Analysis of Partnership Structures and Regulatory Guidance for the Minnesota Credit for Increasing Research Activities

Partnerships within the framework of the Minnesota R&D tax credit represent pass-through vehicles where qualified research costs are aggregated at the entity level and subsequently distributed to partners as credits against their individual or corporate tax liabilities. This mechanism aligns the financial incentive for innovation with the tax burdens of the owners who fund the state’s technological progress, ensuring the benefit directly offsets the cost of performing qualified research in Minnesota.1

The detailed analysis of this tax instrument requires an understanding of how Minnesota Statute 290.068 interacts with the federal Internal Revenue Code while maintaining state-specific limitations regarding geographic boundaries and tiered credit rates. For partnerships, the credit is not a reduction of an entity-level income tax but a transferable benefit that passes through to partners on their respective Schedule KPI forms.2 This pass-through nature necessitates a rigorous calculation of qualified research expenses at the partnership level, followed by a pro-rata allocation to the partners based on their distributive share of the entity’s income or loss.1 In recent years, the landscape for these entities has been dramatically altered by legislative shifts, most notably the transition from a purely nonrefundable credit to a partially refundable one beginning in tax year 2025.4 This evolution reflects the state’s broader economic strategy to support capital-intensive startups and innovation-heavy partnerships that may lack the immediate tax liability needed to utilize traditional credits.5

Statutory Framework and the Definition of Qualified Research

The Credit for Increasing Research Activities is governed primarily by Minnesota Statutes Section 290.068, which establishes the eligibility criteria, the calculation methodology, and the allocation rules for various business entities.1 While the credit is available to C corporations, it holds a unique significance for partnerships, S corporations, and limited liability companies (LLCs) taxed as partnerships, as these entities serve as the primary engines for early-stage and mid-market innovation in Minnesota.7

The Tiered Rate Structure for Partnerships

Minnesota employs a tiered credit rate that differs from the flat percentage often found at the federal level. This structure is designed to provide a more potent incentive for the first few million dollars of research spending, which disproportionately benefits smaller partnerships and emerging tech firms.6

This tiered approach ensures that a partnership with $\$2,000,000$ in excess research expenses over its base amount would generate a $\$200,000$ credit to be shared among its partners.2 The drop to a $4\%$ rate for expenditures beyond the $\$2,000,000$ threshold acts as a fiscal stabilizer for the state’s budget while still providing a meaningful incentive for large-scale industrial research.1

Eligibility and the Four-Part Test

To qualify for the credit, a partnership’s activities must meet the federal “Four-Part Test” as defined under Section 41(d) of the Internal Revenue Code, with the added requirement that the research be conducted physically within the state of Minnesota.9 The four components of this test are central to any audit or substantiation effort by the Minnesota Department of Revenue.9

1. Elimination of Uncertainty: The partnership must demonstrate that it intended to discover information to eliminate technical uncertainty regarding the capability or method for developing or improving a business component, or the appropriateness of its design.3
2. Process of Experimentation: The research must involve a systematic process of evaluating alternatives through modeling, simulation, or trial-and-error, rather than routine data collection or market testing.3
3. Technological in Nature: The activity must fundamentally rely on principles of physical or biological science, engineering, or computer science.9
4. Qualified Purpose: The research must relate to a new or improved function, performance, reliability, or quality of a business component, such as a product, process, formula, or software.9

Activities such as market research, social science studies, routine quality control, and research conducted after the start of commercial production are explicitly excluded from eligibility.9 Furthermore, any expenditures funded by Minnesota Innovation Grants are not considered qualified research expenses, as the state seeks to avoid subsidizing the same activity through both direct grants and tax credits.9

Pass-Through Mechanics and Partner Allocations

For partnerships, the R&D credit is an “attribute” that follows the same allocation rules as other items of income and loss. Under Minnesota Statute 290.068, subdivision 4, the credit must be allocated in the same manner as provided by Section 41(f)(2) of the Internal Revenue Code.1

Allocation to Partners

The partnership calculates the total credit on Schedule RD and then reports the distributive share for each partner on Schedule KPI (for partners) or Schedule KS (for S corporation shareholders).2 The partners then use these schedules to claim the credit on their own individual or corporate tax returns.11

This pass-through mechanism is particularly complex when a partnership has corporate partners that are members of a unitary business group.1 In such cases, if a corporation is a partner, the credit allowed to that corporation cannot exceed the lesser of the tax attributable to its interest in the partnership or its share of the unitary group’s tax liability.1 This “limitation of credit” ensures that the R&D credit generated by a specific partnership interest remains tethered to the income generated by that interest, preventing corporations from using partnership-derived credits to wipe out unrelated income across their entire unitary group.1

