The Statutory Priority of Nonrefundable Credits in the Michigan Research and Development Tax Framework

In the Michigan tax system, “Nonrefundable Credits (Claimed before R&D Credit)” refers to a mandatory sequence where nonrefundable offsets must reduce a taxpayer’s liability to zero before applying the Research and Development credit. This legislative ordering ensures that taxpayers first exhaust credits that would otherwise expire, thereby preserving the R&D credit’s status as a refundable asset that provides direct cash liquidity.1

The Regulatory Genesis and Legal Framework of Michigan Innovation Incentives

The reintroduction of a state-level Research and Development (R&D) tax credit in Michigan represents a strategic shift in the state’s economic policy, marking the first time such an incentive has been available since the previous program sunset in 2012.4 Effective for tax years beginning on or after January 1, 2025, the Michigan R&D credit was established through a bipartisan legislative package, specifically Public Acts 186 and 187 of 2024, which originated as House Bills 5100 and 5101.5 These acts amend the Michigan Income Tax Act to provide a refundable credit for qualifying research expenses incurred within the state’s borders.8

The legal structure of this credit is inextricably linked to the federal Internal Revenue Code (IRC), specifically Section 41, which defines “qualified research expenses”.1 However, Michigan has established its own unique base amount calculations and rate structures that diverge from the federal Alternative Simplified Credit (ASC) model.4 The most critical statutory nuance for corporate taxpayers is the “ordering rule,” which dictates that the R&D credit must be claimed only after all other nonrefundable credits allowed under the Corporate Income Tax (CIT) have been exhausted.1

This requirement serves a dual purpose: it maximizes the utility of nonrefundable credits that have no value beyond zeroing out a tax liability, and it protects the taxpayer’s ability to receive a refund for the R&D credit. Because the R&D credit is designed to be refundable, any amount of the credit that exceeds the remaining tax liability, after nonrefundable credits are applied, is paid out to the taxpayer as a refund.3

Analyzing the Ordering Hierarchy and Tax Neutrality

The concept of “Nonrefundable Credits (Claimed before R&D Credit)” is central to Michigan’s tax compliance because it defines the “residual tax liability” that the R&D credit eventually addresses. In Michigan, a nonrefundable credit is a tax offset that can reduce a taxpayer’s liability to zero but cannot, by itself, result in a payment from the state if the credit amount exceeds the tax due.3

The Corporate Income Tax Sequence

For standard taxpayers subject to the Michigan Corporate Income Tax (CIT), which is levied at a flat rate of 6.0%, the identification of nonrefundable credits is essential.13 The primary nonrefundable credit currently available to most standard CIT taxpayers is the Small Business Alternative Credit (SBAC).12

The Michigan Department of Treasury requires taxpayers to follow this sequence strictly on their annual returns. If a business were to claim the R&D credit before its nonrefundable credits, it would effectively waste the nonrefundable offsets, as they cannot be carried forward or back in most instances.10 By applying nonrefundable credits first, the taxpayer ensures that every dollar of the R&D credit is either reducing a real tax cost or being returned as cash.

The Role of Certificated Credits

Many taxpayers still utilize certificated credits executed prior to January 1, 2012, under the old Michigan Business Tax (MBT) structure.13 These credits, such as the MEGA Employment Tax Credit, Brownfield Redevelopment Credit, and Historic Preservation Credit, often require the taxpayer to continue filing under the MBT framework.13 When these credits are nonrefundable, they occupy the same pre-R&D slot in the tax calculation. For taxpayers electing to remain under the MBT to claim these credits, the interaction with the new R&D credit requires a hypothetical CIT calculation to determine the final liability.17

Detailed Analysis of Qualifying Research Expenses

To understand the value of the credit that remains after nonrefundable offsets, businesses must accurately calculate their Michigan-specific Qualifying Research Expenses (QREs). The Michigan Department of Treasury mirrors the federal definition under IRC Section 41(b) but adds a critical geographic restriction: only research conducted within Michigan qualifies for the state credit.1

Included Expenditures

Qualified research expenses generally fall into four distinct categories within the Michigan jurisdiction:

1. Wages: Payments made to employees who are directly performing, supporting, or supervising qualified research activities within Michigan.4 This includes taxable wages subject to Michigan withholding.
2. Supplies: Tangible property used in the research process, such as prototypes, raw materials, or chemicals, provided they are not capitalized or subject to depreciation.4
3. Contract Research: A portion, typically 65% as per federal standards adopted by the state, of amounts paid to third-party vendors for research performed on the taxpayer’s behalf within the state.4
4. Cloud Computing and Server Space: Expenditures for the rental of off-site and cloud-based server space specifically for the design or testing of new or improved software or products.10

The Four-Part Test in the Michigan Context

While Michigan guidance confirms that taxpayers should not apply federal regulations or concepts other than those applicable under the Michigan Income Tax Act, the underlying definition of research still relies on the IRS Four-Part Test as a foundational element of IRC Section 41 1:

