KNETSCH v. UNITED STATES

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Argument of W. Lee Mclane, Jr.

Chief Justice Earl Warren: Number 23, Karl F. Knetsch, et al., Petitioner versus United States.

Mr. McLane.

Mr. W. Lee Mclane, Jr.: Mr. Chief Justice, may it please the Court.

Since the time is limited to 30 minutes on the summary calendar, I will not have the opportunity to cover some of the material that has been submitted by other counsel in the various amicus briefs, and therefore I request the Court's knowledge of it.

This case is an income tax refund (Inaudible).

The years involved are 1953 and 1954.

The petitioners, Karl F. Knetsch and Eva Knetsch are husband and wife, both of whom are residents of California.

With respect to the transaction involved, Mr. Knetsch acted on behalf of the community and transacted all of the business for himself and for his wife.

The sections of the code involved are Sections 23 (b) and 24 (a) (6) of the 1939 Code and Sections 163 (a) and Section 264 (a) of the 1954 Code.

Section 23 (b) of the 1939 Code and Section 163 (a) of the 1954 Code, both authorize a deduction from gross income for all interest paid or accrued on indebtedness.

Section 24 (a) (6) of the 1939 Code, provided for the disallowance of certain items paid or incurred to carry or purchase either a single-premium life insurance or endowment contract.

In 1954, that disallowance provided for in Section 24 (a) (6) was broadened by Section 264 of the 1954 Code.

The Section provided in substance that no deduction shall be allowed for any amount paid or accrued on indebtedness incurred or continued to purchase or carry a single-premium, life insurance, endowment or annuity contract.

Justice William O. Douglas: Well, that was -- that won't affect the time of these transactions?

Mr. W. Lee Mclane, Jr.: No, it was not Mr. Justice Douglas.

It was --

Justice William O. Douglas: It came into effect after.

Mr. W. Lee Mclane, Jr.: It came into effect in 1954.

The annuities involved in this matter were purchased in 1953 but we have two taxable years involved, 1953 and 1954.

Justice William O. Douglas: Now, what statute was enforced at the time of these transactions?

Are they printed on page 3 of your brief?

Mr. W. Lee Mclane, Jr.: 1939 Code, Sections 23 (b) and Section 24 (a) (6) were in effect for the year 1953.

The case arose in the following fashion.

A deficiency notice was issued by the Commissioner, a refund claim was filed and the suit was filed for a refund in the United States District Court for the Southern District of California.

The case was heard before U.S. District Judge Mathis.

All of the facts were stipulated or admitted in the answer.

There were roughly 70 some exhibits which were offered and most of which were admitted in evidence.

The question presented according to the petitioners' lights is set forth at page 2 of the petitioner's opening brief and I'd like to state, if I may, what petitioners' believe is the question before the Court.

It is it seems to us whether the courts below had the power to disallow as a deduction from gross income, interest paid on indebtedness incurred to purchase and carry a single-premium annuity which was acquired before March 1st, 1954 in view of the clear intent of Congress, when in 1954, it amended Section 24(a) (6) of the 1939 Internal Revenue Code and explained the Amendment saying, “It has come to your committee's attention that a few insurance companies have promoted the 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 and the 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 1st, 1954.

Now --

Justice John M. Harlan: That describes -- I don't know if this is of any significance but that describes your situation, precisely except for one element, doesn't it, namely, the additional borrowing that were made by the taxpayer.

Mr. W. Lee Mclane, Jr.: Well except that I -- I think I can answer that --

Justice John M. Harlan: Maybe it's not material.

Mr. W. Lee Mclane, Jr.: I think it is precisely the situation and I'd like to cover that right now, if I may, Mr. Justice Harlan.

There is as the Court knows a conflict in the Circuits on this question.

In the case of the United States versus Bond, the Fifth Circuit ruled in favor of the taxpayer, holding with legislative history, sustained the interest deduction in this case.

The Bond case involved the same life insurance company which is involved in the case which is now before the Court.

The name of the company was the Sam Houston Life Insurance Company.

The annuity contracts, loan agreements were identical.

The transaction was what is called the Sam Houston Transaction.

Now, in the 1930's, Mr. Justice Harlan, members of the Court, they've developed a proposal or plan of selling single-premium annuities to purchasers which never really caught hold, I suppose, because the income tax rates among other things, were not high enough to make it terribly attractive to people.

