The Process of Experimentation Test in the Minnesota Research and Development Tax Credit

The Process of Experimentation Test is a systematic method of evaluating technical alternatives to resolve scientific or engineering uncertainties regarding the capability, method, or design of a business component. In the context of the Minnesota Research and Development tax credit, it serves as the primary functional gatekeeper to ensure that state incentives are directed toward iterative, technology-based innovation rather than routine engineering or aesthetic modifications.

The legal framework governing this test is established by a synergistic relationship between state and federal law. While the Minnesota credit for increasing research activities is codified under Minnesota Statutes Section 290.068, the definition of “qualified research” is explicitly tethered to Section 41 of the Internal Revenue Code (IRC).1 This structural alignment necessitates that any activity seeking to qualify for the Minnesota credit must satisfy the federal “Four-Part Test,” with the Process of Experimentation (PoE) representing the most rigorous and frequently audited component.3 Under the guidance of the Minnesota Department of Revenue (DOR), taxpayers are required to demonstrate a systematic evaluative process that relies on the principles of physical science, biological science, engineering, or computer science to overcome technical challenges.6 The following analysis explores the statutory origin, mechanical application, and industry-specific nuances of the PoE test, alongside the documentation standards required to substantiate claims within the Minnesota tax jurisdiction.

Statutory Foundation and the Federal Nexus

The Minnesota Research and Development (R&D) tax credit was established by the 1981 Legislature and patterned after the federal credit for increasing research activities.7 Its primary function is to reduce the corporate franchise tax or individual income tax liability for businesses that invest in innovation within the state’s borders.1 To understand the meaning of the Process of Experimentation in this context, one must first examine the statutory bridge between Minnesota Statutes and the Internal Revenue Code.

Minnesota Statutes Section 290.068, Subdivision 2, defines “qualified research” as research meeting the definition provided in IRC Section 41(d), with the specific caveat that the research must be conducted within Minnesota.1 This means that the state of Minnesota adopts the federal “Four-Part Test” in its entirety as the legal standard for determining what constitutes an eligible R&D activity. The PoE is the fourth and often most complex prong of this test.

The legislative intent behind this nexus is to provide a consistent environment for businesses operating both in Minnesota and across state lines, while simultaneously incentivizing the retention of high-skilled labor and technological investment within the state.7 By adopting the federal standard, Minnesota allows taxpayers to leverage existing federal documentation to support state claims, provided they can clearly isolate the expenses and activities occurring within the Minnesota tax jurisdiction.6

The Four-Part Test Framework

Before an activity can even be evaluated under the Process of Experimentation test, it must satisfy three preceding requirements. These prerequisites ensure that the research is fundamental to the business’s core technological capabilities rather than peripheral or aesthetic in nature.

The first requirement is the Section 174 Test, which dictates that the expenditures must be treatable as research or experimental expenditures under IRC Section 174.3 This involves a high-level determination of whether the costs were incurred in connection with the taxpayer’s trade or business and represent research and development in the experimental or laboratory sense. The second requirement is the Technological in Nature Test, which mandates that the process of experimentation must fundamentally rely on the principles of the “hard” sciences—physical science, biological science, engineering, or computer science.3 Research based on social sciences, arts, or humanities is strictly excluded.3

The third requirement is the Business Component Test, or the Permitted Purpose Test. This requires that the research be undertaken for the purpose of discovering information that is intended to be useful in the development of a new or improved “business component”.3 A business component can be a product, process, computer software, technique, formula, or invention held for sale, lease, or license, or used by the taxpayer in its trade or business.3 Specifically, the research must relate to improving function, performance, reliability, or quality.6

Deconstructing the Process of Experimentation

The Process of Experimentation test is the final and most rigorous prong of the qualifying test. Under IRC Section 41(d)(1)(C), qualified research is that which constitutes “elements of a process of experimentation”.3 Federal regulations and Minnesota Department of Revenue guidance break this down into several distinct conceptual requirements: technical uncertainty, the evaluation of alternatives, and the systematic nature of the effort.6

