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.
364 U. S.
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.
364 U. S. 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.
364 U. S.
367-370.
272 F.2d 200 affirmed.
Page 364 U. S. 362
MR. JUSTICE BRENNAN delivered the 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. [
Footnote 1] 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.
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
Page 364 U. S. 363
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
Page 364 U. S. 364
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 "[t]here was no commercial
economic substance to the . . . transaction," that the parties did
not intend that Knetsch "become indebted to Sam Houston," that
"[n]o indebtedness of [Knetsch] was created by any of the . . .
transactions," and that
Page 364 U. S. 365
"[n]o 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,
"[w]hile, 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." [
Footnote 2] As was said in
Gregory v. Helvering,
293 U. S. 465,
293 U. S.
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."
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,
Page 364 U. S. 366
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. [
Footnote 3] Plainly,
therefore, Kentsch'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. [
Footnote 4]
Page 364 U. S. 367
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 to carry a single premium annuity
contract, but only as to contracts purchased after March 1, 1954.
[
Footnote 5] 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.
293 U. S. 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.
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
Page 364 U. S. 368
developing a policy to deny a deduction for interest allocable
to tax-exempt income; [
Footnote
6] 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.
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
Page 364 U. S. 369
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' longstanding 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. [
Footnote 7]
Page 364 U. S. 370
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.
[
Footnote 1]
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. . . ."
[
Footnote 2]
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.
[
Footnote 3]
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."
[
Footnote 4]
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. � 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.),
certiorari
denied, 347 U.S. 908;
Haggard v. United States, 59-1
U.S.T.C. � 9299;
Oliver L Williams, 18 T.C.M. 205.
See also Rev.Rul. 54-94, 1954-1 Cum.Bull. 53, and the
dissenting opinion of Judge Wisdom in
Bond.
[
Footnote 5]
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.
[
Footnote 6]
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."
[
Footnote 7]
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."
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
self-same bank at a higher rate. His aim there, as here, may only
to be 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
Page 364 U. S. 371
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 now 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.
* 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.