But in effect, persons were buying single-premium annuities and borrowing the amount of the single-premium from the insurance company having the single-premium annuity issued to the purchaser and executing a note as payment thereof.

This practice continued from about 1934, through the 1930's and through the 1940's, until the early part of 1953 when the Commissioner of Internal Revenue, having observed advertisements on the Wall Street Journal such as one which is involved in this case, and having become aware that there were a fairly substantial number of these cases involved, I think this petition for certiorari says here about 140.

It went to the Congress in the fall of 1953, in the spring of 1954 and asked the Congress if the Congress would give him, the Commissioner, remedial legislations.

The Commissioner was not given all that he asked.

Section 264 and the committee report explaining it, was published by the Ways and Means Committee of the House on about March the 9th, 1954.

That is the language which I have just read to the Court and the language of Section 264, states in substance, that the bill or rather the section only applies to contracts which were acquired on or after March 1st, 1954.

Thereafter, about March 17th, 1954, the revenue ruling which appears in the back of the Government's brief in this case was issued by the Commissioner of Internal Revenue.

Both the Committee Report and the Revenue Ruling it seems to me, present the transaction which is before the Court.

Now, I have been under the impression that because of the advertisements and the advertising by the Sam Houston Life Insurance Company that this was the transaction which the Commissioner showed to the Congress.

If I am wrong, I have been unable to ascertain from any source that that is not the case.

Now, in 1954 after the Revenue Ruling was issued, a statutory notice of deficiency was then issued to the taxpayer in this case.

Now, the facts of this case specifically and in more detail, are set forth at page 5 of petitioner's opening brief.

I'd like to say before going into these facts that the record here will show that Mr. Knetsch is a man of considerable means.

That is he operated the business which produced for him based on the exhibits in this case, some $220 some thousand dollars of income from 1955, $179 for the year 1956.

He -- his return showed approximately $18,000 of rental income for both of those years and about $18,000 of interest income in a savings deposit.

Those items indicate considerable means and net worth.

The particular transaction before the Court was one which took place in Houston, Texas between the petitioner and the Sam Houston Life Insurance Company.

On December 11th, 1953, Mr. Knetsch acquired 10 single-premium annuities from the Sam Houston Life Insurance Company.

The purchase price set forth in each annuity was $400,400.

The total purchase price was paid by Knetsch's delivery to Sam Houston of his check, his personal check of $4,000 and by the execution of 10 separate contract loan agreements for $400,000 each.

As evidence of the $400,000 debt for each annuity, Knetsch executed and delivered to Sam Houston the 10 individual contract loan agreements.

Each of the 10 contract loan agreements provided that interest at a rate specified in the respective annuity contracts of 3.5% per annum, must be paid in advance.

Therefore, on December 11th, 1953, Mr. Knetsch delivered to Sam Houston a cashier's check for $140,000 which amount is 3.5% of $4 million.

This sum, by the way, the cashier's check was drawn on a Los Angeles California Bank.

This sum of $140,000 constitutes the bulk of the $143,465 which Knetsch claimed as an interest deduction for the year 1953.

The additional $3,465 was paid to Sam Houston by Knetsch on or about December 16th, 1953 as a result of this following transaction.

On December 16th, 1953, Mr. Knetsch borrowed or received an additional sum of $99,000 from Sam Houston and agreed to pay interest there on at the rate of 3.5% per annum.

Thus, on that same day, December 16th, he delivered to Sam Houston a second check for $3,465.

Concurrently, with the payment of this $3,465 to Sam Houston, Mr. Knetsch delivered to Sam Houston 10 contract loan agreements, each in the principal amount of $9,900.

It is this $3,465 payment of December 16th, 1953, plus the $140,000 payment of December 11th, 1953, which comprised the total interest deducted and claimed by the taxpayer as being paid to Sam Houston in 1953.

In short, petitioners purchased each of the 10 single-premium annuities for a nominal cash payment, $400 each with a loan to cover the balance of the cost of each annuity.

During the following year, the $400,000 purchase price loan was renewed, an additional amount of $104,000 was borrowed from Sam Houston, and again, a cashier's check was delivered in the sum of $143,465 and an additional check of Mr. Knetsch's $3,640 delivery.

The two figures represent the claimed interest deduction for 1954.