Pass-Through Entity (PTE) Tax Integration

A significant layer of complexity was added with the introduction of the Pass-Through Entity (PTE) Tax, which allows partnerships to pay Minnesota income tax at the entity level on behalf of their partners.7 This election, available for tax years beginning after 2020 and before 2026, allows partners to receive a refundable credit for the tax paid by the partnership.7

While the R&D credit itself was nonrefundable for most of this period, the PTE tax election creates a scenario where a partner can use the R&D credit to reduce their tax liability and then receive a refund of the PTE tax credits.7 The interaction between these two instruments requires careful tax planning. For example, the PTE tax is calculated by multiplying the entity’s taxable income by the highest individual rate of $9.85\%$.7 A partnership generating substantial R&D credits may find that the credit significantly offsets the liability that the PTE tax was intended to cover, potentially leading to overpayments that must be reconciled on the partners’ individual returns.7

The 2025 Refundability Revolution (H.F. 9)

In June 2025, Governor Tim Walz signed H.F. 9 into law, marking a pivot in Minnesota’s innovation policy.4 For the first time since the 2010-2012 stimulus era, a portion of the Minnesota R&D credit is now refundable, providing a direct cash benefit to partnerships that lack the tax liability to absorb their credits.4

Refundability Rates and Timelines

The new law introduces a specific refundability rate that applies to the unused portion of the current-year credit. It is important to note that the election for refundability is made by the partners, not the partnership itself.9

The mechanism for the refund is straightforward but requires precise filing. After a partner applies the R&D credit to reduce their tax liability to zero, they may elect to receive a refund of the remaining credit multiplied by the applicable rate for that year.9 For 2025, if a partner has $\$100,000$ in unused credits, they can receive a cash refund of $\$19,200$.4 The portion of the credit that is neither used nor refunded continues to carry forward for up to 15 years.1

The Statewide Refund Cap

To manage the fiscal impact on the state’s General Fund, the legislature implemented a target of $\$25,000,000$ in total annual refunds starting in 2028.1 The Commissioner of Revenue is authorized to adjust the refundability rate downward if the projected total refunds across all taxpayers exceed this amount.6 This requires partnerships to maintain a long-term view of their tax planning, as the “monetization rate” of their credits may fluctuate based on statewide economic activity.4

Qualified Research Expenses and the Base Amount Calculation

The calculation of the Minnesota R&D credit for a partnership is an incremental process, meaning the partnership is only rewarded for research spending that exceeds a certain “base amount”.14 This ensures that the state is subsidizing new or expanded research rather than routine, ongoing expenditures.9

Components of Qualified Research Expenses (QREs)

A partnership must aggregate four primary categories of expenses to determine its total QREs for the year.9

• Wages: This includes salaries and taxable benefits paid to employees for direct performance, direct supervision, or direct support of qualified research activities in Minnesota.6
• Supplies: Tangible property consumed in the research process, such as prototypes, chemicals, or mockups. This excludes land, capital improvements, and general administrative supplies like office furniture or utilities.6
• Contract Research: $65\%$ of the amounts paid to third-party contractors for research performed on behalf of the partnership in Minnesota.3
• Computer Rentals and Cloud Costs: Amounts paid for the right to use computers to conduct research, which in the modern era frequently includes cloud-based servers and development platforms.6

Establishing the Base Amount

The base amount is calculated using the partnership’s historical research intensity.14 For most established businesses, this involves taking the average annual gross receipts for the previous four years and multiplying that by a “fixed-base percentage”.1 For Minnesota purposes, only Minnesota sales and receipts are used in this calculation.1

For “start-up” companies—defined as those that did not have both gross receipts and qualified research expenses during the 1984-1988 period—the fixed-base percentage is set at $3\%$ for the first five years of research activity.9 This percentage then evolves over time based on the company’s actual research spending in its early years.9

Crucially, the base amount cannot be less than $50\%$ of the current year’s qualified research expenses.6 This “50% rule” prevents companies with extremely low historical spending from generating a credit on nearly $100\%$ of their current research, thus acting as a cap on the state’s total liability for the credit.6

State Revenue Office Guidance and Documentation Standards

The Minnesota Department of Revenue (MDOR) provides extensive guidance on the documentation required to sustain an R&D credit claim. Because partnerships pass these credits to their owners, a disallowance at the partnership level cascades through every partner’s return, making contemporaneous record-keeping essential.9

Audit Defense and Substantiation

Under IRS Regulation 1.6001-1 and Minnesota’s adoption of federal standards, the burden of proof lies with the taxpayer.9 Partnerships are encouraged to maintain a “nexus” between their expenses and specific projects.9

MDOR guidance emphasizes that if a taxpayer fails to provide requested substantiation within 120 days, the credit must be disallowed.18 This highlights the need for partnerships to centralize their R&D documentation rather than relying on the memories of individual researchers or partners after the fact.3