• Permissible Purpose: The activity must relate to a new or improved function, performance, reliability, or quality of a business component.10
• Elimination of Uncertainty: The research must intend to discover information that would eliminate uncertainty regarding the development or improvement of a product or process.20
• Process of Experimentation: The activities must involve a systematic process of evaluating alternatives, such as modeling, simulation, or systematic trial and error.10
• Technological in Nature: The research must rely on principles of the hard sciences, such as engineering, biology, chemistry, or computer science.4

Computation of the Michigan R&D Credit and Tiered Rates

The calculation of the Michigan R&D credit is tiered based on the size of the company, defined by the number of employees. This distinction is vital, as the small taxpayer category offers a more aggressive credit rate for expenses exceeding the base amount to encourage entrepreneurship and scaling within the state.1

Determining Employee Count

The Michigan Department of Treasury is developing specific guidance for counting employees to determine if a claimant falls above or below the 250-employee threshold.1 Generally, this count applies to the authorized business claiming the credit. For a Unitary Business Group (UBG), the UBG itself is the taxpayer, and eligibility is determined at the group level based on a calculation of the UBG’s combined R&D expenses and base amount.1

The Base Amount Formula

Unlike the federal credit, which often uses a fixed-base percentage or a 50% average for the ASC, Michigan uses a rolling three-year average of actual Michigan QREs as its base amount.4 The mathematical expression for the base amount ($BA$) for a tax year is 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.1

$$BA = \frac{QRE_{n-1} + QRE_{n-2} + QRE_{n-3}}{3}$$

If a taxpayer has been in existence for fewer than three years, the average is taken over the available years. If the taxpayer had no R&D expenses in the prior three years, such as a new startup, the base amount is zero, allowing the company to claim the higher excess rate on its entire first-year spend.9

Credit Rates and Individual Caps

The credit consists of two parts: a 3% credit on expenses up to the base amount, and a higher percentage on expenses that exceed that base.3

University Collaboration Bonus

To incentivize public-private partnerships, Michigan offers an additional 5% credit for QREs incurred in collaboration with a Michigan research university.2 This bonus is capped at $200,000 per year and requires a written agreement with an eligible institution.1 An eligible research university must be a public university in Michigan that is classified as having very high research activity by the Carnegie Foundation for the Advancement of Teaching and spent at least $70 million on R&D in the previous academic year.10

State Revenue Office Guidance and Administrative Milestones

The Michigan Department of Treasury has issued specific notices and instructions to clarify how businesses should navigate the new credit. Key administrative milestones and rules have been established to manage the $100 million statewide annual cap.1

The Tentative Claim Process

Because the statewide total for all R&D credits is capped at $100 million, the Treasury cannot allow businesses to simply claim the credit on their annual returns without prior approval.7 Taxpayers must submit a tentative claim by a specific deadline to reserve their portion of the pool.1

• For 2025 Expenses: The tentative claim must be submitted by April 1, 2026.1
• For 2026 and Beyond: The deadline moves to March 15 of the following year.1

The tentative claim must report the total QREs incurred and the number of employees. Treasury then aggregates all claims and, if the total exceeds $100 million, applies proration.1

Statewide Caps and Proration Rules

The $100 million annual cap is divided into two separate pools to ensure small businesses are not crowded out by large corporations 5:

• Small Business Pool: $25 million.9
• Large Business Pool: $75 million.9

If small business claims stay under $25 million, they are paid in full. If they exceed $25 million, they are prorated among small businesses. Large businesses are prorated against the remaining $75 million pool. However, if small business claims exceed 25% of the total claims from both groups, the Treasury may shift to a universal proration against the full $100 million.2

Refundability and Interaction with Sales, Use, and Withholding

Flow-through entities (FTEs), such as S-corporations and partnerships, do not pay the CIT directly. Instead, they will claim the R&D credit on their Sales, Use, and Withholding (SUW) annual returns.1 Because the credit is refundable, it can be used to offset the entity’s withholding tax liability. Treasury guidance allows FTEs to adjust their periodic withholding payments once the tentative claim adjustment notice is published, providing immediate cash flow relief rather than waiting for an annual refund check.10

Comparative Analysis of Decoupling from IRC Section 174

The importance of the Michigan R&D credit is heightened by the state’s recent decoupling from federal tax changes regarding research and experimental (R&E) expenses.7 Historically, IRC Section 174 allowed businesses to immediately deduct 100% of their R&D costs. The 2017 Tax Cuts and Jobs Act (TCJA) changed this, requiring costs to be capitalized and amortized over five years for domestic research and fifteen years for foreign research.