Now for the year 1955, although the year is not before the Court, the same transaction occurred again.

And in the year 1956, Mr. Knetsch surrendered his annuities to Sam Houston.

At the time of the surrender, he received the cancellation of approximately $307,000 in indebtedness plus $1,000 in cash.

The issue before the Court is whether or not the interest deductions which he claimed for 1953 and 1954 are proper deductions under Section 23 (b) and Section 163 (a).

In the lower court, U.S. District Judge Mathis held that the dissenting opinion of Judge Wisdom in the United States versus Bond was the proper decision and he therefore adopted it.

When the case went to the United States Court of Appeals for the Ninth Circuit, the Ninth Circuit at the day of oral argument was presented with the decision of the Third Circuit in Weller versus Commissioner and in its opinion subsequently adopted the Weller opinion.Subsequent to the Weller opinion, another Circuit, the Second, has decided the issue in fact -- in a case in which facts are quite similar to this one and a majority of the Court sustained the Government approving the Weller and dissenting opinion of Judge Wisdom.

There was a dissenting opinion of Circuit Judge Moore in the Diggs case, however, that is the Second Circuit's decision.

The petitioners in this case believed that not only the Committee language and the Section 264 (a) of the 1954 Code, reflect that this transaction was presented to the Congress and that the Congress adopted of course with respect to it but if the legislation and the legislative history for the intersection and the interest of disallowance sections all the way back to 1932 reflect the intent of Congress that items such as these and the instant case would be proper deductions.

In the dissent of Judge Wisdom and Weller opinion, the petitioner submit that Judge Wisdom has not given effect to the Section passed in 1954 nor to the Committee language explaining that Section.

Judge Wisdom said that, while it is true that Section 264 provides for disallowance under certain circumstances that it does not follow.

If the taxpayer shows that Section 264 does not apply that he perforce to use the language of the Government's brief is allowed a deduction under Section 23 (b) and of course, the petitioners and the taxpayers did not suggest that that is their position.

Clearly, we are not entitled to an interest deduction simply if we show that Section 264 does not disallow the interest deduction.

What we are intending is that the language of this committee report reflects an intent by Congress in 1954 to treat this type of transaction in a certain manner that while that committee language explains -- is found rather under the explanation to Section 264 that it certainly reflects the position of Congress with respect to whether or not interest in this cases was or was not to be disallowed.

The Internal Revenue Code, petitioner submit as an integrated whole, it does not consist of the series of isolated sections, each living in a world of its own and that when the Congress decided to disallow interest in such cases as the committee language states, there really was no other Section where it would disallow what it considered to be an interest deduction other than in Section 264.

In Wisdom's -- in Judge Wisdom's dissent in the Weller opinion, it was also indicated, and I believe it's the Government's position here that interest could not have exist in that case because interest is limited to indebtedness incurred for the payment of the sum of money which is actually received.

Petitioner submit that the Court has held that interest is paid for indebtedness assumed or acquired for the use or forbearance of money and that in this case, there certainly was forbearance of the sum which is represented by the face amounts of the notes which were executed by Mr. Knetsch.

Chief Justice Earl Warren: We'll recess now.

Mr. W. Lee Mclane, Jr.: Thank you.

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Argument of W. Lee Mclane, Jr.

Chief Justice Earl Warren: Number 23, Karl F. Knetsch et al., Petitioners versus United States.

Mr. McLane.

Mr. 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.

Chief Justice Earl Warren: Mr. Wiprud.

Argument of Grant W. Wiprud

Mr. 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 --

Justice 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.

Mr. 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.

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.

Justice John M. Harlan: Can I ask you a question.

Mr. Grant W. Wiprud: Yes, Your Honor.

Justice John M. Harlan: Before the Code of 1954, was this specific type of transaction an infrequent one or was it -- or there are lots of these contracts?

Mr. 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.

Justice John M. Harlan: If you're right -- if you are right on your position here, I would suppose the injection of a bank into this situation.

Mr. 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.

Justice John M. Harlan: The Diggs case in the Second Circuit involved a bank.

Mr. 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.

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.

Justice John M. Harlan: Would you regard this case differently from the Government's point of view if he hadn't had his loan-back?

Mr. 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).

Justice John M. Harlan: 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?

Mr. 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.

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.

Justice John M. Harlan: All of these have been taken out by a very young man.

