## Facts

- Karl F. Knetsch and his wife purchased ten deferred annuity savings bonds from an insurance company with a total face value of $4,000,000 and a stated purchase price of $4,004,000.
- Knetsch paid $4,000 in cash and delivered nonrecourse annuity loan notes for $4,000,000 secured by the annuity bonds, bearing 3.5% interest payable in advance; he prepaid $140,000 in first-year “interest.”
- The annuities’ cash/loan value exceeded the stated indebtedness, and contract terms permitted borrowing against the excess without waiting until the end of the first year.
- Within days, Knetsch borrowed nearly all available excess cash value, gave additional notes at 3.5% interest payable in advance, and prepaid additional amounts labeled “interest.”
- He repeated this pattern over multiple years, keeping his net cash value (equity) in the annuities minimal while generating large prepaid “interest” payments.
- The annuity bonds were surrendered and the indebtedness cancelled in 1956.
- The Knetsches claimed deductions for “interest paid … on indebtedness” of $143,465 (1953) and $147,105 (1954).
- The Commissioner disallowed the deductions; the taxpayers paid deficiencies and sought refunds. The district court ruled for the United States, and the Ninth Circuit affirmed.

## Issues

1. Whether the prepaid amounts labeled “interest” were deductible as “interest paid … on indebtedness” under I.R.C. § 23(b) (1939) and I.R.C. § 163(a) (1954).
2. Whether enactment of I.R.C. § 264(a)(2) (1954) implied that similar interest deductions were allowable for earlier annuity-loan arrangements.

## Decision

- The Supreme Court affirmed the judgment for the United States.
- The Court held the claimed “interest” payments were not deductible because the arrangement created no genuine “indebtedness” within the meaning of the tax statutes.
- The Court rejected the argument that § 264(a)(2) validated deductions for pre–March 1, 1954 contracts; the statute did not authorize deductions for sham transactions.
- The dissent would have allowed the deductions because the transaction conformed to the formal terms of the insurance and loan instruments, leaving changes to Congress.

## Legal Principles

- Deductions for “interest on indebtedness” require a genuine debt; a transaction that is a loan in form but not a real indebtedness in substance does not generate deductible interest.
- Payments labeled as interest may be disregarded for tax purposes when the overall arrangement lacks commercial economic substance and can produce no meaningful non-tax financial benefit.
- Later statutory limits on interest deductions (such as § 264(a)(2)) do not, by implication, authorize deductions for earlier transactions that fail to create true indebtedness.

## Conclusion

The Court denied the taxpayers’ interest deductions because the annuity-loan arrangement, though formally documented, lacked real indebtedness and economic substance and functioned chiefly to generate tax deductions, and Congress’s later enactment of § 264(a)(2) did not legitimate such deductions for earlier years.


Knetsch v. United States, 364 U.S. 361 (1960)