Ekman v. Comm'r of Internal Revenue, PETITIONERS-APPELLANTS

• Decision Date: 22 April 1999
• Docket Number: No. 98-1576,PETITIONERS-APPELLANTS,RESPONDENT-APPELLEE,98-1576
• Citation: 184 F.3d 522
• Parties: (6th Cir. 1999) LEONARD CHARLES EKMAN; KAYE LAYNE EKMAN,, v. COMMISSIONER OF INTERNAL REVENUE, Argued:
• Court: U.S. Court of Appeals — Sixth Circuit

Page 522

184 F.3d 522 (6th Cir. 1999)

LEONARD CHARLES EKMAN; KAYE LAYNE EKMAN, PETITIONERS-APPELLANTS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT-APPELLEE.

No. 98-1576

U.S. Court of Appeals, Sixth Circuit

Argued: April 22, 1999

Filed: June 04, 1999

Paul Croushore, JD, LLM (argued and briefed), Cincinnati, OH, for Petitioners-Appellants.

William S. Estabrook (briefed), Joel L. McElvain (argued), U.S. Department of Justice, Appellate Section, Tax Division, Jeffrey R. Meyer (briefed), Tax Division, Department of Justice, Washington, D.C., for Respondent-Appellee.

On Appeal from the United States Tax Court. No. 01920-95.

Before: Guy, Suhrheinrich, and Gilman, Circuit Judges.

OPINION

Ralph B. Guy, Jr., Circuit Judge.

Taxpayers Leonard Charles Ekman and Kaye Layne Ekman appeal from the United States Tax Court's decision on their petition for redetermination of the tax deficiencies in their joint income tax for the year 1991 set forth in a notice of deficiency issued by the Commissioner of Internal Revenue. The taxpayers argue on appeal that the tax court erred (1) in finding that the cost of a Porsche automobile engine purchased by Leonard Ekman was not a deductible research or experimental expense under 26 U.S.C. § 174 and Treas. Reg. § 1.174-2(b); 26 C.F.R. § 1.174-2(b); and (2) in denying the taxpayers' petition for litigation costs under 26 U.S.C. § 7430 on the grounds that the Commissioner's position was substantially justified. After review of the record and the arguments on appeal, we affirm in all respects.

I.

The parties submitted a stipulation of certain facts and exhibits to the tax court. Between the stipulations, the tax court's decision and the parties' briefs, there do not appear to be significant disputed issues of fact. The tax court succinctly set forth the following pertinent facts.

Petitioner [Leonard Ekman] is a graduate of the U.S. Air Force Academy and retired after a career in the Air Force. He possesses dual degrees from the Air Force Academy in aeronautical engineering and political science. He also has advanced degrees from other institutions of higher learning. While petitioner was on active duty in the Air Force, he developed an interest in the Porsche automobile, which is manufactured in Germany. Although Porsche produced several types of engines, petitioner was particularly interested in the Porsche 928 S4 engine. From the evidence adduced at trial, it appears that this engine was designed to run comfortably at speeds of 130 to 150 miles per hour; however, the engine was not designed for racing. Petitioner became interested in developing modifications to the engine that would increase the engine's horsepower so that the car would be adaptable for racing and still could be used as a regular street vehicle. Petitioner felt that there was a niche in the market for this type of vehicle, although the manufacturer, Porsche, was not interested in producing such an engine for the reason that Porsche offered other types of engines for racing purposes. The Porsche 928 S4 engine is a V-8 engine, while other engines Porsche produces are V-6.

Petitioner began working on his concept around 1984, initially on a Porsche 928 S4 two-valve engine. In late 1990, petitioner decided to intensify his efforts to develop the engine modifications. After consultations with other mechanics who were familiar with the Porsche engine it was suggested to petitioner that his concept would be more suitable for a four-valve Porsche engine rather than a two-valve engine.