Unitary Business Group Sharing

A unique aspect of Minnesota law is the ability of unitary groups to share credits. If a partnership has a corporate partner that is part of a combined report, and that corporate partner cannot use its full credit, the unused portion may be shared with other members of the unitary group.2 MDOR guidance issued in 2020 clarified that this sharing applies not just to current-year credits but also to credit carryovers, ensuring that the incentive remains useful to large, multi-entity organizations operating in the state.2

Longitudinal Fiscal Impact and Statistical Context

Data from the 2024 Minnesota Tax Expenditure Budget and the Tax Expenditure Review Commission reveals the scale of the state’s commitment to the R&D credit. While the credit has been an indefinite part of the tax code since 1981, its fiscal footprint has expanded significantly in recent years.8

Expenditure Estimates 2020-2027

The following table displays the estimated cost of the R&D credit to the state treasury, broken down by the tax type on which the credit is claimed.14

The steady increase in credits claimed through the individual income tax reflects the growing role of partnerships and S corporations in the state’s technology sector.14 The significant jump in corporate franchise tax claims in 2024 suggests a potential expansion of research activities by large, established firms or perhaps a change in the apportionment of multi-state research into Minnesota.14

Economic Evaluation of the Credit

The Tax Expenditure Review Commission, established in 2021, has noted that while the credit stimulates research activity, its primary purpose—whether job creation, business retention, or increased innovation—remains largely implicit rather than codified in statute.8 Legislative audits have indicated that for every dollar of tax credit, there is a measurable increase in economic activity, though the net benefit to the General Fund is often a fraction of the credit’s cost.8 For partnerships, the credit remains a critical factor in the “cost of capital” calculation, often determining whether a project is conducted in Minnesota or in a competing state with its own R&D incentives.5

Practical Example: Gopher Innovative Solutions LLC

To understand the lifecycle of the R&D credit within a partnership, consider Gopher Innovative Solutions LLC, a Minnesota-based software development partnership founded in 2022.

Scenario: The 2025 Tax Year

In 2025, Gopher Innovative Solutions has $\$ 5,000,000$ in total qualified research expenses, all incurred in Minnesota. The partnership is owned by two equal partners, Partner A (an individual) and Partner B (a C corporation).

1. Establishing the Base Amount: As a relatively new company, Gopher uses the $3\%$ start-up fixed-base percentage. Their average Minnesota gross receipts for the previous four years are $\$ 20,000,000$.

• $Base Amount = \$20,000,000 \times 0.03 = \$600,000$.
• However, the $50\%$ rule applies: $Base Amount$ cannot be less than $50\% \text{ of } \$5,000,000 = \$2,500,000$.
• Final Base Amount = $\$2,500,000$.6

1. Calculating the Total Credit:

• $Excess QREs = \$5,000,000 – \$2,500,000 = \$2,500,000$.
• Tier 1 Credit: $10\% \text{ of first } \$2,000,000 = \$200,000$.
• Tier 2 Credit: $4\% \text{ of remaining } \$ 500,000 = \$20,000$.
• Total Credit = $\$220,000$.1

1. Allocating the Credit:

• Each partner receives a Schedule KPI showing a distributive share of $\$110,000$.2

1. Partner Claims and Refund Election:

• Partner A (the individual) has a Minnesota tax liability of $\$20,000$. They apply $\$20,000$ of their R&D credit to bring their liability to zero.
• They have $\$90,000$ in unused current-year credits.
• Partner A elects the $19.2\%$ refund for 2025 on their Form M1 and Schedule M1REF.13
• $Refund = \$90,000 \times 0.192 = \$17,280$.
• The remaining portion of the unused credit ($\$90,000 – \$17,280 = \$72,720$) is carried forward to the 2026 tax year.1
• Partner B (the C corporation) uses their $\$110,000$ credit to offset their own corporate franchise tax. If they cannot use it all, they may share it with other members of their unitary group if applicable.2

Conclusion

The partnership interest in the Minnesota Credit for Increasing Research Activities has transformed from a passive pass-through benefit into a dynamic financial tool for innovation. The legislative move toward partial refundability in 2025 acknowledges the reality that the most impactful research is often performed by entities that do not yet have significant profits—and therefore do not have significant tax liabilities to offset.

By integrating federal standards with state-specific geographic and tiered rate requirements, Minnesota has created a framework that rewards local investment while maintaining fiscal oversight through the base amount formula and the 2028 statewide refund cap. For the partners in these entities, success depends on a meticulous approach to the four-part test, a deep understanding of the interactions between R&D credits and other instruments like the PTE tax, and a robust documentation strategy to survive the 120-day substantiation window required by the Department of Revenue. As the state moves toward a $25\%$ refund rate in 2026, the partnership will remain the quintessential vehicle for driving Minnesota’s economic future through the power of research and development.

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