The Regulatory Synergy and Divergence of Internal Revenue Code Section 174 and Minnesota Research Incentives

Internal Revenue Code Section 174 requires businesses to capitalize and amortize research and development costs over a five or fifteen-year period, effectively deferring the immediate tax benefit of innovation expenditures. In Minnesota, this federal mandate dictates the eligibility of expenses for the state’s R&D tax credit, although current state law notably decouples from recent federal efforts to restore immediate expensing.1

The intersection of federal tax policy and state-level innovation incentives creates one of the most complex regulatory landscapes for American businesses. For over sixty years, the tax treatment of research and experimental (R&E) expenditures was a bastion of simplicity, allowing for immediate expensing that served as a direct subsidy for domestic innovation. The enactment of the Tax Cuts and Jobs Act (TCJA) of 2017, however, fundamentally altered this dynamic by introducing mandatory capitalization under Internal Revenue Code (IRC) Section 174.1 This shift has had profound ripple effects in Minnesota, where the state’s Credit for Increasing Research Activities—governed by Minnesota Statutes Section 290.068—remains tethered to federal definitions but has strategically decoupled from recent federal legislative “fixes.” As businesses navigate the 2024 and 2025 tax years, they must contend with a divergent environment where the federal government has attempted to restore immediate expensing through the One Big Beautiful Bill Act (OBBBA), while the Minnesota Department of Revenue maintains a requirement for amortization.2

The Evolution and Mechanism of IRC Section 174

Internal Revenue Code Section 174 was originally established in 1954 to eliminate the ambiguity surrounding the treatment of research and development costs. Historically, the law allowed taxpayers to choose between immediately expensing these costs or capitalizing them and amortizing them over a period of not less than 60 months.4 This flexibility was intended to support small businesses and innovators who might lack the accounting infrastructure to manage long-term capital accounts for intangible research assets.8 For decades, the vast majority of firms elected immediate expensing, creating a virtuous cycle where research spending reduced current-year tax liability, thereby freeing up cash for further innovation.

The paradigm shift occurred with the passage of the TCJA in 2017. To satisfy budgetary constraints and offset the revenue loss from a significant reduction in the corporate tax rate from 35% to 21%, Congress modified Section 174 to require mandatory capitalization for tax years beginning after December 31, 2021.1 This change transformed what was once a “tax deduction” into a “deferred asset,” forcing companies to spread their research costs over five years for domestic spending and fifteen years for foreign spending.1

Technical Mechanics of Amortization

The amortization of Section 174 expenditures utilizes a half-year convention in both the year the expenditure is incurred and the year the amortization period concludes. This means that regardless of the month in which an expense is paid or incurred, the taxpayer is only entitled to a partial deduction in the first year.1

Source: 1

The fiscal impact of this schedule is severe. A company with $1,000,000 in domestic research expenses that previously could deduct the full amount in Year 1 now finds itself with only a $100,000 deduction. The resulting $900,000 increase in taxable income creates an immediate federal tax liability increase of $189,000 at the current 21% rate.1 For many technology and life sciences firms, particularly those that were previously “break-even” for tax purposes, this mandate has forced them into an income-tax-paying position despite having no actual net cash profit.5

Scope of Specified Research or Experimental Expenditures (SREs)

The definition of a Section 174 expense is significantly broader than what is traditionally considered “R&D” in a scientific laboratory setting. IRS Notice 2023-63 and subsequent guidance have clarified that Section 174 encompasses all costs “incident to” the development of a product, process, formula, invention, or software.6 This include:

• Compensation: Salaries, wages, and benefits for employees directly involved in research, as well as those who supervise or directly support research activities.6
• Materials and Supplies: Costs of tangible property consumed in the research process that are not subject to depreciation under Section 167.6
• Software Development: Statutorily, all costs incurred in connection with the development of software are treated as Section 174 expenditures, regardless of whether the software is for sale or for internal use.3
• Overhead and Facilities: A reasonable allocation of rent, utilities, insurance, taxes, and maintenance for facilities used in research activities.6
• Patent Costs: Legal fees and filing costs associated with obtaining a patent.4

Excluded from this definition are costs related to market research, advertising, quality control testing, and the acquisition of an existing patent or business component.9

