                         T.C. Memo. 1997-318



                       UNITED STATES TAX COURT



         LEONARD CHARLES AND KAYE LAYNE EKMAN, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent


     Docket No. 1920-95.                 Filed July 9, 1997.


     Paul Croushore, for petitioners.

     James W. Ruger, for respondent.



                          MEMORANDUM OPINION


     COUVILLION, Special Trial Judge:    This case was heard

pursuant to section 7443A(b)(3)1 and Rules 180, 181, and 182.

     Respondent determined a deficiency of $2,925 in petitioners'

Federal income tax for 1991.    The issues for decision are:

     1
           Unless otherwise indicated, section references are to
the Internal Revenue Code in effect for the year at issue. All
Rule references are to the Tax Court Rules of Practice and
Procedure.
                                - 2 -


(1) Whether petitioners are entitled, under section 174(a), to a

deduction for the cost of an automobile engine that was used in

connection with a research or experimentation activity of Leonard

Charles Ekman (petitioner); (2) if the automobile engine is not

deductible as a research or experimentation expense, whether the

cost is deductible under section 179; and (3) if the cost of the

automobile engine is not deductible under either section 174(a)

or section 179, whether the engine is depreciable under section

167.

       Some of the facts were stipulated.   Those facts, with the

annexed exhibits, are so found and are incorporated herein by

reference.    At the time the petition was filed, petitioners,

husband and wife, were legal residents of Panama City, Florida.

       Although the issues in this case involve one item, an

automobile engine that was used in a research and experimental

activity, there are several other adjustments in the notice of

deficiency as to which the parties reached a basis for settlement

prior to trial.2

       2
          On their income tax return, petitioners claimed
Schedule A itemized deductions of $11,819. In the notice of
deficiency, respondent disallowed these expenses as itemized
deductions but allowed Schedule E expenses on rental property of
$12,725 and $1,790 for depreciation. Petitioners agree to these
adjustments. On Schedule C of their income tax return, relating
to petitioners' research or experimental activity, petitioners
claimed expenses totaling $18,305 that respondent totally
disallowed. Respondent, however, allowed a deduction, under
Schedule C, in the amount of $609, for expenses petitioners had
                                                   (continued...)
                               - 3 -


     Petitioner 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



     2
      (...continued)
not claimed on their return. In the written stipulation filed at
trial, with respect to the $18,305 disallowed expenses,
respondent conceded that petitioners were entitled to a deduction
for $11,305 of these expenses, leaving at issue $7,000,
representing the cost of the automobile engine referred to in the
statement of issues.
                               - 4 -


engine is a V-8 engine, while the other engines Porsche produces

are V-6 engines.

     The engine enhancements petitioner envisioned for the 928 S4

engine were modifications to the cam, camshaft, pistons, and

cylinders, as well as modifications to the car's braking system,

and other components to complement the modifications.    Without

any modifications, the Porsche 928 S4 engine generated

approximately 66 horsepower per liter, whereas petitioner's

objective was to increase the engine's horsepower to a range of

100 to 118 horsepower per liter, for a total horsepower in excess

of 500 for a 5-liter engine.

     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 the 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
                               - 5 -


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 apparently had not anticipated.    For example, with the

enhanced engine running at higher revolutions per minute,

petitioner had to make modifications to the engine's oil system.

These modifications were also successful.    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.

     Respondent agrees that petitioner was engaged, during 1991,

in an activity that qualified as research or experimentation

under section 174(a).   Respondent, after issuance of the notice
                               - 6 -


of deficiency, conceded petitioners' entitlement to a deduction

of various expenses for research or experimentation on the

subject engine:   $3,050 for cam development, $2,120 for piston

development, $4,135 for engine block development, and $2,000 for

cylinder head development, totaling $11,305.   Respondent

maintains that the $7,000 paid by petitioner for the damaged

Porsche 928 S4 engine does not constitute a research or

experimentation expense on the ground that the engine constituted

the acquisition of another's patent, model, production, or

process under section 1.174-2(a)(1), Income Tax Regs., and,

therefore, the cost of the engine is not deductible.   Respondent

further contends that the engine was an asset used in connection

with research or experimentation under section 1.174-2(b)(1),

(2), and (4), Income Tax Regs., and, therefore, could not be

expensed but could only be depreciated.   However, respondent

further contends that no depreciation should be allowed because

the engine was not placed in service during 1991.

     Petitioners contend that the $7,000 cost of the engine

constitutes a research or experimentation expense that is fully

deductible in 1991 under section 174(a) or, alternatively, under

section 179, or, as a final alternative, that the cost of the

engine may be depreciated under section 167.

     Deductions are a matter of legislative grace, and the

taxpayer must satisfy the specific statutory requirements claimed
                                - 7 -


to reduce a tax liability.    New Colonial Ice Co. v. Helvering,

292 U.S. 435, 440 (1934).    The determinations of the Commissioner

in a notice of deficiency are presumed correct, and the taxpayer

has the burden of proving that the determinations are in error.

Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933).

