The Strategic Integration of Pass-Through Tax Entities and the Minnesota Research and Development Credit

Pass-through tax entities facilitate the flow of tax credits from the business level to individual owners, ensuring innovation incentives directly reduce personal tax liabilities. This mechanism is central to the Minnesota Research and Development tax credit, which rewards qualified research performed within the state.

The structural relationship between pass-through entities—such as S corporations, partnerships, and limited liability companies (LLCs)—and the Minnesota Credit for Increasing Research Activities represents a pivotal component of the state’s tax architecture. For decades, the Minnesota Department of Revenue has utilized the conduit principle to encourage technical innovation by allowing credits generated at the entity level to offset the individual income tax obligations of the business owners.1 This arrangement is particularly critical in Minnesota, where the individual income tax rates are among the highest in the nation, peaking at 9.85 percent.4 By funneling these credits to the individuals who bear the economic risk of research, the state seeks to stimulate job creation, attract high-tech industry, and foster a robust climate for scientific discovery.3

The legal foundation for this interaction is primarily codified in Minnesota Statutes section 290.068, which outlines the eligibility, calculation, and allocation of the research credit.5 Historically, the credit was designed as a nonrefundable incentive, meaning it could only reduce a taxpayer’s liability to zero, with any excess carried forward to future years.7 However, the legislative landscape underwent a transformative shift in 2025. Following the enactment of H.F. 9, the state introduced a partial refundability mechanism, allowing pass-through owners to monetize a portion of their unused credits for the first time since a brief temporary period between 2010 and 2012.6 This modernization reflects a growing recognition that startups and early-stage innovative firms often lack the tax liability necessary to benefit from traditional nonrefundable credits.

The Conceptual Framework of Pass-Through Entities

In the context of Minnesota taxation, a pass-through entity is defined by its lack of an entity-level income tax. Instead of taxing the profits at the corporate level, the state “passes” the income, losses, deductions, and credits through to the partners, members, or shareholders.4 These individuals then report their share of the entity’s financial activity on their personal Minnesota income tax returns.

Statutory Definition and Classification

The Minnesota Department of Revenue adheres strictly to federal classifications for tax entities. If an entity is treated as a partnership or an S corporation for federal tax purposes, it maintains that status in Minnesota.4 This consistency reduces administrative burdens for multi-state businesses but necessitates a deep understanding of how federal rules, such as those found in Internal Revenue Code (IRC) Section 41 and Section 1366, translate into state-specific applications.2

A critical distinction exists for single-member LLCs. Unless they elect to be taxed as a corporation, they are generally treated as disregarded entities. While the research activities of a disregarded LLC still flow to the owner’s return, the specific Pass-Through Entity (PTE) tax election is unavailable to them.17 This limitation underscores the importance of entity selection for firms seeking to optimize their tax position through specialized state elections.

The Conduit Principle and Credit Allocation

The conduit principle ensures that the character of an item—such as the Research and Development (R&D) credit—remains the same as it moves from the entity to the owner. If an S corporation performs “qualified research” in Minnesota, the credit remains a “Minnesota R&D credit” in the hands of the shareholder.2 This is governed by the pro rata allocation rules for S corporations and the distributive share rules for partnerships.2

For S corporations, the allocation is strictly based on the percentage of share ownership held by each shareholder on each day of the taxable year.2 For partnerships, the allocation is generally determined by the partnership agreement, provided that the allocation has “substantial economic effect” as defined by federal treasury regulations.2 In both cases, the entity acts as a reporting vehicle, while the owners act as the ultimate taxpayers.

