Comprehensive Analysis of the Michigan Research and Development Tax Credit: The Statutory Function of the Three-Year Average Annual QREs and Regulatory Implementation

The Average Annual QREs for the three preceding calendar years, formally designated as the base amount, serves as the rolling historical benchmark against which current-year innovation investments are measured to determine incremental tax credit eligibility. Under Michigan law, this calculation dictates whether a business receives a baseline 3% credit or qualifies for the significantly higher 10% to 15% incremental rates reserved for research spending that exceeds a company’s recent historical average.1

The Evolution of Innovation Incentives in the Michigan Tax Landscape

The reintroduction of a standalone research and development incentive represents one of the most significant shifts in Michigan’s corporate tax policy in over a decade. To understand the current application of the Average Annual QREs, it is necessary to examine the historical trajectory of Michigan’s business tax environment. From 1976 until 2007, the state utilized the Single Business Tax (SBT), which included various credits for research and development to foster industrial growth.5 This was replaced in 2008 by the Michigan Business Tax (MBT), which maintained similar incentives. However, the transition to the Corporate Income Tax (CIT) in 2012 essentially eliminated most credits, including those for R&D, in an effort to simplify the tax code and lower the overall headline rate.5

This decade-long absence of a dedicated R&D credit eventually placed Michigan at a competitive disadvantage. By 2024, more than 30 other states had established robust R&D incentives, leaving Michigan as an outlier in the Midwest.6 The passage of House Bills 5100 and 5101, signed into law by Governor Gretchen Whitmer in January 2025, sought to rectify this by creating a refundable credit effective for tax years beginning on or after January 1, 2025.5 This legislative package aims to attract high-paying jobs and support sectors such as semiconductors, life sciences, and automotive engineering by lowering the after-tax cost of innovation.6

The mechanism chosen for this incentive—an incremental credit based on a three-year rolling average—reflects a policy goal of rewarding growth. Rather than providing a flat credit on all research spending, the Michigan legislature designed the system to provide the greatest financial relief to those entities that are actively expanding their research footprint within the state.10 The “Average Annual QREs” (the base amount) is the mathematical heart of this growth-oriented strategy.

Defining the Base Amount: The Mechanics of Average Annual QREs

At its core, the Average Annual QREs, or “base amount,” is defined by MCL 206.677 and MCL 206.717 as the average annual amount of qualifying research and development expenses incurred during the three calendar years immediately preceding the calendar year ending with or within the tax year for which a credit is being claimed.2 This definition contains several critical components that taxpayers must analyze to ensure accurate filing.

The first critical component is the requirement for a calendar-year basis. Regardless of whether a taxpayer utilizes a fiscal tax year or a calendar tax year for general income tax purposes, the R&D credit calculation must be performed using data from the calendar years.4 This means a fiscal-year filer with a June 30 year-end must still aggregate its R&D expenses from January 1 to December 31 to establish both the current-year claim and the historical base amount.4

The second component is the “rolling” nature of the average. For a credit claimed in the 2025 tax year, the base period consists of the calendar years 2022, 2023, and 2024.4 For the 2026 tax year, the base period will shift to 2023, 2024, and 2025. This prevents the base from becoming stagnant and ensures that the higher incremental credit rates (10% or 15%) are only applied to spending that represents a genuine increase over the company’s recent performance.10

Statutory Treatment of Incomplete Histories

The legislation provides specific rules for businesses that do not have a continuous three-year history of Michigan-based R&D spending. These rules are designed to prevent the exclusion of startups and new arrivals to the Michigan market.

