Ekman v. Commissioner

The statutory architecture of the United States tax code regarding innovation has undergone profound transformations since the mid-twentieth century, moving from a regime of immediate incentive to one of mandatory capitalization and strategic substantiation. At the heart of this legal evolution lies a series of pivotal court cases that have defined the boundaries of what constitutes a deductible research expense versus a capital investment. Among these, the litigation involving Leonard and Kaye Ekman serves as a primary touchstone for understanding the distinction between "supplies" used in research and "depreciable assets" that support it. The legacy of Ekman v. Commissioner, 184 F.3d 522 (6th Cir. 1999), along with subsequent interpretations in cases such as Ekman v. Commissioner, T.C. Memo. 2017-107, provides a comprehensive framework for analyzing the rigorous documentation standards and the "character of property" doctrine that continue to govern R&D tax credit applications today.

Historical Context and the Legislative Intent of Section 174

To appreciate the significance of the Ekman decisions, one must first understand the historical purpose of Internal Revenue Code (IRC) Section 174. Enacted in 1954, Section 174 was designed to eliminate the pervasive uncertainty that had previously surrounded the tax treatment of research and experimental expenditures. Before its inception, businesses often struggled to determine whether costs associated with developing new products should be capitalized as long-term assets or deducted as current business expenses. This ambiguity particularly disadvantaged small businesses and startups that lacked the sophisticated accounting departments of larger industrial conglomerates. By allowing for the immediate deduction of research and experimental (R&E) costs, Congress sought to level the playing field and incentivize domestic innovation across all sectors of the economy.

The introduction of the Credit for Increasing Research Activities under Section 41 in 1981 added a secondary layer to this incentive structure. While Section 174 addresses the deductibility (and now amortization) of research costs, Section 41 provides a dollar-for-dollar tax credit for a specific subset of those costs, known as Qualified Research Expenses (QREs). Crucially, the eligibility for the Section 41 credit is predicated on the expenditure first satisfying the requirements of Section 174. If an item fails to meet the definition of a research expenditure under Section 174—often because it is deemed a depreciable asset rather than a consumable supply—it is automatically disqualified from the research credit calculation. This hierarchical relationship forms the basis for much of the litigation in this field, as taxpayers seek to maximize their credits by categorizing high-value equipment and prototypes as deductible supplies.

The Porsche Engine Controversy: Ekman v. Commissioner (1999)

The most cited iteration of the Ekman litigation involves the 1991 joint income tax return of Leonard Charles Ekman and Kaye Layne Ekman. Leonard Ekman was a developer focused on the high-performance automotive market, specifically targeting the potential for racing vehicles utilizing the Porsche 928 S4 engine. This engine was a sophisticated four-valve power plant designed for sustained speeds of 130 to 150 miles per hour, representing a significant technological undertaking for an independent developer. Ekman had been conducting research on a two-valve version of the engine since 1984, but in late 1991, he purchased a damaged four-valve version for $7,000 to intensify his development efforts.

The research project involved more than just the engine itself; Ekman collaborated with other specialists who were tasked with developing complementary components to enhance the engine's overall performance and horsepower. The primary objective of the project was not to sell the specific engine purchased but to perfect a series of modifications—including cam, piston, engine block, and cylinder head developments—that could be implemented on other 928 S4 engines for commercial sale.

The Core Dispute and Tax Court Findings

The Commissioner of Internal Revenue challenged several deductions claimed on the Ekmans' Schedule C for the 1991 tax year. Initially, the Commissioner disputed over $18,000 in itemized deductions related to the development of the cam, piston, engine block, and cylinder heads, as well as the $7,000 cost of the Porsche engine. The Commissioner's position was that all these items were capital expenditures subject to depreciation over their useful lives rather than immediate deduction.

Before the trial, a partial settlement was reached in which the Commissioner allowed the deductions for the various component development costs. However, the $7,000 expenditure for the engine remained in dispute. The Tax Court, and subsequently the Sixth Circuit Court of Appeals, was forced to grapple with the definition of "property of a character subject to an allowance for depreciation" as found in Section 174(c).