Minnesota Statutes Section 290.068: The R&D Credit Framework

Minnesota offers the Credit for Increasing Research Activities to incentivize investment within the state. The credit is available to C corporations, and for pass-through entities such as S corporations and partnerships, it is allocated to shareholders and partners.13 The architecture of the Minnesota credit is “incremental,” meaning it is calculated based on the excess of qualified research expenses (QREs) over a historical “base amount”.16

The dependency between Section 174 and the Minnesota credit is foundational. For an expense to be considered a “qualified research expense” (QRE) under Minnesota law, it must first be eligible for treatment under IRC Section 174.8 This creates a strict hierarchy: while Section 174 defines the broad universe of research costs that must be capitalized, Section 41 (and by extension Minnesota Section 290.068) identifies a narrower subset of those costs that qualify for a tax credit.9

The Tiered Rate Structure

Minnesota employs a tiered rate structure designed to maximize the incentive for small-to-mid-sized projects while still rewarding large-scale innovation.16

Source: 13

The “base amount” is a critical component of this calculation. It is determined by the business’s average Minnesota gross receipts over the preceding four years and its “fixed-base percentage,” which represents the ratio of research spending to gross receipts during the 1984-1988 period (or a default 3% for newer startups).16 To prevent the credit from providing an excessive windfall to established companies, the base amount cannot be less than 50% of the current year’s QREs.18

Minnesota’s Non-Conformity to Federal Simplification

A primary point of divergence between federal and state law is the Alternative Simplified Method (ASM). While the federal government allows taxpayers to use the ASM to calculate their credit—which simplifies recordkeeping by focusing solely on a three-year average of QREs—Minnesota does not conform to this method.13 Taxpayers in Minnesota must use the “regular” incremental method, which requires historical gross receipts data and, in many cases, 1980s-era spending records.15 This administrative requirement necessitates that Minnesota businesses maintain more robust historical documentation than may be required for their federal filings.

The Jurisdictional Conflict: Conformity and the 2025 Legislative Shifts

The term “conformity” describes how Minnesota adopts changes to the Internal Revenue Code. Minnesota generally uses a “static” conformity model, meaning it adopts the IRC as it existed on a specific date, rather than “rolling” conformity where federal changes are adopted automatically.20 In May 2023, the Minnesota legislature updated the state’s conformity date to May 1, 2023.20 This update ensured that Minnesota was in alignment with the TCJA’s mandatory Section 174 amortization for the 2022, 2023, and 2024 tax years.2

However, the federal landscape shifted significantly with the enactment of the One Big Beautiful Bill Act (OBBBA) on July 4, 2025. This Republican-led tax reform bill introduced IRC Section 174A, which effectively restored the ability of taxpayers to immediately expense domestic research costs for tax years beginning after December 31, 2024.6

The 2025 Decoupling

As of the fourth quarter of 2025, Minnesota has not conformed to Section 174A. While the federal government has returned to a policy of immediate expensing for domestic innovation, Minnesota remains tethered to the TCJA’s five-year amortization requirement for domestic research expenditures.2

This divergence creates a substantial “non-conformity adjustment” for Minnesota taxpayers. On a 2025 federal return, a company may claim a 100% deduction for its domestic R&D costs. On the corresponding Minnesota return, that same company must add back the federal deduction and instead claim only a 10% amortization tranche (the first year’s portion under the half-year convention).2

Small Business Retroactivity Gaps

The OBBBA also provided a generous retroactive provision for “qualified small businesses” (those with average annual gross receipts under $31 million). These businesses were given the option to retroactively adopt immediate expensing for the 2022-2024 tax years by filing amended federal returns.6 Because Minnesota has not conformed to this retroactive provision, a small business that amends its federal return to claim a refund for 2022 will find no corresponding relief at the state level.2 For state purposes, the amortization schedule established in 2022 must continue to run its course.

Local Revenue Office Guidance and Administrative Compliance

The Minnesota Department of Revenue (MDOR) has issued specific guidance and developed specialized forms to help taxpayers manage the complexities of Section 174 and the R&D credit.