• New Entrants: For any authorized business with zero prior qualifying research and development expenses in Michigan during the three preceding years, the base amount is legally established as zero.1 This is highly advantageous for new ventures, as it allows their entire current-year QRE spend to be treated as “excess” and qualify for the higher incremental rates.11
• One or Two Years of History: If a business incurred qualifying expenses in only one or two of the immediately preceding three years, the average is calculated by dividing the total expenses by the actual number of years in which those expenses were incurred.1 For example, if a company only had expenses in 2024, that 2024 figure alone becomes the base amount for a 2025 claim.12
• Zero-Expense Years for Existing Firms: A nuance clarified by the Department of Treasury in April 2025 involves companies that existed but spent nothing on R&D. If a company was in operation but incurred no R&D expenses in one of the three years, that year is still included as a zero in the numerator but counts toward the denominator, effectively lowering the base and making it easier to qualify for the higher credit.8

Quantitative Comparison of Credit Tiers

The Average Annual QREs serves as the threshold between two different credit rates. The specific rates and caps depend on the size of the business, measured by the number of employees.

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The application of these rates ensures that even if a company’s R&D spending is flat or declining compared to its three-year average, it still receives a 3% baseline credit for its ongoing commitment to innovation in Michigan.4 However, the 15% rate for small businesses and the 10% rate for large businesses provide a powerful incentive to increase spending year-over-year.10

Qualifying Research Expenses: The Scope of Michigan-Based Activity

The Michigan R&D credit identifies eligible expenditures by referencing Section 41(b) of the Internal Revenue Code (IRC).1 By adopting the federal definition of “qualified research expenses,” the state allows businesses to use existing federal R&D tax credit study data as a foundation for their state-level claims, thereby reducing the administrative burden of compliance.11 However, the Michigan statute imposes a strict nexus requirement: only expenses for research conducted within the borders of Michigan are eligible.1

Categories of Eligible Expenditures

There are three primary categories of costs that constitute a company’s QREs under both federal and Michigan standards.

1. Direct and Indirect Wages: This includes the taxable wages paid to employees who are directly performing research, as well as those who are directly supervising or supporting such research.15 For the purposes of the Michigan credit, the employee must be performing these tasks within Michigan.1
2. Supplies and Materials: Tangible property used in the conduct of qualified research, such as materials used for prototypes, testing, and experimental development, are included.15 This does not include land or depreciable property.15
3. Contract Research Expenses: Payments made to third parties for research performed on behalf of the taxpayer are eligible.15 Under federal rules, which Michigan follows, typically only 65% of these contract costs are includable in the QRE calculation.16 Crucially, the third-party research must be performed within Michigan to be included in the Michigan credit.1

Geographical Limitations and Exclusions

The “Michigan-only” rule is absolute. Even if a Michigan-based company’s employees are conducting research in a neighboring state like Ohio or Indiana, those wages and expenses are excluded from both the current-year calculation and the three-year base amount.1 This requires businesses to implement rigorous cost-tracking systems to segregate Michigan-based R&D activities from their global or national R&D operations.11

Furthermore, the state has decoupled from federal Section 174 expense treatment. While federal law (under the One Big Beautiful Bill Act) may allow for the immediate expensing of domestic R&D costs for 2025, Michigan requires these same costs to be capitalized and amortized over five years for state income tax purposes.8 This decoupling makes the refundable R&D credit even more vital for corporate liquidity, as it helps offset the tax burden created by the forced amortization of research costs.17

Department of Treasury Guidance: The April 2025 Regulatory Clarifications

The Michigan Department of Treasury is the primary administrative body responsible for the oversight of the R&D credit. In April 2025, the Treasury issued a critical “Response to Comments” document that provided detailed interpretations of the law following feedback from the Michigan Association of CPAs (MICPA) and other industry stakeholders.8 This guidance is essential for businesses attempting to calculate their Average Annual QREs correctly.