Mr. Grant W. Wiprud: Yes.

Justice John M. Harlan: 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.

Mr. 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.

Justice John M. Harlan: That's in consequence -- that's in consequence of the continued borrowing back.

Mr. Grant W. Wiprud: That's right, Your Honor.

Justice John M. Harlan: So you might have a different situation I would think if -- on your premises if you didn't have the borrowing back.

Mr. 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.

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

Justice William J. Brennan: So when you say he can't win, you mean he can't win if he can't win this case?

Mr. Grant W. Wiprud: He can't win except by tax benefits.

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

Justice Charles E. Whittaker: Well, may I ask you (Inaudible).

Mr. Grant W. Wiprud: Yes sir.

Justice 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?

Mr. 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 --

Justice Felix Frankfurter: Well, if you're right about --

Mr. Grant W. Wiprud: -- Congress did not intend -- excuse me.

Justice Felix Frankfurter: I beg -- excuse you -- excuse me if I interrupted you.

Mr. 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.

Justice John M. Harlan: It says he doesn't get a tax benefit.

Mr. Grant W. Wiprud: And we say he does not get it, yes, Your Honor.

Justice John M. Harlan: 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?

Mr. Grant W. Wiprud: He would if his -- the deductions were allowed, Your Honor but we say --

Justice John M. Harlan: No, no.

Mr. Grant W. Wiprud: -- that they should not be allowed.

Justice John M. Harlan: I mean if these deductions were allowed?

Mr. Grant W. Wiprud: He would -- he would -- the money in the pocket, yes, Your Honor.

Justice John M. Harlan: He says he doesn't.

Mr. Grant W. Wiprud: He says --

Justice John M. Harlan: He gave some illustrations (Voice Overlap) --

Mr. Grant W. Wiprud: He says--

Justice John M. Harlan: -- puzzle me (Voice Overlap) --

Mr. Grant W. Wiprud: Yes, he makes (Voice Overlap) --

Justice John M. Harlan: I wish you deal with it.

Mr. 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.

Justice John M. Harlan: Well, can you answer it though?

Mr. 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.

Justice William O. Douglas: But don't some taxpayers in certain high brackets look for opportunities if you'd get to suffer losses?

Mr. Grant W. Wiprud: Yes, Your Honor.

Yes, Your Honor

Justice William O. Douglas: Is that -- there's any more than that?

Mr. 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.

Justice Felix Frankfurter: If you are right about that.

You said there are two answer.

One, this is not intended?

Mr. Grant W. Wiprud: Right and that's the specific.

Justice Felix Frankfurter: And two that he buys the tax benefit?

Mr. Grant W. Wiprud: And we think --

Justice Felix Frankfurter: If you're right about one, you don't need two?

Mr. Grant W. Wiprud: Right.

Right, Your Honor.

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

Justice Felix Frankfurter: If you're right about --

Mr. Grant W. Wiprud: Excuse me.

Justice Felix Frankfurter: -- two is really the usual make of Gregory and Helvering, isn't it?

Mr. 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 --

Justice 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.

Mr. Grant W. Wiprud: No, Your Honor.

Justice Felix Frankfurter: That's brought in the dictum.

Mr. Grant W. Wiprud: Oh no, Your Honor, that's perfectly correct.

Justice Felix Frankfurter: You reject to that (Voice Overlap) --

Mr. Grant W. Wiprud: That's correct.

Justice Felix Frankfurter: Reject that and many relies on it.

Mr. Grant W. Wiprud: That's correct.

Justice Felix Frankfurter: Let me -- isn't that true?

Mr. Grant W. Wiprud: Yes, it's correct, Your Honor.

Justice Felix Frankfurter: (Voice Overlap) of his opinion.

Mr. Grant W. Wiprud: I think that's correct.

Justice Felix Frankfurter: He first rejects it and then relied on it.

Mr. Grant W. Wiprud: But a taxpayer must do what he purports to do in the first instance, i.e. --

Justice 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.

Mr. Grant W. Wiprud: Right.

Justice 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?

Mr. Grant W. Wiprud: Right.

Justice Felix Frankfurter: It's done everyday all over the United States.

Mr. Grant W. Wiprud: Right.

But we --

Justice Felix Frankfurter: Perfectly honest people and if you can do it without sham, you can do it, isn't that right?