The Minnesota Credit for Increasing Research Activities

The Minnesota research credit, officially titled the Credit for Increasing Research Activities, is the primary vehicle through which the state subsidizes technical experimentation. It is patterned after the federal research credit but contains several unique Minnesota-specific modifications, particularly regarding geographic scope and the two-tiered rate structure.1

Two-Tiered Rate Structure

Minnesota employs a tiered calculation designed to provide a higher marginal benefit to smaller research budgets or the initial phases of larger projects. For taxable years beginning after December 31, 2016, the credit rates are established as follows:

1. Tier One: 10 percent of the first $2,000,000 of excess qualified research expenses over the base amount.6
2. Tier Two: 4 percent of any excess qualified research expenses that exceed the $2,000,000 threshold.6

This tiered structure creates a significant incentive for mid-sized projects. For example, a business with $2 million in excess qualified research expenses would generate a $200,000 credit.8 If that same business had $3 million in excess expenses, the credit would be $240,000 ($200,000 from the first tier plus $40,000 from the second tier).8

The Geographic Constraint: Research Performed in Minnesota

The most significant deviation from the federal credit is the “In-State” requirement. Every expense claimed for the Minnesota credit must be for research activities physically conducted within the borders of Minnesota.5 If a Minnesota-based partnership hires a contractor in North Dakota to perform testing, the 65 percent contract research expense is generally ineligible for the Minnesota credit, even if it qualifies for the federal credit.7

Guidance for Identifying Qualified Research Expenses (QREs)

The Minnesota Department of Revenue provides extensive guidance on what constitutes a Qualified Research Expense (QRE). While the state adopts the federal definitions found in IRC Section 41(b), it enforces them with a focus on Minnesota-specific documentation.7

Categories of Eligible Expenditures

QREs are generally categorized into three main areas of spending: internal wages, supplies, and external contract research.

Wages typically account for the vast majority of credit claims—approximately three-quarters of the total value for most corporations.3 For pass-through entities, this means that the credit is often a direct reflection of the Minnesota payroll dedicated to technical innovation.

The Exclusion of Innovation Grants

A critical piece of guidance from the Minnesota Department of Employment and Economic Development (DEED) and the Department of Revenue concerns the treatment of Innovation Grants. If a business receives a grant from DEED to fund research, any expenditures paid for with those grant funds are ineligible for the R&D tax credit.2 This rule prevents “double-dipping,” where the state would essentially be providing both a direct grant and a tax credit for the same dollar of research spending.

The Impact of IRC Section 174 Amortization

Following the implementation of the Tax Cuts and Jobs Act (TCJA) at the federal level, research and experimental expenditures must be amortized over five years for domestic research or 15 years for foreign research.1 Minnesota conforms to this requirement. For owners of pass-through entities, this means they can no longer deduct 100 percent of their research expenses in the year they are incurred. Instead, the amortization creates higher taxable income in the early years of a research project, making the R&D credit an essential tool for offsetting the resulting increase in tax liability.1

Calculating the Base Amount in the Pass-Through Context

The credit is “incremental,” meaning it is only awarded for research spending that exceeds a specific “base amount.” This mechanism is intended to reward businesses for increasing their research efforts rather than simply maintaining their current levels of investment.1

The Fixed-Base Percentage and Gross Receipts

For established businesses, the base amount is calculated by multiplying the average Minnesota gross receipts for the previous four years by a “fixed-base percentage”.1 The fixed-base percentage is determined by the ratio of Minnesota research spending to Minnesota gross receipts during the 1984–1988 period, capped at 16 percent.1

For startup companies—defined as those that did not have both Minnesota gross receipts and Minnesota research expenses during the 1984–1988 period—the fixed-base percentage is set at 3 percent for the first five years and gradually shifts to a calculated rate thereafter.1

The 50-Percent Minimum Base Rule

A crucial statutory limitation is that the base amount can never be less than 50 percent of the current year’s qualified research expenses.1 This rule ensures that the credit is always capped relative to total research spending, preventing an infinite credit in years of explosive growth.

The formula for the base amount can be expressed as:

$$Base Amount = \max(Average Gross Receipts \times Fixed Base \%, 0.50 \times Current QREs)$$

For pass-through entities with zero gross receipts—a common occurrence for pre-revenue tech startups—the base amount defaults to the 50 percent minimum.7

The 2025 Refundability Paradigm Shift

Historically, the Minnesota research credit was nonrefundable for all taxpayers except for a brief window from 2010 to 2012.9 Outside of that window, any credit that exceeded a taxpayer’s liability was carried forward for 15 years.1 This changed on June 14, 2025, when Governor Tim Walz signed H.F. 9, introducing a permanent partial refundability component.6

The Refundability Mechanism for Pass-Through Owners

For S corporations and partnerships, the election to claim the refundable portion of the credit is made by the individual partners, members, or shareholders rather than at the entity level.7 This is a critical distinction, as it allows each owner to decide whether they prefer a refund or a carryforward based on their personal financial situation.