Short Taxable Years and Calculation Denominators

One of the most complex areas of tax compliance involves “short” taxable years, which often occur due to mergers, acquisitions, or changes in a company’s accounting period. The Treasury clarified that for the purposes of the three-year base amount calculation, short taxable years are treated as full calendar years.8

Importantly, the Treasury specified that only whole numbers (1, 2, or 3) would be used in the denominator of the base year fraction.8 There is no requirement or allowance for the annualization of expenses. For instance, if a company only existed for six months in 2024 and spent $100,000 on R&D, that $100,000 is divided by one to determine the base amount for a 2025 claim; it is not doubled to represent a “full year” of spending.8

Mergers, Acquisitions, and Dispositions

In a significant departure from the federal R&D credit regulations, the Michigan Department of Treasury stated that it would not require or permit the restatement of the base amount following an acquisition or disposition.8 Under federal rules (Treasury Regulation § 1.41-7), a company that acquires another must add the acquired company’s historical R&D expenses to its own base amount to ensure an accurate “growth” measurement. Michigan law, however, only adopts the definition of “qualifying research and development expenses” from IRC 41(b) and does not adopt the federal regulations concerning credit computation or base year restatements.4

This “no restatement” rule has profound strategic implications. A company that acquires a research-heavy firm in Michigan may find its credit potential temporarily inflated because the target’s historical expenses are not added to the acquirer’s base amount.8 Conversely, if a company sells a research division, it cannot subtract those historical expenses from its base, potentially making it harder to exceed the Average Annual QREs in subsequent years.12

Fiscal Year Safe Harbor and Conversion

Because the credit is calculated on a calendar-year basis, the Treasury recognized that fiscal-year filers might struggle to reconstruct historical calendar-year data for the 2022-2024 base period.4 To address this, the Treasury introduced an “optional method” or “safe harbor” for fiscal-year filers to convert their fiscal-year R&D expenses into calendar-year equivalents for the base period years prior to 2025.4 Further details on this conversion method are expected to be published in a forthcoming Revenue Administrative Bulletin (RAB).4

Categorization of Claimants and Employee Counting Rules

The Average Annual QREs is applied differently depending on whether a business is classified as “small” or “large.” This classification is determined by the number of employees.4

The 250-Employee Threshold

The statutory dividing line is 250 employees. This threshold determines not only the incremental credit rate (15% for small, 10% for large) but also the maximum annual credit cap ($250,000 for small, $2,000,000 for large).4

The definition of an “employee” for this purpose is drawn from the Michigan Corporate Income Tax (CIT) Act and IRC Section 3401(c). An employee is any individual from whom an employer is required to withhold federal income tax.4 The Department of Treasury has clarified that this count includes all employees, not just those engaged in R&D activities.4

Unitary Business Groups (UBGs) and Affiliated Entities

For corporations that file as part of a Unitary Business Group (UBG), the credit must be calculated and claimed at the group level.4 The UBG, not its individual members, is considered the taxpayer. Consequently:

• Headcount Aggregation: The 250-employee threshold is measured by the total number of employees across all members of the UBG.8
• Base Amount Aggregation: The Average Annual QREs is calculated using the combined historical Michigan research spending of all members of the group.4
• Single Credit Cap: The group is limited to a single annual cap ($250,000 or $2,000,000), even if multiple members within the group are conducting research.8

Interestingly, the Treasury noted that Michigan does not adopt federal IRC sections regarding the aggregation of entities under “common control” for non-corporate filers.8 Therefore, for flow-through entities that are not part of a corporate UBG, each entity may be able to file for the credit independently, potentially allowing affiliated businesses to claim multiple caps, provided they are truly separate employers.8

The University Collaboration Bonus

To encourage a deeper partnership between the private sector and Michigan’s academic institutions, the legislature included an “Additional Credit” for collaborative research.5 This bonus is separate from the primary 3% and 10/15% tiers but is still dependent on the Average Annual QREs framework.