Required Forms and Filing Procedures

To claim the R&D credit and properly report non-conformity adjustments, taxpayers must use a suite of forms tailored to their entity type.13

Source: 22

The MDOR emphasizes that Schedule RD is the primary document for calculating the credit. It requires detailed inputs for Minnesota-specific wages, supplies, and contract research.13 Crucially, the non-conformity schedules (e.g., M4NC) are where the discrepancy between federal expensing (Section 174A) and state amortization (Section 174) is reconciled.22

Guidance on Qualified Research Activities (QRAs)

The MDOR follows the federal “Four-Part Test” but applies it strictly to activities conducted within Minnesota borders.13 Guidance released in late 2024 and 2025 clarifies that for an activity to meet the “Elimination of Uncertainty” test—a prerequisite for both Section 174 treatment and the R&D credit—it must involve an activity to discover information that resolves technical uncertainty regarding the capability, method, or appropriate design of a product or process.13

Revenue notices also specify that expenditures funded by state Innovation Grants from the Minnesota Department of Employment and Economic Development (DEED) are not eligible QREs for the state credit, as the research is considered “funded” by a third party.13

Record Retention Requirements

The MDOR has clarified that because the R&D credit can be carried forward for 15 years, the statute of limitations for auditing a credit remains open as long as the credit is available to be used on a return.15 Taxpayers are advised to maintain records for at least four to seven years after the credit is fully utilized, which in some cases could necessitate keeping documentation for over 20 years.18

The 2025 Refundability Paradigm

A landmark change in Minnesota tax law occurred in June 2025 with the signing of H.F. 9, which introduced partial refundability for the R&D tax credit.13 Historically, the Minnesota credit was nonrefundable, providing no immediate cash benefit to startups or companies in a net operating loss (NOL) position.15

Refundability Rates and Mechanics

The new law allows taxpayers to elect to receive a cash refund for a portion of their unused current-year credits, rather than carrying the full amount forward to future years.13

Source: 13

The election to claim the refund must be made on a timely filed return (including extensions) and is irrevocable for that tax year.13 This provision is particularly powerful for Minnesota’s agriculture, biotechnology, and clean energy sectors, where research cycles are long and profitability may be years away.32 For a startup with $100,000 in unused credits in 2025, this election provides an immediate $19,200 cash infusion, which can be reinvested in payroll or equipment.

Comprehensive Financial Example: MedTech Innovations Inc.

To illustrate the interplay between federal Section 174A expensing, Minnesota Section 174 amortization, and the new 2025 refundability election, consider a hypothetical Minnesota medical device company, MedTech Innovations Inc.

Scenario Background (2025 Tax Year)

• Status: C Corporation based in Minneapolis.
• 2025 Domestic R&D Expenditures (Section 174): $4,000,000.

• Direct Wages (MN-based): $3,000,000.
• Supplies and Contract Research: $500,000.
• Indirect Section 174 Costs (Rent/Overhead): $500,000.

• MN Gross Receipts (4-Year Average): $20,000,000.
• Fixed Base Percentage: 3.0%.
• MN Taxable Income (Before R&D Adjustments): $200,000.

Step 1: Calculate Minnesota Qualified Research Expenses (QREs)

Only direct costs qualify for the credit, whereas all $4,000,000 are subject to Section 174 rules.9

• Total MN QREs: $3,000,000 (Wages) + $500,000 (Supplies/Contract) = $3,500,000.

Step 2: Calculate the Minnesota R&D Credit

1. Base Amount: $20,000,000 * 3.0% = $600,000.16
2. Excess QREs: $3,500,000 – $600,000 = $2,900,000.
3. Tier 1 Credit: $2,000,000 * 10% = $200,000.18
4. Tier 2 Credit: ($2,900,000 – $2,000,000) * 4% = $36,000.
5. Total Credit Generated: $236,000.

Step 3: Reconcile Federal Expensing vs. Minnesota Amortization

MedTech Innovations follows the OBBBA federal rules and the Minnesota non-conformity rules.2

• Federal Deduction: $4,000,000 (Immediate expensing under Section 174A).
• Minnesota Addback: $4,000,000 (Must reverse the federal deduction on Schedule M4NC).
• Minnesota Amortization Subtraction: $4,000,000 * 10% = $400,000 (First-year tranche allowed under MN law).
• Net MN Income Impact: +$3,600,000.
• Final MN Taxable Income: $200,000 + $3,600,000 = $3,800,000.

Step 4: Apply Credit and Elect Refund

1. MN Tax Liability (9.8% Rate): $3,800,000 * 9.8% = $372,400.
2. Net Tax Due: $372,400 – $236,000 = $136,400.

In this scenario, because MedTech has high taxable income due to the mandatory amortization, it uses its entire credit and has no “unused” portion to refund.13 If, however, the company had an initial loss of $1,000,000, the “unused” credit could have generated a check from the state for 19.2% of its value.

