Analysis of Contractor Research Expenses within the Framework of the Minnesota Credit for Increasing Research Activities

Contractor expenses in the context of the Minnesota Research and Development (R&D) tax credit represent sixty-five percent of the payments made to third-party entities for qualified research activities physically conducted within the state. These expenditures must satisfy the federal Four-Part Test while adhering to strict Minnesota-specific geographic nexus requirements and documentation standards set by the Department of Revenue. 1

The Minnesota Credit for Increasing Research Activities, codified under Minnesota Statutes Section 290.068, represents a critical pillar of the state’s economic development strategy, designed to foster a competitive environment for technological advancement. 1 Since its inception in 1981, the credit has mirrored the federal research credit under Internal Revenue Code (IRC) Section 41, yet it has evolved to address the specific industrial and fiscal needs of the North Star State. 3 For businesses navigating this landscape, the classification of “Contractor Expenses” serves as a significant lever for recovering R&D costs, particularly for those that rely on specialized laboratory testing, engineering consultants, or university-led research initiatives. 2 This analysis provides a comprehensive examination of the legal definitions, state revenue office guidance, and practical applications of contractor-related research expenses, including the significant pivot toward partial refundability starting in the 2025 tax year. 1

Statutory Foundations and Federal Conformity

The legal architecture of the Minnesota R&D tax credit is built upon a foundation of federal conformity, yet it is distinguished by several key departures that mandate precise accounting for state-level claims. 1 Minnesota Statutes Section 290.068, Subdivision 2, explicitly defines “qualified research expenses” by referencing IRC Section 41(b) and (e). 4 This means that the types of expenses eligible for the credit—including wages, supplies, and contractor costs—are generally the same as those recognized by the Internal Revenue Service (IRS). 1 However, the state introduces a rigorous geographic limitation: all qualified research must be conducted within Minnesota borders. 1

The relationship between the state and federal credits is summarized in the following table, illustrating the structural alignment and the unique constraints of the Minnesota regime. 1

Comparison of Federal and Minnesota R&D Credit Frameworks

Source: 1

The adoption of the federal 65% “haircut” for contractor expenses is a mechanism designed to strip away the contractor’s profit margin and overhead costs from the tax subsidy. 14 By only allowing 65% of the gross payment to be considered a qualified research expense, the legislature ensures that the credit specifically incentivizes the labor and material effort of the research rather than the commercial success of the service provider. 14

Defining the Scope of Qualified Contractor Expenses

Contractor expenses, often referred to in official documentation as “contracted research,” occur when a taxpayer pays a person other than an employee to perform qualified research on their behalf. 2 For these payments to be included on Schedule RD, they must pass a series of technical and legal hurdles that go beyond the mere performance of work. 1

The “On Behalf Of” Requirement

The core of a qualified contractor relationship is that the research must be conducted at the direction and for the benefit of the taxpayer. 14 This implies a proactive engagement where the taxpayer defines the technical objectives and maintains oversight of the research process. 1 Research performed spontaneously by a vendor or research purchased after-the-fact in the form of a pre-existing patent or product does not qualify as contractor research. 1

The 65% Rule and Its Applications

The Minnesota Department of Revenue follows the federal standard where 65% of the total amount paid to a contractor is considered a qualified research expense. 2 This rule applies to traditional third-party engineering firms, private laboratories, and independent consultants. 2 There are specialized circumstances, however, where the percentage may increase:

• 75% Rate: Applies to payments made to a “qualified research consortium,” which is generally a tax-exempt organization (such as a non-profit research institute) that conducts research for the taxpayer and at least one other unrelated person. 14
• 100% Rate: Typically reserved for “basic research” payments made to qualified organizations, such as universities or scientific research organizations, under a written agreement. 14

For the vast majority of commercial R&D projects in Minnesota, the 65% figure remains the operative calculation for Schedule RD, Line 4. 20