Bonus Eligibility and Calculation

• Additional Rate: A business can claim an extra 5% credit on the portion of its QREs that were incurred in collaboration with a Michigan research university.2
• Application to Excess Spending: The 5% bonus only applies to those collaborative expenses that are part of the QREs used to calculate the primary credit (i.e., those that exceed the base amount or fall within the 3% base tier).2
• Cap and Agreement: The bonus is capped at $200,000 per taxpayer per year.10 To claim the bonus, the taxpayer must provide a copy of a written agreement with the university if requested by the Treasury.16

A “research university” is defined as a public university described in the State Constitution or an independent nonprofit college or university within Michigan.1 This incentive is particularly relevant for the “innovation corridors” in regions like Ann Arbor and Adrian-Tecumseh, where university-industry ties are traditionally strong.10

Statewide Funding Caps and the Proration Mechanism

While the R&D credit is designed to be a robust incentive, the state has limited its fiscal exposure by implementing an aggregate annual cap of $100,000,000.9 This cap necessitated the creation of a “tentative claim” system and a proration hierarchy to ensure that the credit remains within budget.9

The Proration Hierarchy

The $100 million total fund is allocated between small and large businesses using a “small business first” priority system.

1. Small Business Reserve: $25,000,000 of the total $100,000,000 is reserved specifically for businesses with fewer than 250 employees.10
2. Tier 1 Proration: If small business claims are $25 million or less, they receive 100% of their claimed credits. The remaining balance of the $100 million is then distributed among large business claimants on a pro rata basis.18
3. Tier 2 Proration: If small business claims exceed $25 million, they are prorated so that the total small business pool equals $25 million. Large businesses are then prorated to a total of $75 million.9
4. The 25% Aggregate Trigger: If the total claims from small businesses exceed 25% of the aggregate value of all claims (both small and large), the specialized pools are ignored. Instead, all claimants, regardless of size, are prorated based on their share of the $100 million total.9

Proration Scenario Analysis

To illustrate how proration might affect a business, consider a year where total tentative claims reach $150 million.

Note: If Small Business claims ($40M) were more than 25% of total claims ($150M), which they are (26.6%), then all businesses would receive the same 66.6% proration factor. 9

This structure creates significant uncertainty for taxpayers. A business may calculate a tentative credit of $100,000, but they might only receive $66,600 after the Treasury applies the statewide proration factors.9 The Treasury has stated it will attempt to publish the final proration adjustments by April 30th each year to allow for timely return filing.8

Compliance Deadlines and Administrative Procedures

Because of the proration rules, Michigan’s R&D credit follows a strict two-step compliance calendar that differs significantly from federal R&D credit filing.

Step 1: The Tentative Claim

Taxpayers must notify the Treasury of their intent to claim the credit by filing a tentative claim. This document must include the business’s total Michigan QREs, its Average Annual QREs (base amount), its employee count, and any university collaborative expenses.13

• 2025 Expenses: The tentative claim is due by April 1, 2026.4
• 2026 and Later Expenses: The tentative claim is due by March 15 of the following year.4

Failure to file a tentative claim by these deadlines results in a forfeiture of the credit for that year. The Treasury has emphasized that these claims must be based on actual, realized expenses, not estimates, to ensure the integrity of the proration calculation.8

Step 2: The Annual Return and Refund

Once the Treasury issues the proration notice, the taxpayer reports the finalized credit on its annual tax return.

• Corporate Filers: The credit is reported on the annual Corporate Income Tax (CIT) return.13
• Flow-Through Entities: The credit is reported on the annual withholding tax return for the year in which the tentative claim was filed.3
• Refundability: If the credit exceeds the taxpayer’s state tax liability, the excess is fully refundable.10

Unlike some other state credits, there is no provision for the carryforward or carryback of the Michigan R&D credit. Because it is refundable, any excess credit is paid out immediately in cash, providing vital liquidity to research-intensive firms that may not yet be profitable.8

Mathematical Example: Case Study of a Michigan Semiconductor Startup

To demonstrate the practical application of the Average Annual QREs and the tiered credit structure, let us analyze “Silicon Mitten Inc.,” a hypothetical semiconductor design firm based in Ann Arbor.