The Requirement of Technical Uncertainty

Technical uncertainty is the starting point of any qualified process of experimentation. It exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component, or the appropriate design of that component.3

There is a critical distinction between “business uncertainty” and “technical uncertainty.” Business uncertainty—such as whether a product will find a market or whether a project will be profitable—does not satisfy the test. Technical uncertainty must stem from an inability to predict the outcome of a design or process based on current engineering knowledge.6 The Minnesota DOR emphasizes that if the solution is already known or can be achieved through routine knowledge within the industry, no uncertainty exists for tax credit purposes.6

The Systematic Evaluation of Alternatives

Once an uncertainty is identified, the taxpayer must engage in a process to resolve it. This is not a haphazard “trial and error” in the colloquial sense, but a systematic evaluative process.15 The PoE typically follows a structured path that mirrors the scientific method:

1. Identification of Uncertainty: Defining the specific technical challenge.6
2. Formation of a Hypothesis: Developing a technical theory on how to resolve the challenge.6
3. Identification and Evaluation of Alternatives: Proposing multiple paths or designs to test the hypothesis.3
4. Testing and Analysis: Using modeling, simulation, or physical testing (such as prototypes or pilot models) to gather data on the alternatives.5
5. Refinement or Discarding: Adjusting the design based on test results or abandoning failed alternatives to focus on viable ones.6

The Minnesota DOR specifically requires taxpayers to be able to “outline the steps you took to develop or improve the product or process; in the order they happened”.6 This requirement for a chronological narrative of the experimentation process underscores the necessity of contemporaneous recordkeeping.

The Substantially All Element (The 80% Rule)

Perhaps the most significant hurdle in the PoE test is the “Substantially All” requirement. Under IRC Section 41(d)(1)(C), which Minnesota follows, at least 80% of the research activities for each business component must constitute elements of a process of experimentation for a qualified purpose.3

This measurement is typically performed on a cost basis, such as labor hours or total qualified research expenses (QREs).13 If 80% or more of the activities satisfy the PoE test, the entire business component is considered qualified research.3 However, if the experimental portion is less than 80% of the total effort, none of the activities for that specific business component qualify for the credit.13 This “all-or-nothing” threshold at the project level is a frequent point of contention in audits, particularly in cases where research is intertwined with routine production or maintenance.13

Minnesota Department of Revenue Guidance and Audit Standards

The Minnesota Department of Revenue provides extensive guidance to help taxpayers navigate the complexities of the research credit. This guidance is primarily disseminated through the official “Credit for Increasing Research Activities” overview page, the instructions for Schedule RD, and various Revenue Notices.2

Official Guidance on PoE Requirements

The Minnesota DOR defines the Process of Experimentation test as an activity that must evaluate alternatives, develop and test hypotheses, and refine or discard those hypotheses until the technical uncertainty is resolved.6 The state explicitly highlights the role of technical risk, noting that the process should involve a situation where “failure may occur”.6

Furthermore, the DOR clarifies that research is only treated as performed for a “permitted purpose” if it relates to a new or improved business component’s function, reliability, performance, or quality.6 Activities directed toward the following are explicitly excluded from the state credit:

• Style, taste, cosmetic, or seasonal design.6
• The adaptation of an existing business component to a particular customer’s need.3
• The duplication of an existing business component from physical inspection, blueprints, or specifications.3
• Market research, testing, or development, including advertising and promotion.12
• Routine data collection or ordinary testing for quality control.6

Documentation and Recordkeeping

Minnesota law places the burden of proof squarely on the taxpayer to substantiate their credit claim.7 The DOR follows the federal recordkeeping procedures outlined in 26 C.F.R. 1.6001-1, which requires that records be kept in a “usable form” to validate expenditures.2

According to state guidance, taxpayers must maintain records that identify the individuals involved, their location, the specific activities they performed, and the portion of their time dedicated to qualified research.6 During a review or audit, the DOR may request specific documents generated at the time the research was performed:

• Research Documentation: Issue logs, meeting minutes, project authorization records, and emails that show the scope of research and testing of alternatives.6
• Experimental Evidence: Lab schedules, experiment results, testing protocols, and reports from trial runs.6
• Technical Drawings: CAD renderings, fabrication drawings, and blueprints that illustrate the progression of a design.20
• Expense Substantiation: Employee W-2s, payroll records, and invoices for supplies and contractor expenses.6

The DOR specifically warns that “solely interviewing employees to reconstruct activities believed to qualify for the credit is generally insufficient without additional evidence”.6 This underscores the necessity of a contemporaneous documentation strategy.