The Software Development Conundrum

The statutory inclusion of software development in Section 174 has fundamentally shifted the tax profile of Minnesota’s technology sector. Prior to 2022, software development could be treated as a current expense under Revenue Procedure 2000-50.11 Today, even software maintenance and minor iterative updates that may not meet the “Elimination of Uncertainty” requirement for the R&D tax credit must still be capitalized and amortized.4

Internal Use Software (IUS) Nuances

For companies developing software for internal administrative use—such as an HR portal or an internal financial dashboard—the hurdles for the Minnesota R&D credit are even higher. IUS must meet an “Additional Three-Part Test,” requiring that the software be innovative, involve significant economic risk, and not be commercially available.13 However, regardless of whether the software qualifies for the credit, the development costs must be capitalized for state purposes under Minnesota’s current non-conformity to Section 174A.2

Economic Impact and Policy Projections

The cost of the R&D credit to the state of Minnesota is a significant portion of the tax expenditure budget, reflecting the high value the state places on innovation.

Projected Cost of the Minnesota R&D Credit

The following data represents the estimated revenue impact of the credit on the Minnesota general fund.16

Source: 16

The increase in cost between 2024 and 2025 is largely attributed to the introduction of partial refundability, which is expected to increase the utilization of the credit by early-stage firms that previously let credits expire or sit unused on their balance sheets.32

User Cost Elasticity and Knowledge Spillovers

Economic analysis of R&D tax credits, such as the “B-index” studies, suggests that when research costs are amortized instead of expensed, the “user cost” of R&D increases, potentially leading to a decrease in private investment.34 Minnesota’s decision to maintain amortization while the federal government has moved back to expensing creates a relative increase in the cost of innovation in Minnesota compared to federal levels. However, the 10% tiered rate for the first $2 million of excess QREs is among the most competitive in the region, helping to offset this “conformity gap”.16

Strategic Planning and Compliance Considerations

For Minnesota businesses, the 2025 tax year is a period of transition and careful modeling. The divergence between federal and state law requires a dual-track accounting strategy.

Multi-State Apportionment and Section 174

For businesses operating in multiple states, the allocation of Section 174 costs becomes a complex exercise in apportionment. Minnesota requires that only research conducted within the state qualify for the credit, but the amortization of Section 174 costs applies to the company’s total apportionable income.13 This means a company could be amortizing costs in Minnesota for research actually performed in California or overseas, provided those costs are part of the unitary group’s business income.15

Unitary Group Allocation Rules

Minnesota allows for the sharing of the R&D credit among members of a unitary business group. Guidance from the MDOR in 2020 and 2025 clarifies that the earning member must first use the credit to offset its own liability; any remaining credit can then be used by other members of the group.13 Unused credits that are not refunded continue to carry forward for 15 years at the level of the earning member.13

Audit Defense and Documentation

The “Process of Experimentation” test remains the most frequently challenged area in MDOR audits. Taxpayers must be prepared to show a “systematic trial and error” process. Simply “testing” a product for quality control is insufficient; the taxpayer must prove they were evaluating alternatives to achieve a result where the appropriate design was initially uncertain.13

Documentation should include:

• Technical Specifications: Documents showing the initial design goals and the technical uncertainties identified.13
• Testing Logs: Evidence of failed prototypes, modeling results, and refinements.13
• Employee Interviews: MDOR auditors frequently request interviews with lead engineers to verify the technological nature of the research.30

Conclusion: Navigating the New Normal

The tax treatment of research and experimentation in Minnesota has entered a period of sophisticated complexity. The mandatory capitalization required by IRC Section 174—while now reversed at the federal level by Section 174A—remains the governing rule for Minnesota state tax filings. This “conformity gap” creates a unique challenge where the federal government encourages immediate cash-flow relief for innovators, while the state requires a more measured, long-term amortization of those same costs.2

To maximize the benefits of the Minnesota R&D credit, businesses must transcend traditional accounting and adopt a rigorous, project-based documentation culture. The new 2025 refundability provisions provide a vital lifeline for the state’s burgeoning startup ecosystem, but they require timely elections and precise calculation of unused credits.13 As the Commissioner of Revenue continues to issue guidance in the wake of the 2025 legislative session, Minnesota firms should model their tax liabilities under both federal and state tranches, ensuring that their innovation strategy is not just technologically sound, but fiscally optimized for this divergent regulatory environment.1

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