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).