The refundable amount is calculated as follows:

1. Reduce Liability: The current year R&D credit must first be applied to reduce the taxpayer’s Minnesota tax liability to zero.6
2. Identify Unused Portion: The excess of the current year’s credit over the tax liability is identified.
3. Apply Refundability Rate: The unused portion is multiplied by the statutory “refundability rate” for that year.6

Scheduled Refundability Rates

The legislation establishes a tiered phase-in of refundability rates to manage the state’s fiscal exposure.

The provision allowing the Commissioner of Revenue to adjust the rate after 2027 is intended to target a statewide total refund amount of approximately $25 million per year.6

Strategic Implications of the Election

The election to claim the refund is irrevocable for the year it is made.6 This necessitates a complex decision for pass-through owners. If a shareholder expects to have high tax liability in the next two to three years, they may be better off carrying the full credit forward, where it can offset tax at 100 percent of its value. However, if the owner’s business is in a growth phase and requires cash today, taking a 19.2 percent or 25 percent refund provides immediate liquidity that may be more valuable than a full tax offset in the distant future.6

Guidance on the Pass-Through Entity (PTE) Tax Intersection

The Minnesota Pass-Through Entity (PTE) Tax, established for tax years 2021 through 2025, allows entities to pay tax on behalf of their owners to circumvent the federal $10,000 SALT deduction cap.4 The interaction between the PTE tax and the R&D credit is one of the most technical areas of Minnesota tax law.

Entity-Level Payment and Individual Credits

When a partnership or S corporation elects to pay the PTE tax, it calculates its tax at the 9.85 percent rate.4 The owners then receive a refundable credit for their share of the taxes paid by the entity. This creates a scenario where an individual may have their tax liability effectively “pre-paid” by the entity.

However, the R&D credit can still be used to offset the individual’s tax liability before the PTE credit is applied.4 If the R&D credit reduces the liability to zero, the PTE credit then becomes a full refund to the owner. This synergy allows owners to maximize their federal tax deductions while still benefiting from the state’s innovation incentives.4

Nonresident Withholding and Composite Returns

For nonresident owners, the PTE tax election or participation in a composite return can eliminate the requirement to file an individual Minnesota return.4 However, there is a major caveat regarding the R&D credit: partners or shareholders electing to file as part of a composite return are not entitled to receive the R&D credit.2

Consequently, nonresident owners who wish to benefit from the R&D credit—especially the new refundable portion—must generally opt out of the composite filing and file an individual Minnesota Form M1.2

Reporting Requirements: From Schedule RD to Schedule M1C

Navigating the administrative requirements for the Minnesota R&D credit requires precise coordination between the business entity and its owners. Failure to attach the correct schedules or provide necessary documentation can lead to the immediate disallowance of the credit.16

The Role of the Business Entity

The S corporation or partnership begins the process by completing Schedule RD, Credit for Increasing Research Activities.2

• The entity identifies its Minnesota QREs and calculates the base amount.
• The entity determines the total “Tentative Credit”.2
• The entity then allocates this credit pro rata to its owners.

For partnerships, the credit is reported on Schedule KPI (for individuals/estates) or Schedule KPC (for corporate/partnership partners).2 For S corporations, the credit is reported on Schedule KS.2

The Role of the Individual Owner

The individual partner or shareholder must then take the information from their KPI or KS and report it on their personal return.

• The credit amount is typically entered on Schedule M1C, Other Nonrefundable Credits (for tax years prior to 2025).9
• Starting in 2025, the refundable portion is reported on Schedule M1REF, Refundable Credits.4

The Department of Revenue emphasizes that a copy of the entity’s Schedule RD and the owner’s specific KPI or KS must be attached to the individual’s tax return to substantiate the claim.7

Comprehensive Example: The Pass-Through Lifecycle of an R&D Credit

To clarify these complex interactions, consider “Northern Tech Partners,” a Minnesota-based partnership with two equal partners, Alice (a MN resident) and Bob (a nonresident).

