Your Honor?

John M. Harlan II:

The Regulation Commissioner passed 1954?

Grant W. Wiprud:

Yes, Your Honor.

You mean the revenue ruling?

John M. Harlan II:

The revenue ruling.

Grant W. Wiprud:

Yes, Your Honor.

John M. Harlan II:

Was that in existence before Congress acted on the (Voice Overlap) —

Grant W. Wiprud:

It had certainly been formulated, Your Honor.

It was — actually published and print about six days after the House of Representatives Report went to the floor.

But as Your Honor well know is these things take the wheels grind slowly in the Government and these rulings, general rulings like these are in process of formulating over many months and sometimes years.

John M. Harlan II:

It can’t be said that Congress had that before the time it enacted this legislation?

Grant W. Wiprud:

Oh no, Your Honor.

Thank you.

Earl Warren:

Mr. McLane?

W. Lee McLane, Jr.:

Mr. Chief Justice, may it please the Court.

I think I should point out that so far as I am concerned and I’ve been representing taxpayer in this case from the District Court.

This is the first time the word “sham” is been used.

I think that if you’ll read the briefs in this case in the court and find that there is no use of that term up to this point, the Government’s position has been, that there is no indebtedness here because there were no economic benefits and the Government says there is no economic benefits because without tax benefit they argue, the transaction could not have resulted into profit to the taxpayer.

Felix Frankfurter:

If one could find it as sham, that was the end of the matter.

W. Lee McLane, Jr.:

Yes, sir.

I think, Mr. Justice Frankfurter that the court below and the argument was that this was a masquerade of sham that under Gregory versus Helvering clearly that disposes off the matter.

However, the argument that the petitioners made from the lower court on is that Gregory versus Helvering came into existence to assist or alleviate the case where a taxpayer had formally complied with the literal provisions of the statute.

It seemed to me that Judge Learned Hand said that where there is this formal or literal compliance, it will not be given effect for tax purposes if to do so would be to defeat the intent of Congress.

W. Lee McLane, Jr.:

But then, I submit to the Court that within our back, it’s the petitioner’s primary argument in this case which was that these transactions were commonly known from 1934 through 1954.

These transactions, in fact, this one was presented to the Congress.

The Congress was aware of it from 1934 on and not in 1954 as the Government mentioned in its brief.

Here, the United States has left the impression and I’d like to respond to Mr. Justice Harlan’s question if I could, that somehow or another, the taxpayer in this case has created a large interest deduction out of the thin air so to speak at no cost of him.

The fact here is that he reaches this conclusion only by emphasizing that there were tax benefits if he had continued on with the program.

The Government ignores the fact that this taxpayer surrendered his contract in 1956.

As a result of that surrender, he must pay in the year 1956 ordinary income tax on a rough — approximately $308,000 of additional income which represents the indebtedness which was cancelled when these contracts were surrendered.

The additional tax on that has been computed in our brief and it was computed in the lower court and there has been no dispute raised yet as to the correctness of those computations that this additional tax which he must pay now for the year 1956 will be $269,869.21.

In addition, Mr. Knetsch paid insurance company, Sam Houston, $137,315 and more than he received from it.

This makes a total of $401,184.21 and I say that that sum, mathematically speaking, is $50,650.36 more than the $356,533.85 tax benefits which the U.S. says he realized for the years 1953, 1954, and 1955.

So all I’m arguing here is that it seems to me that when the Government argues, there’s been tax avoidance and that purely because there was tax avoidance, the transaction should be ignored that the facts of the case should show that the taxpayer realize tax avoidance.

In this case, I think or rather realized tax benefits.

In this case, I think it’s perfectly clear, he did not.

Charles E. Whittaker:

How, if I may ask, Mr. McLane, could there be taxable income to him upon the forgiveness of debt here?

W. Lee McLane, Jr.:

Your Honor —

Charles E. Whittaker:

There wasn’t any debt, was there?

W. Lee McLane, Jr.:

Well of course if the interest deductions are sustained, that is if this was indebtedness and if the interest disallowed for 1953, 1954 and 1955, yes there was debt.

He owed the company the difference between — he owed the company — if you’ll turn to —

Charles E. Whittaker:

Well —

W. Lee McLane, Jr.:

— my brief Mr. Justice Whittaker at page —

Charles E. Whittaker:

Forget it.

I could find it.

I don’t want to take your time.

W. Lee McLane, Jr.:

I’m Sorry, Your Honor.

On page 6, you will note that the proceeds of the loans, $307,000, are listed as a receipt from the company.

In addition, he received from the company $1,000 making a total of $308,000.

That sum represents the $4 million which he originally paid plus the $307,000 which he borrowed in each of the succeeding three years making a total of $307,000 plus the one he received from the company upon surrender.

Therefore at surrendering, he realized a total amount of $4,308,000.

He had a cost basis of $4 million, therefore he had $307,000 and $308,000 of gain upon which he must pay ordinary income tax because upon surrender, there cannot conceivably be capital gain treatment even though there was at that time some question as to whether or not they could be applied.

Potter Stewart:

Of course this surrender came in 1956 after the disallowance and deductions?

W. Lee McLane, Jr.:

That is correct Mr. Justice Stewart.

Potter Stewart:

And has not surrendered the annuity contract, the economic detriment that — upon which you’ve told us, would not have been encouraged?

W. Lee McLane, Jr.:

Not until he surrendered or until he dispose off the contract, that is correct, Your Honor.

In concluding, I’d like to say that in this case, since Congress was aware since 1934 of this method of purchasing single premium annuities, since the taxpayer has relied upon the law which existed since 1934 that he should be entitled to rely upon the statute which existed prior to 1954 and also as it reads subsequent to 1954.

To argue that the 1954 committee language sheds no light on the problem for earlier years, ignores, it seems to me the long congressional history regarding the borrowing of sums to purchase single premium annuities or 1934 on.

Furthermore, it seems to me that Congress didn’t somewhat more than counsel has suggested.

I think that it affirmatively acted with respect to 1953 by saying as Mr. Justice Whittaker quoted the language that interest in such cases will be disallowed if the contract is acquired on or after March 1st, 1954.

Thank you very much.

Earl Warren:

Now Mr. McLane, I understood counsel to — to say that if the petitioner had continued this arrangement for the 30 years until he became 90 years of age, and had paid this $140,000 a year with the repayments back and so forth, that when he became 90 years of age, he would have an annuity that was worth $43 a month, is that correct?

W. Lee McLane, Jr.:

Yes sir, if you assume that each year he borrowed the full cash surrendered value of the annuity, then the amount that he would’ve received at the age of 90 would’ve been the cash surrendered value compounded at 2.5% annually, that is a correct statement.

Earl Warren:

(Voice Overlap) about $40 — $43 a month.

W. Lee McLane, Jr.:

Yes, Your Honor.

That was stipulated over to court.

Earl Warren:

Yes, thank you.