Mr. Grant W. Wiprud: That's correct, Your Honor.

Justice Felix Frankfurter: Alright.

Mr. Grant W. Wiprud: We say that as merely cumulative in this case and that is --

Justice Felix Frankfurter: But something that isn't so can't be cumulative, something that is nothing isn't cumulative?

Mr. 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.

Justice John M. Harlan: Did the commissioner asked the legislation -- 1954 legislation be made retroactive?

Mr. Grant W. Wiprud: Yes he did, Your Honor.

Justice John M. Harlan: And the Congress didn't do it?

Mr. 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.

Justice John M. Harlan: Is the Commissioner's proposal to Congress of 1954, printed many of these papers?

Mr. Grant W. Wiprud: No, Your Honor.

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

Justice John M. Harlan: What's the basis of your answer to my question that the Commissioner did specifically proposed retroactive legislation?

Mr. Grant W. Wiprud: So I understand Your Honor.

Justice John M. Harlan: Well, let me -- one put his fingers on what (Voice Overlap) --

Mr. Grant W. Wiprud: I can -- this is -- I have personal knowledge one way or the other but so I understand.

Justice John M. Harlan: Not documented?

Mr. Grant W. Wiprud: No sir, it's not in the record.

Justice John M. Harlan: You have to get it by inference or (Voice Overlap) --

Mr. 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.

Justice 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?

Mr. 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.

Justice 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) --

Mr. Grant W. Wiprud: Yes.

Justice Charles E. Whittaker: -- nondeductible?

Mr. Grant W. Wiprud: We would say he did not seek to change it but to clarify it.

Justice Charles E. Whittaker: To clarify it --

Mr. Grant W. Wiprud: Yes.

Justice Charles E. Whittaker: -- to make -- all right.

To the make them nondeductible?

Mr. Grant W. Wiprud: To make it clear for the future.

Justice Charles E. Whittaker: And was it in response to that request of the commissioner that the 1954 Act resulted?

Mr. Grant W. Wiprud: That this are of provision was enacted, that is correct, Your Honor.

Justice 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?

Mr. Grant W. Wiprud: That is correct, Your Honor.

Justice Charles E. Whittaker: Then how do you get away from that?

Mr. 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.

Justice 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 --

Mr. Grant W. Wiprud: We think that the --

Justice Charles E. Whittaker: -- (Voice Overlap) with this very situation?

Mr. 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.

Justice John M. Harlan: May I ask you one more question?

Mr. Grant W. Wiprud: Yes, Your Honor?

Justice John M. Harlan: The Regulation Commissioner passed 1954?

Mr. Grant W. Wiprud: Yes, Your Honor.

You mean the revenue ruling?

Justice John M. Harlan: The revenue ruling.

Mr. Grant W. Wiprud: Yes, Your Honor.

Justice John M. Harlan: Was that in existence before Congress acted on the (Voice Overlap) --

Mr. 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.

Justice John M. Harlan: It can't be said that Congress had that before the time it enacted this legislation?

Mr. Grant W. Wiprud: Oh no, Your Honor.

Thank you.

Chief Justice Earl Warren: Mr. McLane?

Rebuttal of W. Lee Mclane, Jr.

Mr. 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.

Justice Felix Frankfurter: If one could find it as sham, that was the end of the matter.

Mr. 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.

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.

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

Mr. W. Lee Mclane, Jr.: Your Honor --

Justice Charles E. Whittaker: There wasn't any debt, was there?

Mr. 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 --

Justice Charles E. Whittaker: Well --

Mr. W. Lee Mclane, Jr.: -- my brief Mr. Justice Whittaker at page --

Justice Charles E. Whittaker: Forget it.

I could find it.

I don't want to take your time.

Mr. 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.

Justice Potter Stewart: Of course this surrender came in 1956 after the disallowance and deductions?

Mr. W. Lee Mclane, Jr.: That is correct Mr. Justice Stewart.

Justice Potter Stewart: And has not surrendered the annuity contract, the economic detriment that -- upon which you've told us, would not have been encouraged?

Mr. 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.

Chief Justice 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?

Mr. 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.

Chief Justice Earl Warren: (Voice Overlap) about $40 -- $43 a month.

Mr. W. Lee Mclane, Jr.: Yes, Your Honor.

That was stipulated over to court.

Chief Justice Earl Warren: Yes, thank you.