The Scenario (Tax Year 2025)

Northern Tech Partners conducts all its research in a laboratory in St. Paul. In 2025, the firm has the following financials:

• Wages for MN Researchers: $1,200,000.
• MN Supplies: $200,000.
• Contract Research in MN: $100,000 (of which 65%, or $65,000, is qualified).
• DEED Innovation Grant Received: $100,000 (fully spent on research wages).
• Total Minnesota Gross Receipts (4-year average): $5,000,000.
• Historical Fixed-Base Percentage: 3% (Startup).

Step 1: Calculating the Entity-Level Credit (Schedule RD)

First, the partnership must subtract the DEED grant from its total research spending to avoid double-dipping.2

• Total Gross QREs: $1,200,000 + $200,000 + $65,000 = $1,465,000.
• Net QREs (Adjusted for Grant): $1,465,000 – $100,000 = $1,365,000.2

Next, the partnership calculates the base amount.

• Gross Receipts Calculation: $5,000,000 \times 3% = $150,000.
• Minimum Base (50% rule): $1,365,000 \times 50% = $682,500.1
• Statutory Base Amount: $682,500 (the greater of the two).8

Finally, the credit is calculated based on the excess QREs.

• Excess QREs: $1,365,000 – $682,500 = $682,500.
• Tentative Credit (Tier 1): $682,500 \times 10% = $68,250.6

Step 2: Allocation to Partners (Schedule KPI)

The $68,250 credit is split equally between Alice and Bob. Each receives a Schedule KPI showing a $34,125 R&D credit on Line 26.2

Step 3: Individual Partner Tax Filings

Partner A (Alice): Alice has a Minnesota tax liability of $10,000 from Northern Tech Partners and other sources. She elects to receive the refundable portion of her credit for 2025.6

• Liability Offset: Alice uses $10,000 of her $34,125 credit to reduce her tax to zero.
• Unused Credit: $34,125 – $10,000 = $24,125.
• Refundable Amount: $24,125 \times 19.2% = $4,632.6
• Carryforward: $24,125 – $4,632 = $19,493 (to be used over 15 years).6

Partner B (Bob): Bob is a nonresident. He decides to file an individual M1 return rather than a composite return so he can claim the credit. Bob has $2,000 in Minnesota tax liability.2

• Liability Offset: Bob uses $2,000 of his $34,125 credit to reduce his tax to zero.
• Unused Credit: $32,125.
• Decision: Bob chooses not to elect refundability, preferring to carry the full $32,125 forward to offset future Minnesota income tax at its full value.6

Unitary Groups and Combined Reporting

For larger pass-through structures that are part of a unitary business (multiple corporations or entities operated as a single business), Minnesota allows for a strategic allocation of the R&D credit among group members.7

Intra-Group Sharing Rules

Starting in 2013, Minnesota law was amended to allow the sharing of R&D credits among members of a combined group.14 The current protocol for utilizing the credit in the year it is generated is as follows:

1. The earning member (the entity that physically performed the research) uses the credit to offset its own tax liability.14
2. Any remaining credit is then shared with other members of the unitary group to offset their tax liabilities.7
3. Any final unused portion is carried forward by the earning member for 15 years.14

Updated Guidance on Carryforwards

A significant shift in Department of Revenue policy occurred on June 18, 2020. Previously, the state maintained that while credits could be shared in the year they were generated, any carryforward credits could only be used by the specific entity that originally earned them.14 The updated guidance now allows R&D credit carryforwards to be applied to all members of a combined group, consistent with the rules for the generation year.14 This change provides a major tax planning opportunity for unitary groups, as it prevents credits from becoming “trapped” in entities with no tax liability while other group members have tax due.

