Knetsch v. United States

Karl Knetsch (plaintiff) bought deferred annuity bonds from an insurance company as a tax shelter, financed by a loan from the same insurer, and was allowed to borrow further against the bonds' value as it grew. Knetsch borrowed heavily against the bonds and deducted the loan interest on his federal tax returns. Because he borrowed so much against the bonds' value, their expected payout at maturity -- when Knetsch would turn 90 -- was negligible; the net effect was that the bonds generated interest deductions far exceeding Knetsch's actual investment, with no real financial value beyond the tax benefit. The tax commissioner (defendant) disallowed the deductions, and Knetsch sued for a refund. The district court found the transaction a sham lacking economic substance and ruled for the commissioner; the court of appeals affirmed, and the Supreme Court granted certiorari.