Technical Compliance: The Four-Part Test

For a contractor’s work to be eligible for the Minnesota credit, the activity must satisfy the federal Four-Part Test as mandated by IRC Section 41(d). 1 The Minnesota Department of Revenue applies these standards rigorously during audits to ensure that the work performed by third parties constitutes genuine innovation rather than routine business activities. 1

1. Permitted Purpose

The research must be directed toward the development of a new or improved “business component,” defined as a product, process, technique, formula, invention, or computer software. 1 The goal must be to improve the component’s function, performance, reliability, or quality. 1 When hiring a contractor, the taxpayer must be able to describe how the contractor’s specific deliverables led to these functional improvements. 1

2. Elimination of Uncertainty

Qualified research must be intended to eliminate uncertainty regarding the “capability,” “method,” or “appropriate design” for developing or improving the business component. 1 If the contractor is simply applying a known solution or following a standard industry manual, there is no technical uncertainty, and the expense is disqualified. 1 The uncertainty must be technical in nature—meaning it cannot be resolved through routine engineering or existing expertise. 1

3. Process of Experimentation

The contractor must utilize a “process of experimentation,” which involves the systematic evaluation of alternatives. 1 This typically includes developing a hypothesis, testing it through modeling or prototyping, analyzing the results, and refining the design. 1 For contractor expenses, documentation such as testing logs, failure reports, and iterative CAD models provided by the contractor are essential to prove that a true process of experimentation occurred. 1

4. Technological in Nature

The research must fundamentally rely on the “hard” sciences—physics, chemistry, biology, metallurgy, computer science, or engineering. 1 Work that relies on social sciences, economics, or marketing does not qualify. 1 If a contractor is hired to conduct market research or a “usability study” based on consumer psychology, those expenses are strictly ineligible for the credit. 1

Revenue Office Guidance: The Documentation Standard

The Minnesota Department of Revenue (MDOR) provides clear directives on the types of records required to substantiate a claim for contractor expenses. 1 Under audit, the burden of proof is on the taxpayer to demonstrate that the contractor’s work was both qualified and performed within the state. 2

Mandatory Record-Keeping Checklist

To withstand an MDOR review, companies must maintain a comprehensive “Contractor File” for each project. 1 The documentation must be contemporaneous, meaning it was created during the same period the research was performed. 1

Source: 1

The “In Minnesota” Geographic Nexus

The geographic restriction is perhaps the most frequent cause of disallowance for contractor expenses in Minnesota. 1 Schedule RD requires a specific confirmation on Line 3b: “Were the following performed/conducted within the state of Minnesota?” 20 If the answer is “No,” the taxpayer is prohibited from claiming those expenses. 20

A common pitfall occurs when a Minnesota company hires a contractor with a Minnesota billing address, but the contractor performs the actual laboratory work at a facility in another state. 1 The MDOR guidance is explicit: the performance of the research must happen in Minnesota. 1 Taxpayers should require contractors to certify their work locations annually to protect the validity of the credit. 12

Legal Nuances: Risk and Rights Analysis

The determination of whether a contractor’s work is “qualified research” hinges on two advanced legal concepts: Economic Risk and Substantial Rights. 14 If the contractor holds these, the research is considered “funded” from the taxpayer’s perspective, and the taxpayer cannot claim the credit. 17

Allocation of Economic Risk

Economic risk refers to which party suffers the financial loss if the research project fails. 17 For the taxpayer to claim the credit, they must bear the risk. 14 This is typically evaluated through the contract type:

• Fixed-Price Contracts: Generally considered to place the risk on the contractor (the service provider) if the contractor is obligated to deliver a specific result regardless of the cost. 17 However, if the taxpayer is obligated to pay the contractor for the research effort even if it fails to yield a result, the risk remains with the taxpayer, and the expense may be qualified. 14
• Cost-Plus/Time and Materials Contracts: These usually place the risk on the taxpayer (the client), as the taxpayer pays for the hours and materials used regardless of whether the technical goal is achieved. 17 These are often the most favorable contract structures for R&D tax credit claims. 17