The Tax Court concluded that the Porsche engine was an asset of a character subject to depreciation and was used in connection with research or experimentation. Consequently, the $7,000 cost was not deductible under Section 174(a). The Ekmans appealed, presenting a nuanced but ultimately unsuccessful argument that challenged the very nature of what makes an asset depreciable in an R&D context.

The "Character vs. Use" Doctrine in R&D Jurisprudence

The Sixth Circuit's ruling in Ekman solidified a critical legal distinction: the deductibility of an expense is determined by the "character" of the property rather than its "use" in a specific project. This distinction has become a cornerstone of IRS examinations for R&D tax credits.

Arguments Regarding Final Goods and Intellectual Property

Leonard Ekman argued that the engine should be deductible because it was not used to produce final goods for sale. He posited that since the engine was merely a test platform for modifications that would eventually be sold as intellectual property or service-based upgrades, it did not fit the traditional model of a depreciable asset used in production. The court disagreed, stating that the clear import of the tax code is that the inherent nature of the property is what matters. If an engine is the type of property that normally wears out over time—even if it is being used for research—it must be capitalized.

The "Intentional Destruction" and "Blowing It Up" Defense

Perhaps the most memorable aspect of the Ekman case was the taxpayer's claim that the engine was purchased specifically for the purpose of "blowing it up" as part of the research process. Under tax law, if a piece of property is consumed or destroyed during experimentation, it may lose its character as a depreciable asset and instead qualify as a deductible supply. Ekman testified that "blowing the engine" meant causing internal damage through high-performance testing to identify failure points.

However, the court found Ekman’s testimony undermined his own legal position. Evidence showed that while the engine was subjected to extreme stress, it was repeatedly repaired and modified. Crucially, the engine was still running five years after the initial purchase. The court ruled that "excessive wear and tear" is not the same as "destruction". This finding created a high bar for future taxpayers: to claim a high-value asset as a supply, they must demonstrate that the item was rendered useless or essentially non-existent by the experimentation.

Implications for Supply Classification under Section 41

The Ekman decision has significant ripple effects on how "supplies" are calculated for the Section 41 research credit. Under Section 41(b)(2)(C), supplies are defined as any tangible property other than land, improvements to land, and property of a character subject to an allowance for depreciation. By affirming that the engine was a depreciable asset, the court ensured its exclusion from the credit base.

The Ekman principle acts as a "wrench" that can remove significant costs from a taxpayer's R&D claim if they cannot prove the property lacks a depreciable character. This is particularly relevant in industries like aerospace or heavy machinery, where prototypes may cost millions of dollars but still maintain a "character" that could be subject to depreciation if they are not destroyed during testing.

The Second Ekman Case: Related-Entity Transactions and Substantiation

While the 1991 Porsche case is the most famous, the litigation involving the name Ekman appeared again in Ekman v. Commissioner, T.C. Memo. 2017-107, highlighting a different but equally vital aspect of tax compliance: the substantiation of payments between related entities. In this 2017 case, the taxpayer was a realtor and cinematographer who operated several single-member LLCs and a C corporation. The IRS questioned payments made from one of the LLCs to the C corporation, totaling $191,000 for "consulting fees" and $75,000 for "commissions and fees".

The 2017 case serves as a warning for taxpayers who use complex corporate structures to manage their R&D activities. When transactions do not occur between unrelated parties, the "market-based check on reasonableness" is absent. The court noted that merely providing accounting records and bank statements is insufficient to prove that an expense is "ordinary and necessary" under Section 162. The taxpayer failed to provide testimony explaining how the expenses were calculated or whether the corporation charged third parties similar amounts for the same services.

The Nexus of Reasonableness and R&D Credits

The 2017 Ekman decision reinforces the necessity of "contemporaneous documentation" that goes beyond simple bookkeeping. For R&D purposes, this means that even if a taxpayer is paying a related entity for "contract research," they must be able to demonstrate that the amount paid was reasonable and that the entity paying received something of value in return. The lack of a "market check" requires the taxpayer to be even more diligent in documenting the specific research activities performed by the related entity.