Industry-Specific Applications of the PoE Test

The practical application of the Process of Experimentation test varies significantly across Minnesota’s major industries, including manufacturing, medical technology, software development, and mining.

Manufacturing and Engineering

In the manufacturing sector, experimentation often revolves around the development of “pilot models”—defined as any representation of a business component that is produced to evaluate and resolve uncertainties during development.6 This includes prototypes used to test structural integrity, material durability, or manufacturing efficiency.

Common qualified activities in Minnesota manufacturing include:

• Developing new fabrication techniques to reduce material waste.6
• Experimenting with different alloy compositions to improve the heat resistance of an engine component.3
• Testing the integration of automation sensors into an existing assembly line where the “method” of integration is uncertain.6

Conversely, routine maintenance, “troubleshooting” that doesn’t involve a systematic evaluation of alternatives, and aesthetic modifications to a product’s exterior housing would not qualify as a process of experimentation.6

Medical Devices and Biotechnology

Minnesota is a global center for medical innovation, and the R&D credit is a vital incentive for this sector. Experimentation in medical technology often involves rigorous laboratory testing and clinical trials intended to prove the safety and efficacy of a device.14

Qualified activities in medical technology might include:

• Testing different biocompatible coatings on a pacemaker lead to resolve uncertainties about long-term tissue rejection.14
• Developing and modeling a new fluid dynamics algorithm for a drug delivery pump.15
• Iterative testing of a surgical instrument’s grip to improve ergonomic performance and reliability during high-stress procedures.6

Documentation for these projects typically includes laboratory rosters, analytical reports, testing protocols, and detailed logs showing the evolution of the device through successive design iterations.14

Software Development

Software development is one of the most highly scrutinized areas for the PoE test.21 To qualify, the development must fundamentally rely on computer science principles rather than routine programming or configuration.3

Guidance from the IRS, which Minnesota follows, categorizes software activities by risk level. “High-risk” (meaning less likely to qualify) activities include aesthetic changes to user interfaces or the routine integration of existing software modules using established tools.17 “Qualified” activities are more likely to involve:

• Developing new data encryption algorithms to protect the integrity of electronic submissions.21
• Modifying heuristic algorithms in anti-virus software to detect previously unknown malware patterns.21
• Resolving uncertainties in embedded applications, such as developing new communication protocols for failing-safe automotive systems.21

Mining and Extraction

A unique aspect of Minnesota tax law is the application of the R&D credit to mining companies subject to the Occupation Tax. Under Revenue Notice #22-01, the Minnesota DOR confirmed that mining companies are allowed to claim the Credit for Increasing Research Activities against their occupation tax liabilities.19

In this context, the PoE test might apply to the development of new ore refining techniques, the creation of more efficient waste management processes, or the testing of new materials to withstand the corrosive environments of deep-well extraction. The same Four-Part Test apply: the mining company must prove that they evaluated multiple technical alternatives to resolve a specific uncertainty regarding their refining or production methods.6

Example Scenario: Iterative Development in a Minnesota Tech Firm

To illustrate the application of the Process of Experimentation test, consider “NorthStar Avionics,” a hypothetical aerospace manufacturer based in Duluth, Minnesota.

The Project: NorthStar Avionics is developing a new flight control system that uses fiber-optic sensors to detect wing stress in real-time. The goal is to improve the reliability and performance of the aircraft under extreme turbulence.

The Uncertainty: At the start of the project, the engineering team is uncertain about the “appropriate design” for the sensor placement. They do not know if a series of linear sensors or a grid-based sensor array will provide more accurate data while maintaining the structural integrity of the wing’s composite materials. They also face uncertainty regarding the “method” of bonding the fiber optics to the composite without interfering with the sensors’ light-transmission properties.