Retention of Substantial Rights

The taxpayer must also retain “substantial rights” to the research results. 14 This means the taxpayer must have the right to use the research findings in its trade or business without paying a royalty or fee to the contractor. 14 While the contractor may also retain rights (shared ownership), the taxpayer cannot be excluded from using the technology they funded if they wish to claim the credit. 14

The Calculation Methodology: A Tiered Incremental System

Minnesota’s R&D tax credit calculation is distinct from the federal system because it does not allow the Alternative Simplified Method. 1 Instead, all Minnesota taxpayers must use a regular incremental method that compares current year QREs to a computed “base amount.” 2

Determining the Base Amount

The base amount represents the level of research spending the state considers “normal” for the company. 2 Only spending above this base qualifies for the credit. 1 The base is calculated by taking the taxpayer’s “fixed-base percentage” (a ratio of historical R&D spending to historical gross receipts) and multiplying it by the average Minnesota gross receipts for the prior four years. 2

Importantly, the Minnesota base amount has a “floor.” 2 The base amount can never be less than 50% of the current year’s QREs. 2 This effectively caps the credit at a percentage of half of the company’s total R&D spend for the year. 11

Tiered Credit Rates

Once the “excess” QREs (Current QREs minus Base Amount) are calculated, the following tiered rates are applied: 1

Source: 1

Comprehensive Example: The “BioGen Minnesota” Case Study

To illustrate the integration of contractor expenses into the Minnesota R&D credit, consider the hypothetical case of BioGen Minnesota, a mid-sized biotechnology firm based in Rochester. 2

In the 2024 tax year, BioGen Minnesota engaged in several projects to develop a new diagnostic enzyme. Their expenses were as follows:

• Internal Salaries for Research Scientists: $1,200,000
• Laboratory Supplies and Reagents: $300,000
• Contract with University of Minnesota Lab for specialized sequencing (Minnesota-based): $500,000
• Contract with a Boston-based consultant for data analysis (Performed in MA): $200,000
• Federal Innovation Grant received for this project: $100,000

Step 1: Identify Qualified Research Expenses (QREs)

First, we must filter these expenses through the Minnesota-specific requirements. 1

1. Salaries: $1,200,000 (Fully qualified if work performed in MN). 2
2. Supplies: $300,000 (Qualified). 1
3. University Contract (MN): $500,000 × 65% = $325,000. (Qualified because work was in MN). 2
4. Boston Consultant: $0. (Disqualified because research was conducted outside of Minnesota). 1
5. Innovation Grant Adjustment: Expenses must be reduced by the amount of any innovation grant funding. 1

• Calculation: $1,200,000 + $300,000 + $325,000 = $1,825,000.
• Reduction: $1,825,000 – $100,000 (Grant) = $1,725,000 Total Minnesota QREs. 1

Step 2: Calculate the Base Amount

BioGen’s average Minnesota gross receipts for the last four years were $10,000,000, and their historical R&D intensity (Fixed-Base Percentage) is 8%. 2

• Preliminary Base: $10,000,000 × 8% = $800,000. 2
• Minimum Base Check: 50% of current QREs ($1,725,000) = $862,500. 2
• Final Base Amount: $862,500 (The greater of the two). 2

Step 3: Calculate the Credit

• Excess QREs: $1,725,000 – $862,500 = $862,500. 2
• Credit Amount: $862,500 × 10% = $86,250 Minnesota R&D Tax Credit. 1

The 2025 Pivot: Transition to Partial Refundability

One of the most transformative changes to the Minnesota tax code in decades is the introduction of partial refundability for the R&D credit, effective for tax years beginning after December 31, 2024. 1

The Cash-Flow Implication for Startups

For over a decade (since 2013), the credit was strictly non-refundable. 10 Unused credits could be carried forward for 15 years, but they provided no immediate value to companies without a tax liability—a common situation for startups heavily engaged in research through contractors. 1

Under the new law, taxpayers can elect to receive a cash refund for a percentage of their unused credit. 1

Refundability Rates and Targets

The state has established a sliding scale for refundability to manage the fiscal impact on the General Fund. 1