In March 1991, petitioner purchased a damaged Porsche 928 S4, four-valve engine, on which he would make the modifications to enhance the engine. Later, in 1991, petitioner enlisted other individuals to participate in the venture. Under the agreement with his partners, the enhancement of the engine remained an activity of petitioner, and his partners were to develop and produce the other parts and components that would complement the enhanced engine. The damaged engine petitioner purchased cost $7,000. Petitioner made the necessary repairs to the engine and then made the necessary modifications to enhance the engine. There is no dispute that petitioner reached his objective of increasing the engine's horsepower. In arriving at that goal, several other modifications were necessary along the way that petitioner had apparently not anticipated.... In addition, petitioner purchased two used Porsche automobiles. They provided the parts and the body into which the $7,000 engine was placed after the engine enhancements had been completed.

The $7,000 engine that petitioner modified was not intended to be sold but, rather, was intended to be used for purposes of making the modifications to see if such modifications would work. The enhanced engine was not designed for, nor was it intended to be, a finished product but, rather, was used solely for purposes of making the modifications that, if successful, would be implemented on other 928 S4 Porsche engines and marketed.

The Commissioner's statutory notices of deficiency issued November 4, 1994, asserted an income tax deficiency of $2,929 for the tax year 1991 resulting in part from the disallowance of over $18,000 in itemized deductions from Schedule C (profit or loss from a business). The Commissioner averred that expenses claimed for cam development, piston development, engine block development, cylinder head development, and the damaged Porsche engine were not deductible because they were capital expenditures which must be depreciated when placed in service. Before trial, the Commissioner agreed to allow all of the disputed Schedule C expenses, except for the $7,000 claimed for the cost of the engine.

After a one-day trial concerning the tax treatment of this expenditure, the tax court determined in a written memorandum opinion that the cost of the engine was not deductible under 26 U.S.C. §174(a) or §179, but was depreciable.¹ In a separate order, the tax court denied the taxpayers' motion for an award of reasonable litigation costs, finding that the position of the Commissioner was "substantially justified." On February 4, 1998, the tax court accordingly entered its decision declaring a deficiency in income tax of $307 for the tax year 1991 and denying the request for litigation costs. The taxpayers filed this appeal.

II.

A. Deficiency

The Commissioner's deficiency determinations are presumed correct and the taxpayer bears the burden of proving otherwise. See Kearns v. Commissioner, 979 F.2d 1176, 1178 (6th Cir. 1992); Smith v. Commissioner, 926 F.2d 1470, 1474 (6th Cir. 1991). We review the tax court's findings of fact for clear error and its application of law de novo. Deductions are a matter of legislative grace, and the taxpayer must satisfy the specific statutory requirements claimed to reduce a tax liability. See New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

Under Internal Revenue Code § 174(a), "[a] taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account. The expenditures so treated shall be allowed as a deduction." 26 U.S.C. § 174(a). This section further provides in subpart (c), however, that:

"This section shall not apply to any expenditure for the acquisition or improvement of land, or for the acquisition or improvement of property to be used in connection with the research or experimentation and of a character which is subject to the allowance under section 167 (relating to allowance for depreciation, etc.) or section 611 (relating to allowance for depletion); but for purposes of this section, allowances under section 167, and allowances under section 611, shall be considered as expenditures." 26 U.S.C. § 174(c) (emphasis added). In general, § 167 provides that "[t]here shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) -- (1) of property used in the trade or business, or (2) of property held for the production of income."

26 U.S.C. § 167(a).

The regulations expand on these provisions stating in part that "[t]he depreciation allowance in the case of tangible property applies only to that part of the property which is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence." Treas. Reg. § 1.167(a)-2; 26 C.F.R. § 1.167(a)-2. With respect to the deduction under §174, the regulations provide in Treas. Reg. § 1.174-2(b), in pertinent part, as follows:

"(2) Expenditures for research or experimentation which result, as an end product of the research or experimentation, in depreciable property to be used in the taxpayer's trade or business may, subject to the limitations of subparagraph (4) of this paragraph, be allowable as a current expense deduction under section 174(a)...."

"...."

"(4) The deductions referred to in subparagraphs (2) and (3) of this paragraph for expenditures in connection with the acquisition or production of depreciable property to be used in the taxpayer's trade or business are limited to amounts expended for research or experimentation. For the purpose of the preceding sentence, amounts expended for research...