While federal legislation in 2025 restored immediate expensing at the federal level, Michigan enacted House Bill 4961 in October 2025 to decouple from this federal treatment.10 As a result, Michigan still requires businesses to capitalize and amortize R&D expenses over five years for state tax purposes.10 This creates a timing difference that increases current-year Michigan taxable income and tax liability. The refundable R&D credit is specifically designed to offset this increased tax burden and restore liquidity to innovative firms.10

Practical Example of Sequencing Nonrefundable and Refundable Credits

To illustrate the application of “Nonrefundable Credits (Claimed before R&D Credit)” under Michigan law, consider the case of a small manufacturing firm with 150 employees.

Scenario Assumptions

• 2025 Michigan QREs: $1,000,000.
• Base Amount (3-year average): $400,000.
• Gross CIT Liability (before credits): $40,000.
• Small Business Alternative Credit (Nonrefundable): $25,000.
• University Collaboration: None.

Step 1: Calculate the R&D Credit Amount

As a small business with fewer than 250 employees, the company uses the 3%/15% rate structure.4

• Credit on Base: $400,000 $\times$ 0.03 = $12,000.
• Credit on Excess: ($1,000,000 – $400,000) $\times$ 0.15 = $90,000.
• Total R&D Credit: $12,000 + $90,000 = $102,000.

Step 2: Apply Nonrefundable Credits (The Sequencing Rule)

The law requires the nonrefundable SBAC to be claimed before the R&D credit.1

• Gross Tax Liability: $40,000.
• Less SBAC (Nonrefundable): ($25,000).
• Residual Tax Liability: $15,000.

Step 3: Apply the Refundable R&D Credit

The R&D credit is applied to the remaining liability. Any excess is refundable.1

• Residual Tax Liability: $15,000.
• Less R&D Credit Applied: ($15,000).
• Net Tax Due: $0.
• Refundable Portion: $102,000 – $15,000 = $87,000.

In this scenario, the business pays $0 in state income tax and receives a refund check for $87,000. If the credits were applied in reverse, the $25,000 SBAC might have been trapped if the tax liability were zeroed out by the R&D credit alone, as nonrefundable credits generally do not result in cash payments.12

Advanced Considerations for Unitary Business Groups

For companies operating as part of a Unitary Business Group (UBG), the authorized business is the group as a single taxpayer.1 This has several implications for the nonrefundable credit sequence. The 3% base and the 10/15% excess rates are calculated based on the combined R&D activity of all members in the group.1 Furthermore, the 250-employee limit is measured at the group level. A small subsidiary of a large multinational parent would likely be treated as a large business subject to the 10% excess rate and the $2 million group cap.1 UBGs must consolidate all nonrefundable credits, such as Renaissance Zone credits held by specific members, before applying the R&D credit to the group’s total liability.8

Compliance and Documentation Requirements

The Michigan Department of Treasury emphasizes that the R&D credit is audit enabled, meaning taxpayers must maintain rigorous documentation to support their claims.19 Because the credit is refundable, it attracts higher scrutiny from state auditors. To defend the credit against state challenges, businesses should retain the following for at least four to six years 14:

• Project Lists: Detailed descriptions of research projects, including goals, technical uncertainties, and the process of experimentation.19
• Time Tracking: Contemporaneous logs or project-based accounting showing the hours employees spent on qualified vs. non-qualified activities.19
• General Ledger Detail: Invoices for supplies and contracts that clearly identify the location of the research, which must be in Michigan.8
• University Agreements: If claiming the collaboration bonus, a copy of the written agreement with the Michigan research university must be provided upon request.1

Economic Impact and Future Policy Outlook

The reintroduction of the R&D credit is part of a broader Make It in Michigan strategy aimed at increasing the state’s competitiveness in high-tech sectors like automotive mobility, semiconductors, and life sciences.9 Michigan currently ranks in the top five states for R&D spending, driven largely by the automotive industry, which accounts for over 60% of the nation’s total mobility R&D.9

State officials anticipate that the $100 million annual credit will act as a multiplier, encouraging as much as $4 in private R&D spending for every $1 of tax credit provided.9 Furthermore, the refundable nature of the credit is expected to increase entrepreneurial activity by approximately 7% and support the formation of new firms in innovation-heavy counties.9

Conclusion

The Michigan Research and Development tax credit is a powerful tool for businesses to recapture costs and reinvest in innovation. However, the efficacy of the credit depends entirely on a firm’s understanding of the statutory ordering rules. By requiring nonrefundable credits to be claimed before the R&D credit, the state has created a taxpayer-friendly sequence that prioritizes liquidity. This structure ensures that businesses first utilize their limited tax offsets to eliminate liability, thereby maximizing the refundable portion of the R&D credit that arrives as a direct cash payment from the Treasury.

As the state continues to decouple from federal Section 174 amortization rules, this credit becomes not just an incentive, but a necessary component of state tax planning. Companies must remain vigilant regarding the April 1 tentative claim deadline and maintain rigorous Michigan-specific documentation to ensure their eligibility for this competitive $100 million pool. Successful integration of nonrefundable credits and the R&D credit serves as a cornerstone of Michigan’s ambition to remain a global leader in technological advancement and industrial design.

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