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I.R.C. § 264(a)(2) (1954) 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.
In 1953, Plaintiff Karl F. Knetsch purchased 30-year maturity deferred annuity savings bonds from the Sam Houston Life Insurance Company, which Knetsch paid $294,570 during the two taxable years involved and received $203,000 back in the form of loans; the difference of $91,570 was an annuity contract that would produce monthly annuity payments of $90,171 at maturity, when taxpayer would be 90 years of age, or substantial life insurance proceeds in the event of his death before maturity. However, each year taxpayer's annual borrowings from Sam Houston Life Insurance Company kept the net cash value, on which any annuity or insurance payments would depend, at a relative pittance of $1,000, so that nothing of substance was to be realized by the taxpayer beyond tax deductions in the sum of over $330,000, which Knetsch attempted to deduct from his gross income 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. The Commissioner of Internal Revenue disallowed the deductions and determined a deficiency for each year. After having paid the deficiencies, Knetsch brought the present action for a refund in the United States District Court for the Southern District of California. The District Court rendered judgment for the United States, which the Court of Appeals for the Ninth Circuit affirmed.
Were the amounts paid as “interest” in 1953 and 1954 deductible from the gross income of the plaintiff taxpayer?
The United States Supreme Court held that the transaction was a sham and did not create an indebtedness which would support the deductions claimed by the taxpayer. It was also held that I.R.C. § 264 (1954), which denied 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, did not authorize the deductions claimed in connection with annuities purchased prior to that date.