Source: 1

If BioGen Minnesota were to generate its $86,250 credit in 2025 and had zero tax liability, they could elect to receive a refund of approximately $16,560 ($86,250 × 19.2%), with the remainder potentially carried forward or forfeited depending on the specific election rules. 1 This represents a significant shift toward providing immediate capital to R&D-intensive firms. 2

Statistical Overview of the Minnesota R&D Credit

The fiscal and economic impact of the research credit is documented in the annual Tax Expenditure Budget and evaluations by the Legislative Auditor. 3 The data indicates that the credit is a powerful but highly concentrated incentive. 3

Sector and Claimant Distribution

The following table highlights the distribution of the credit among different business types and industries based on historical Department of Revenue data. 3

Source: 3

These statistics suggest that while wages for internal engineers and scientists remain the primary driver of the credit, contractor expenses (captured within the remaining 25% of QREs) represent a vital supplementary tool for companies seeking to scale their innovation through third-party expertise. 3

Administrative Compliance: Filing and Amended Returns

Claiming the credit requires the completion of Schedule RD, Credit for Increasing Research Activities. 1 For unitary businesses (groups of related corporations), a separate Schedule RD must be completed for each corporation that is claiming the credit. 20

Key Form Entries for Contractors

On the 2024 and 2025 Schedule RD, contractor expenses are addressed in several key areas: 20

1. Line 4: Total “Applicable percentage of contract expenses” (The 65% or 75% calculated amounts). 20
2. Section 2c: “How were the following calculated?” Taxpayers must check boxes for “Review of contemporaneous records,” “Estimation,” or a combination of both. 20
3. Section 3b: Verification that research was conducted within Minnesota. 20
4. Section 4: “Was the claimed research performed at the request of another individual or entity?” (This targets the “Economic Risk” and “Funded Research” issues). 20

Amending Prior Claims

Businesses can claim missed R&D tax credits retroactively by amending prior-year tax returns. 12 Generally, Minnesota allows amendments for open tax years, which typically extends three and a half years back from the original filing date. 2 However, taxpayers should be aware that the shift to partial refundability in 2025 is not retroactive; amended returns for 2022 or 2023 will still result in non-refundable carryforward credits. 8

Industry-Specific Considerations: Mining and Construction

While often associated with high-tech software and bioscience, the Minnesota R&D credit applies broadly to any sector where technical uncertainty is resolved through experimentation. 7

Mining Occupation Tax

A unique application of the credit is found in the mining industry. 32 Revenue Notice #22-01 clarifies that mining companies subject to the Minnesota Occupation Tax are allowed to claim the Research Credit against their Occupation Tax liability. 32 This reflects the state’s desire to incentivize innovative extraction and refining techniques for taconite and other minerals. 32

Construction and Engineering

The construction industry is a major user of contractor research expenses. 17 Contractors and subcontractors who develop new building techniques, energy-efficient HVAC systems, or innovative structural designs often qualify for the credit. 17 In this domain, the review of contracts (fixed-price vs. cost-plus) is paramount, as it determines which party in the construction hierarchy—the developer, the general contractor, or the specialist subcontractor—retains the right to the credit. 17

Conclusion: Strategy for Minnesota Taxpayers

The “Contractor Expenses” provision of the Minnesota R&D tax credit is a powerful but complex tool for recovering the costs of innovation. 1 To successfully leverage this benefit, businesses must maintain a dual focus on technical innovation and administrative precision. 1

The transition to partial refundability in 2025 significantly raises the stakes for accurate reporting. 1 For the first time, an error in documenting a contractor’s work location or a failure to satisfy the “Substantial Rights” test will not just result in a lost carryforward, but a lost cash refund. 8

As Minnesota continues to position itself as a hub for advanced manufacturing, clean energy, and life sciences, the R&D credit will remain a cornerstone of the corporate tax environment. 2 Companies that integrate these tax considerations into their contractor procurement processes—by ensuring Minnesota-based performance and clear IP ownership—will be best positioned to realize the full economic value of their research and development activities. 2

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