The Process of Experimentation:

1. Hypothesis Formulation: The team hypothesizes that a grid-based array with a specific epoxy bonding agent will provide the best balance of data density and structural strength.
2. Evaluating Alternatives: Engineers design three alternative wing-section prototypes: one with linear sensors, one with a loose grid, and one with a dense grid. They also test four different bonding epoxies.5
3. Modeling and Simulation: Using CAD and stress-simulation software, they model the performance of each sensor layout under various load conditions.15
4. Physical Testing: The prototypes are subjected to physical stress tests in a laboratory. Engineers record data on sensor accuracy and the structural failure point of each bonding agent.6
5. Refinement: After finding that the dense grid caused structural cracking, they discard that alternative. They refine the loose grid design by adjusting the epoxy curing temperature and re-testing until they achieve the desired performance.6

Conclusion of the PoE: Because NorthStar Avionics identified specific technical uncertainties (design and method), evaluated multiple alternatives (linear vs. grid layouts and different epoxies), and used a systematic testing process (simulation and lab testing) based on engineering principles, this activity would likely satisfy the PoE test for the Minnesota R&D credit.5

Financial Calculation of the Minnesota R&D Credit

The Minnesota R&D credit is calculated using a “regular incremental method,” which is distinct from the Alternative Simplified Credit (ASC) used at the federal level.6 This method requires taxpayers to calculate a “base amount” and then apply tiered rates to the qualified research expenses that exceed that base.

Tiered Credit Rates

For most taxpayers, the Minnesota R&D credit for a given taxable year is the sum of:

1. 10% of the first $2,000,000 of excess QREs.1
2. 4% of any excess QREs that exceed $2,000,000.1

Historically, the secondary tier was 2.5%, but this was increased to 4% for taxable years beginning after December 31, 2016, to provide a stronger incentive for larger-scale innovation.6

Determining the Base Amount

The base amount is a critical component of the “incremental” nature of the credit. It is designed to ensure that the credit only applies to research efforts that exceed a business’s historical norms. For Minnesota purposes, the base amount is the greater of:

• A calculated amount based on the business’s fixed-base percentage and its average annual Minnesota gross receipts for the prior four years.1
• 50% of the current year’s Minnesota QREs.9

This 50% limit is particularly relevant for Minnesota-based multistate businesses. Because their Minnesota gross receipts (the denominator in the base calculation) may be relatively low compared to their statewide research spending, their credits are often determined by the 50% rule.9

Mathematical Formula for the Credit

The calculation for the credit ($C$) on excess expenses ($E$) is as follows:

Let $QRE_{MN}$ be the total qualified research expenses in Minnesota.

Let $Base_{MN}$ be the calculated Minnesota base amount.

Let $E = QRE_{MN} – Base_{MN}$.

The credit $C$ is then:

$$C = \begin{cases} 0.10 \times E & \text{if } E \le \$2,000,000 \\ (0.10 \times \$2,000,000) + (0.04 \times (E – \$2,000,000)) & \text{if } E > \$2,000,000 \end{cases}$$

The 2025 Refundability Election and Legislative Changes

One of the most significant shifts in the Minnesota R&D tax credit landscape is the introduction of partial refundability for taxable years beginning after December 31, 2024.6 This change, enacted through H.F. 9, is designed to boost liquidity for startups and R&D-heavy firms that may not yet have a tax liability against which to apply the credit.11

Mechanics of the Refundable Credit

Taxpayers may elect to receive a refund of their current-year R&D credit if the credit exceeds their tax liability. This election must be made on a timely filed return and is irrevocable for that year.6 The refundable portion is calculated by taking the “refundability rate” for the year and multiplying it by the excess credit remaining after the tax liability has been reduced to zero.6

Beginning in 2028, the Commissioner of Revenue will adjust the refundability rate annually based on revenue forecasts to ensure that the total statewide refunds stay at or below a $25 million target.11 This management mechanism allows the state to maintain fiscal control while still providing a cash incentive to innovators.