Historical and Current Year Data

Silicon Mitten Inc. has fewer than 250 employees and is therefore classified as a small business. Its Michigan-based QREs for the base period were as follows:

• 2022 QREs: $200,000
• 2023 QREs: $250,000
• 2024 QREs: $300,000
• 2025 Current Year QREs: $800,000

In 2025, the firm also collaborated with the University of Michigan, incurring $100,000 in expenses specifically related to that partnership.

Phase 1: Calculating the Average Annual QREs (Base Amount)

$$BA = \frac{\$200,000 + \$250,000 + \$300,000}{3} = \$250,000$$

Phase 2: Calculating the Unadjusted Primary Credit

The credit is split between the portion up to the base and the portion in excess of the base.

1. 3% on the Base Amount: $\$250,000 \times 0.03 = \$7,500$
2. 15% on the Excess Amount: $(\$800,000 – \$250,000) \times 0.15 = \$550,000 \times 0.15 = \$82,500$
3. Total Primary Credit: $\$7,500 + \$82,500 = \$90,000$

Phase 3: Calculating the University Bonus

The bonus is 5% of the collaborative expenses that fall within the credit-eligible pool.

• University Bonus: $\$100,000 \times 0.05 = \$5,000$

Phase 4: Applying the Individual Taxpayer Cap

• Total Tentative Claim: $\$90,000 + \$5,000 = \$95,000$
• Since $95,000 is less than the $250,000 cap for small businesses, the firm submits a tentative claim for the full $95,000.11

Phase 5: Proration and Final Credit

If the statewide proration notice subsequently indicates a 10% reduction due to high program demand, the final credit awarded to Silicon Mitten Inc. would be:

• Final Credit: $\$95,000 \times 0.90 = \$85,500$

If Silicon Mitten Inc. has a Michigan tax liability of $5,000, it would use $5,000 of the credit to zero out its tax and receive a $80,500 cash refund.11

Strategic Considerations and Future Outlook

The introduction of the Michigan R&D tax credit creates a complex set of incentives for business leaders and tax professionals. The use of a three-year Average Annual QREs means that the credit is most valuable to companies in a phase of rapid expansion. For established firms with mature research operations, the credit may function more as a 3% baseline incentive, whereas for startups, it can represent a massive 15% to 20% subsidy on new R&D spending.10

Decoupling and the Amortization Hurdle

One of the most important insights for the future is the interaction between this credit and the capitalization requirements of IRC Section 174. Because Michigan has decoupled from federal expensing, companies will see a higher “book-to-tax” difference on their Michigan returns, often leading to a higher initial tax liability.8 The R&D credit is specifically designed to bridge this gap. Companies must ensure their tracking systems are robust enough to capture the Michigan-specific data required to defend a claim in the event of a Treasury audit.17

Transparency and Reporting

Claimants should be aware that the law requires a degree of transparency that is not found in federal R&D tax filings. The Michigan Department of Treasury is required to submit an annual report to the legislature that includes the name of each business receiving a credit and the amount allowed.9 While the Treasury has stated that its proration notices will not contain taxpayer-specific data to protect privacy, the final legislative report is a public record.8

Conclusion

The Michigan Research and Development Tax Credit, through its innovative use of the Average Annual QREs, provides a structured and fiscally responsible method for the state to support its high-tech economy. By rewarding the growth of research activity rather than merely subsidizing existing operations, the credit aligns corporate incentives with the state’s broader economic goals of job creation and technological leadership. For businesses, the key to maximizing this benefit lies in understanding the granular details of the three-year base amount calculation, the strict geographical boundaries of eligible expenses, and the administrative rigor of the tentative claim process. As Michigan continues to position itself as a hub for the next generation of industrial innovation, the R&D credit will undoubtedly serve as a cornerstone of its economic development toolkit..6

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