Ekman v. Commissioner (1999)
Ekman v. Commissioner, 184 F.3d 522 (6th Cir. 1999)
Leonard and Kaye Ekman, in their 1991 joint income tax return, claimed the cost of a Porsche engine that Leonard performed R&D work on. However, the tax court found that this was not a deductible research and development expense, because it was an asset. The Ekmans appealed this decision.
The Commissioner found 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 expenses, except for the $7,000 claimed for the cost of the engine.
The Porsche 928 S4 engine was designed to run comfortably at speeds of 130 to 150 miles per hour. However, Leonard Ekman felt there was a niche market for a racing vehicle with this engine, and as such he began work on this. He started development work on a Porsche 928 S4 two-valve engine in 1984. In late 1991 he sought to intensify his efforts, and purchased a damaged Porsche 928 S4 four-valve engine for $7,000. Ekman also enlisted other people to help with his developments; he developed the engine while they developed other parts to enhance the engine. During the process he also bought two used Porsche automobiles that provided the parts and body for the enhanced engine.
The objective of Ekman’s projects was not to sell the modified engine, but just to make the modifications, and if successful they would be implemented on other 928 S4 engines. He was successful in increasing the engine’s horsepower.
Supplies are deductible if they are used in the project and can’t be used again, but there is a certain amount of allowance for natural ‘wear and tear’. For example, metal bent/manipulated during a project is claimable (because it can’t be used again), but if the company buys a new wrench this can’t be claimed. The wrench, in this scenario, is an asset that might have natural damage, but it was not bought solely for use in this project. The tax court concluded that the expenditure for the engine was not deductible, because the engine was subject to this wear and tear, rather than damage during the R&D process.
Ekman argued that the asset to be depreciated was used in producing final goods to be sold (i.e. the engine was a depreciable asset, but could be claimed because it was used for R&D). The court disagreed. An expense being deductible or only depreciable refers only to the character of the property, not the use of the property.
Ekman also argued that the cost of the engine wasn’t depreciable because the engine was “not subject to wear and tear, but is intentionally being destroyed as part of the on-going research”. He said that the engine was bought for the purpose of “blowing it up”, but his testimony made it clear that the engine was repaired, modified, and still running after five years. He explained that by “blowing” the engine, he meant some internal damage. The engine would then be taken apart and examined for wear and repaired.
The court decided that the property was subject to wear and tear, even excessive wear and tear, and therefore a depreciable rather than deductible research or experimentation expense.
Qualified Research Expenses (QREs) are split into categories: in-house wages, contractor costs, supplies and computer rental. Supplies can be claimed if they’re used in the R&D projects, and are likely to be fully used, or destroyed, during the experimentation. For example, computers, wrenches, and test tubes are all supplies that may be used in the R&D activities, but they’re considered assets because they can be used multiple times and are likely to last a number of years. They will eventually need to be replaced because of general wear and tear, but are not considered deductibles. Comparatively, supplies like metal, wood, and chemicals are likely to be used in only this experimentation, and cannot be used again. Therefore, they’re a supply, rather than an asset, and can be claimed in the R&D tax claim. The line between these two is not often so obvious, so it’s a good idea to get advice from industry experts.
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