The Modern Procedural Landscape: Section 174 Amortization

A seismic shift in the application of Section 174 occurred with the Tax Cuts and Jobs Act (TCJA) of 2017, which took effect for tax years beginning after December 31, 2021. This legislation eliminated the historical ability to immediately deduct domestic R&E expenditures. Instead, taxpayers are now required to capitalize "specified research or experimental" (SRE) expenditures and amortize them over a set period.

Amortization Timelines and International Implications

The current amortization regime creates a stark divide between domestic and foreign research, reflecting a strong legislative preference for onshoring R&D activities.

This new requirement has significant cash-flow implications for companies that previously relied on immediate deductions to fund their ongoing operations. The Ekman (1999) decision remains relevant in this context because it helps define which costs must be captured in this amortization pool. If a cost is deemed a depreciable asset under Section 167/168 (like the Porsche engine), it follows a different depreciation schedule than the 5-year SRE amortization mandated by Section 174. For example, a computer used in research might be depreciated over five years under standard MACRS rules, but the software development costs associated with it must now be amortized over five years under the new Section 174.

The Section 41 Four-Part Test and Judicial Scrutiny

To successfully claim an R&D tax credit in the current environment, a taxpayer must satisfy the "Four-Part Test" for each business component. The Ekman legacy is most influential in the first and third prongs of this test.

• Section 174 Test: The activity must be eligible to be treated as an R&E expense under Section 174.
• Technological in Nature: The research must rely on the principles of physical or biological sciences, engineering, or computer science.
• Permitted Purpose: The research must be aimed at developing a new or improved business component related to function, performance, reliability, or quality.
• Process of Experimentation: Substantially all (at least 80%) of the activities must constitute elements of a process of experimentation.

The Technological Uncertainty Requirement

The Section 174 test requires the identification of "technological uncertainty" regarding the capability, method, or appropriate design of a product. In Phoenix Design Group, Inc. v. Commissioner, the court ruled that simply performing iterative engineering calculations on available data does not constitute "investigative activity". The court noted that "basic calculations on available data is not an investigative activity because the taxpayer already has all the information necessary to address that unknown". This underscores the need for taxpayers to document what was unknown at the start of the project and how the research was intended to eliminate that specific uncertainty.

The "Substantially All" and "Shrinking Back" Rules

One of the most complex aspects of Section 41 is the requirement that "substantially all" of the research activities must constitute a process of experimentation. The IRS defines "substantially all" as 80% or more, measured by costs or another reasonable basis. If an entire project fails this test (for example, if a company is building a custom electrical distribution system but only 50% of the work involves resolving technological uncertainty), the taxpayer must "shrink back" the claim to the largest subset of the project that does meet the 80% requirement.

The Ekman Porsche engine can be viewed through this "shrinking back" lens. If Ekman had been building an entire car using known chassis and body designs, the project might have failed the "substantially all" test at the level of the "car" business component. However, by shrinking back to the "engine" or even "piston" development, he was able to satisfy the requirements for those specific components—a concept validated by the Commissioner's concession on the other development costs in the 1999 case.

Funded Research and the Allocation of Economic Risk

A major battleground in R&D tax litigation is the "funded research" exclusion. Under Section 41(d)(4)(H), research is excluded from the credit if it is "funded" by another person or entity through a grant or contract. To avoid this exclusion, a taxpayer must prove that they bear the "economic risk" in the event of failure and that they retain "substantial rights" to the research results.

The Impact of System Technologies and Smith (2025)

Recent 2025 decisions, such as System Technologies, Inc. v. Commissioner and Smith et al. v. Commissioner, have provided significant victories for taxpayers regarding the funding question. In these cases, the IRS argued that research was funded because the contracts were "fixed-price" or included "progress payments". However, the Tax Court turned to state contract law and the Uniform Commercial Code (UCC) to determine risk.