Implications for the PoE Test

The shift toward refundability is expected to increase the level of scrutiny from the Minnesota Department of Revenue.11 When a tax credit simply reduces a future liability, the immediate fiscal impact on the state is delayed. However, a refundable credit results in a direct cash outflow from the state treasury. Consequently, taxpayers electing refundability should expect rigorous audits of their Four-Part Test compliance, with a specific focus on the Process of Experimentation.6

Fiscal and Economic Impact of the Credit

The Credit for Increasing Research Activities is a major component of Minnesota’s economic development strategy. According to estimates from the Minnesota Department of Revenue’s Tax Expenditure Budget, the fiscal impact of the credit is projected to grow significantly through the mid-2020s.9

Fiscal Year Statistics

The sharp increase from 2022 to 2024 is attributed to several factors, including the expansion of the technology and bioscience sectors in the state and the increased awareness of the credit among pass-through entities (S corporations and partnerships).7

Distribution and Effectiveness

While the credit is available to businesses of all sizes, the majority of the benefits accrue to large C corporations. From 2010 to 2014, C corporations claimed 81% of the credits, and the top 20% of claimants (by sales) received two-thirds of the total credit value.7

An evaluation by the Office of the Legislative Auditor (OLA) found that while the credit increased jobs and earnings statewide, the growth was relatively small compared to the total cost of the credit, and the incentive “did not pay for itself” in terms of direct fiscal benefits to the state treasury.7 This has led to ongoing legislative efforts to establish more explicit and measurable objectives for the credit through the Tax Expenditure Review Commission (TERC).8

Common Pitfalls and Compliance Challenges

Due to the technical and documentary rigor of the Process of Experimentation test, many Minnesota taxpayers face challenges during audits. Understanding these pitfalls is essential for maintaining a compliant R&D program.

Failure to Isolate Minnesota Activities

A frequent mistake is claiming the Minnesota credit based on a proportional allocation of federal research expenses without ensuring that all activities took place within the state.1 Minnesota law is strict: all QREs must be conducted in Minnesota.6 If a contractor or employee performed research outside the state, those specific wages and costs must be excluded from Schedule RD.26

Routine Engineering vs. Experimentation

In many industries, the line between routine engineering and qualified experimentation is thin. The “Substantially All” requirement often catches taxpayers who have documented their final design but failed to document the iterative failures and alternative evaluations that occurred along the way.3 If the work is primarily focused on “adaptation” (modifying an existing product for a new customer) or “duplication” (recreating a competitor’s product), it fails the PoE test.3

Inadequate Contemporaneous Documentation

Relying on “project summaries” written at the end of the year or “expert interviews” conducted during an audit is a high-risk strategy.6 The Minnesota DOR expects to see evidence that was generated during the research process. If a developer did not log their different coding iterations or an engineer did not record the results of their prototype failures at the time they occurred, the credit may be disallowed for lack of substantiation.6

Ineligible Supply and Contract Costs

Taxpayers often mistakenly include general and administrative supplies, capital equipment, or travel expenses in their QRE calculations.6 Only tangible property used in the conduct of research—and not subject to depreciation—qualifies as a supply.6 For contract research, only 65% of the payments are typically eligible, and the taxpayer must retain the “economic risk” and “substantial rights” to the research results.7

Conclusion: Strategic Value and Future Outlook

The Process of Experimentation test remains the most vital and complex element of the Minnesota Research and Development tax credit. It requires a fundamental shift in how businesses view their innovative efforts—not just as successful product launches, but as documented scientific inquiries into technical uncertainty.

As Minnesota moves into a new era of partial refundability in 2025, the strategic value of the R&D credit will only increase, particularly for the state’s burgeoning startup ecosystem. However, this increased value comes with a mandate for higher compliance standards. Businesses that proactively implement contemporaneous documentation practices, identifying technical uncertainties and the systematic steps taken to resolve them, will be best positioned to secure these incentives and defend them against audit scrutiny. By aligning their internal R&D workflows with the rigorous requirements of the PoE test, Minnesota companies can continue to lead in sectors like medical technology, advanced manufacturing, and software development, ensuring that the state remains a premier destination for technological advancement.

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