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

  • Knetsch made a deal with a bank to borrow a lot of money at a certain interest rate, and then redeposit the money back into the bank. Each year, bank would loan Knetsch more and more money to be able to pay back the increased interest.
    • It used to be that there was no limitation on the deductibility of interest, and this was a tax dodge. The bank was never out any real money because all the money they loaned Knetsch was sitting in their own vault, and none of Knetsch's assets were ever at risk.
      • It was a non-recourse loan, which meant that if Knetsch defaulted, the bank could never get at Knetsch's assets. All they could get was the money that they had put into their own bank on Knetsch's behalf.
  • When he filed his taxes, Knetsch claimed a deduction for all the interest he was paying, based on 26 U.S.C. 23(b) (now 26 U.S.C. 163(a)). The IRS denied the deduction. Knetsch appealed.
    • The IRS argued that the deduction was unallowable because Knetsch was only doing it to avoid paying taxes.
    • Knetsch argued that the tax code had no explicit limitations on interest deductions.
  • The US Supreme Court denied the deduction.
    • The US Supreme Court noted that only reason for Knetsch's loan was so he could get the interest deduction.
    • The Court also noted that since it was a non-recourse loan, Knetsch could never lose any of his own money, so he had no incentive to keep interest payments to a minimum.
    • The Court found that this was a sham transaction, and interest payments from sham transactions are not deductible.
      • The two basic elements of a sham transaction are that the only purposes of the transaction was to create a deduction and that there were no assets outside of the deal that could be called upon to satisfy any liability (aka a non-recourse loan).