The court in System Technologies held that if a research provider fails to deliver a successful product, state law (specifically Indiana’s UCC) allows the client to seek a refund of all amounts paid. Therefore, the research provider remains at economic risk even if the contract itself is silent on the matter. This highlights a critical implication: taxpayers do not necessarily need to have their contracts written with "R&D tax credit language" in mind, as long as the underlying legal framework of the jurisdiction places the risk of failure on the researcher.

Rights to Exploitation

The second prong of the funded research test—the retention of substantial rights—requires that the researcher have the right to use the results in their own trade or business without paying the client for that privilege. In Smith, the court ruled that the "transfer of documents with shared rights alone does not divest the taxpayer of substantial rights". This is vital for professional service firms, such as architectural or engineering companies, which often provide designs to clients but retain the internal knowledge and rights to use those techniques on future projects.

Substantiation Strategies and the Role of Statistical Sampling

As the IRS adopts stricter standards, the methodology used to calculate credits is becoming as important as the research itself. In Kapur et al. v. Commissioner (2024), the court addressed the use of "variable sampling" from a frame of 2,000 to 3,000 projects. The taxpayer wanted to limit discovery to only the largest projects, but the court ruled that the IRS is entitled to review the entire sampling frame to verify the accuracy of the extrapolation.

The Union Carbide decision remains a "positive precedent" for taxpayers because it confirms that oral testimony and "re-creation" of records can be used to satisfy the burden of proof if original records are unavailable. However, the court's willingness to apply the "Cohan rule"—which allows the court to make an estimate of expenses—is typically reserved for cases where the taxpayer has some documentary evidence to support their claims.

Future Outlook: Legislative Uncertainty and the 2025/2026 Transition

The R&D tax credit landscape remains in flux due to potential legislative changes. There is ongoing discussion in Congress regarding the potential reinstatement of the immediate deduction for Section 174 expenditures, particularly as the sunset provisions of the TCJA begin to impact corporate cash flows.

Potential Transition Rules and Small Business Relief

As of late 2025, proposed rules suggest a potential transition period for small businesses.

• Retroactive Election: "Eligible small businesses" may be able to elect to apply Section 174A retroactively by amending their 2022-2024 tax returns to deduct R&E costs immediately.
• Full Deduction in 2025: Some proposals allow taxpayers to deduct any remaining unamortized domestic R&E costs entirely in 2025 or over a two-year period (2025-2026).

These potential changes emphasize the importance of maintaining highly detailed records now. If a company is currently amortizing an expense that later becomes deductible, they will need project-level data to correctly file amended returns and capture the full benefit of the tax incentive.

Conclusion: Synthesizing the Ekman Legacy for Future Applications

The case of Ekman v. Commissioner serves as more than just a cautionary tale about a Porsche engine; it is a fundamental lesson in the "character of property" and the necessity of rigorous substantiation. For modern taxpayers, the implications are clear: the IRS is looking for a structured process of experimentation that is documented from the outset and tracks the precise nexus between activities and costs.

As the United States continues to incentivize domestic innovation through a complex web of capitalization, amortization, and credits, the Ekman standard ensures that these incentives are targeted toward the process of discovery rather than the accumulation of durable assets. Whether it is the cinematographers of the 2017 case or the automotive engineers of the 1999 case, the message from the courts is the same: the privilege of a tax incentive comes with the burden of proving that the expenditure was truly ordinary, necessary, and consumable in the pursuit of technological progress.

Taxpayers must now navigate the "funded research" exclusions by carefully analyzing the allocation of risk in their contracts and ensuring that they retain the rights to the knowledge they create. By combining the lessons of Ekman with an understanding of the new Section 174 amortization rules and the latest "funded research" jurisprudence, businesses can build "bulletproof" claims that withstand the scrutiny of a more vigilant Internal Revenue Service. The final lesson of the Porsche engine remains: if it is still running five years after you bought it, it is likely an asset, not an R&D supply.