Substantiation and Audit Readiness

The Research and Development tax credit is frequently scrutinized during audits by the Minnesota Department of Revenue. Because the credit is based on a “facts and circumstances” analysis of technical activities, businesses must be prepared to defend their claims with rigorous documentation.7

The Four-Part Test in Audit Practice

MNDOR auditors look for specific evidence that each project meets the federal requirements:

1. Elimination of Uncertainty: Documentation must show that at the project’s outset, the team did not know if they could achieve the result or how to do it.7
2. Process of Experimentation: Auditors expect to see “issue logs,” meeting minutes, or records of failed prototypes that prove a systematic evaluation of alternatives took place.7
3. Technological in Nature: The project must clearly relate to a hard science. Routine computer programming or market research does not qualify.7
4. Permitted Purpose: The work must aim to improve functionality, performance, reliability, or quality. Efforts to change the “style, taste, or cosmetic design” of a product are expressly excluded.7

Common Pitfalls for Pass-Through Entities

One of the most frequent reasons for credit disallowance in a pass-through context is the lack of “Minnesota-only” accounting.5 Many businesses mistakenly use their federal R&D study as the basis for their Minnesota claim without adjusting for wages paid to employees working remotely from other states.7

Another common issue is the failure to maintain contemporaneous records. The Department of Revenue often rejects claims based on “retrospective interviews” conducted years after the research occurred. Successful claimants maintain “innovation logs” and “labor timesheets” that record activities in real-time.7

State and Local Statistical Overview

The fiscal impact of the R&D tax credit reflects its importance to the Minnesota economy. Data from the Minnesota Department of Revenue and the Legislative Auditor provides a window into the credit’s utilization and effectiveness.

Participation by Entity Type

Historical data indicates that while C corporations claim the largest share of the total credit value, the number of pass-through claimants is significant and growing.

The 2025 refundability provision is expected to shift this balance further toward pass-through entities, particularly as startups and mid-sized innovation firms become more aggressive in their research spending once the credit is partially monetizable.6

Projected Costs and Refund Targets

The state projects a significant increase in the total fiscal impact of the R&D credit over the next several years, driven by both the refundability election and the increasing costs of qualified labor.

The state’s “Refund Target” for 2028 and beyond is managed at a $25 million annual level. This means the Commissioner of Revenue will annually adjust the 25 percent refundability rate downward if total refund requests across all taxpayers exceed the $25 million cap.8

Regional and Industry-Specific Incentives

Minnesota offers several programs that can be combined with the R&D tax credit to create a layered incentive structure for specific regions or industries.25

Border Cities Enterprise Zones

The Border Cities Enterprise Zone program provides a unique set of tax advantages for businesses in cities like Moorhead and East Grand Forks.27 These businesses can claim property tax credits and sales tax credits for construction projects, which reduces the “fixed cost” of establishing a research facility. When combined with the R&D credit, which reduces the “variable cost” of research labor, the resulting tax savings can be substantial.27

The Angel Tax Credit Intersection

For very early-stage startups, the Angel Tax Credit provides a 25 percent refundable credit for investors who put money into high-tech Minnesota firms.23 While a business cannot claim both the Angel Tax Credit and the R&D credit on the same expenditure, a startup can use the equity capital provided by an “Angel” investor to fund its research payroll, which then generates the R&D credit for the business owners.23 This two-step process effectively provides a massive state-funded subsidy for innovation.

Conclusion

The synergy between pass-through tax entities and the Minnesota Credit for Increasing Research Activities represents a sophisticated pillar of the state’s tax policy. By ensuring that innovation credits flow directly to the individual owners who fund and lead technical progress, Minnesota provides a powerful incentive for businesses of all sizes to remain and grow within the state.1

The advent of partial refundability in 2025 marks a new era in this relationship. It acknowledges that for many of the state’s most innovative firms, a carryforward that may not be used for a decade is far less valuable than immediate capital that can be reinvested in new discoveries.6 However, this new flexibility comes with increased complexity. Business owners must now navigate the interaction between the R&D credit, the PTE tax election, and the 15-year carryforward rules, all while maintaining the rigorous documentation required to withstand a Department of Revenue audit.4

Ultimately, the Minnesota R&D credit is more than a simple tax reduction; it is a strategic partnership between the state and its business community. For pass-through entities, it offers a mechanism to significantly reduce the cost of technical advancement, provided they adhere to the detailed administrative guidance and legislative mandates that govern this high-value incentive. As the global economy continues to prioritize technical innovation, the effective utilization of these Minnesota-specific tax attributes will remain a critical factor in the success and sustainability of the state’s professional and technical sectors.

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