     Section 174(a)(2) permits a taxpayer to deduct currently

research and experimental expenditures that are paid or incurred

during the taxable year in connection with the taxpayer's trade

or business.   The term "research or experimental expenditures" is

defined in the regulations as "expenditures incurred in

connection with the taxpayer's trade or business which represent

research and development costs in the experimental or laboratory

sense.   The term includes generally all such costs incident to

the development of an experimental or pilot model, a plant

process, or similar property, and the improvement of already

existing property of the type mentioned."    Sec. 1.174-2(a),

Income Tax Regs.; Kollsman Inv. Corp. v. Commissioner, T.C. Memo.

1986-66, affd. 870 F.2d 89 (2d Cir. 1989).

     Section 1.174-2(a)(1), Income Tax Regs., provides that the

term "research or experimental expenditures", among other things,

does not include the costs of acquiring another's patent, model,

production, or process.   Respondent asserts that this provision

precludes petitioners from claiming the cost of the Porsche 928

S4 engine as a research or experimentation expense because the
                               - 8 -


Porsche engine was a patent or model of Porsche, the

manufacturer.   The Court finds it unnecessary to pass upon the

merits of this argument.

     Section 174(c) and section 1.174-2(b)(1), Income Tax Regs.,

provide generally, in pertinent part, that expenditures for the

acquisition of property that is subject to an allowance for

depreciation under section 167 are not deductible under section

174, irrespective of the fact that the property may be used by

the taxpayer in connection with research or experimentation.

However, this portion of the regulations provides further that

"If any part of the cost or acquisition * * * of depreciable

property is attributable to research or experimentation * * *,

see subparagraphs (2), (3), and (4) of this paragraph."    Sec.

1.174-2(b)(1), Income Tax Regs.   Subparagraph (2) then provides

that "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)

* * *, be allowable as a current expense deduction under section

174(a)."   Sec. 1.174-2(b)(2), Income Tax Regs.   The referenced

subparagraph (4) then provides that the deductions allowable in

connection with the property are limited to "amounts expended for

research or experimentation", and that amounts expended for

research or experimentation do not include the costs of the
                               - 9 -


component materials of the depreciable property, the costs of

labor or other elements involved in its construction and

installation, or costs attributable to the acquisition of the

property.   Sec. 1.174-2(b)(4), Income Tax Regs.   An example in

subparagraph (4) is that of a taxpayer who undertakes to develop

a new machine for use in his business.   The taxpayer expends a

total of $30,000 on the project, of which $10,000 represents the

actual costs of material, labor, etc., to construct the machine,

and $20,000 represents research costs that are not attributable

to the machine itself.   In this example, the $20,000 research

costs are deductible, but the $10,000 costs are not deductible

and must be charged to the asset account (the machine).

     In this case, petitioner's payment of $7,000 for the Porsche

engine represented the cost of an asset that was of a character

subject to an allowance for depreciation and that was used in

connection with research or experimentation.   Since the $7,000

was for the acquisition of such an asset, that amount is not

deductible as a research or experimentation expense.    Sec. 1.174-

2(b)(1), (2), (3), and (4), Income Tax Regs.   All other expenses

petitioner incurred in connection with the enhancement of the

engine represented deductible research or experimentation

expenses, and, indeed, respondent has allowed those expenses as

deductions.   For the $7,000 acquisition cost, however, the Court
                                  - 10 -


sustains respondent's determination that no deduction is allowed

under section 174(a).

        Petitioners contend, alternatively, that the $7,000 cost of

the Porsche engine is deductible under section 179.      Under

section 179, a taxpayer may elect to treat the cost of any

section 179 property as a current expense in the year such

property is placed in service.      Sec. 179(a).   The aggregate cost

that a taxpayer may deduct under section 179, for the year 1991,

may not exceed $10,000.3      Section 179(c)(1) provides that an

election must:


          (A) specify the items of section 179 property to which
     the election applies and the portion of the cost of each of
     such items which is to be taken into account under
     subsection (a), and

          (B) be made on the taxpayer's return of the tax imposed
     by this chapter for the taxable year.


     Petitioners made no election on their income tax return for

1991 to expense the $7,000 under section 179 for the Porsche 928

S4 engine.      They are precluded from making that election at this

time.       Starr v. Commissioner, T.C. Memo. 1995-190, affd. without

published opinion 94 F.3d 1146 (9th Cir. 1996).

        Petitioners next argue that, if the subject engine's cost

cannot be expensed under either sections 174 or 179, the cost


        3
               The dollar limitation has been increased for subsequent
years.
                             - 11 -


should be capitalized, and petitioners should be entitled to a

recovery for depreciation under section 167.   Section 167

provides, in part, for the allowance of a depreciation deduction

with respect to "property used in the trade or business".     The

Court disagrees with respondent's factual premise.   The engine

was acquired by petitioner in March 1991, and the record supports

a finding that the research and experimentation was a trade or

business of petitioner and was conducted during 1991.   The

engine, therefore, was placed in service during 1991.

Petitioners, therefore, are entitled to a depreciation deduction

for the cost of the engine for 1991.



                                        Decision will be entered

                                   under Rule 155.
