Analysis of Qualified Research Under the Minnesota Research and Development Tax Credit Framework

Qualified research in Minnesota refers to systematic, science-based activities performed within the state to develop or improve products, processes, or software by resolving technical uncertainties. Under Minnesota Statute 290.068, these activities must satisfy a rigorous four-part test to yield valuable tax credits against corporate or individual income liabilities.

The evolution of the Minnesota research and development (R&D) tax credit represents a significant policy effort by the state to foster an environment of industrial and technological innovation. Established by the state legislature in 1981, the credit was patterned after the federal credit for increasing research activities found in Section 41 of the Internal Revenue Code (IRC).1 Over the subsequent decades, the Minnesota Credit for Increasing Research Activities has become a cornerstone of the state’s economic development strategy, designed to incentivize businesses to keep their research operations within the state’s borders.1 To understand the meaning of “Qualified Research” in this context, one must navigate the intersection of state statutes, federal definitions, and the specific administrative directives issued by the Minnesota Department of Revenue (MDOR). The credit is fundamentally incremental, meaning it does not merely reward research spending but specifically targets the increase in research effort over a historical benchmark known as the base amount.2

Statutory Framework and Federal Conformity

The primary legal authority for the credit is Minnesota Statute § 290.068, which allows a credit against the corporate franchise tax or the individual income tax for businesses that conduct research and development activities in Minnesota.3 The statute defines “Qualified Research” by direct reference to federal law, specifically IRC § 41(d), with the critical state-level modification that the research must be conducted within the geographical boundaries of Minnesota.3 This geographic restriction is absolute; even if a Minnesota-based company conducts groundbreaking research at a facility in another state, those specific expenses are excluded from the state credit calculation.3

Minnesota’s tax code generally follows a policy of selective conformity to the Internal Revenue Code. For the purposes of the R&D credit, the state adopts the definitions of “Qualified Research Expenses” (QREs) and “Basic Research Payments” as defined in IRC § 41(b) and (e).4 This conformity ensures that businesses can often use the same technical documentation and accounting processes for both their federal and state claims, although the financial calculations differ due to state-specific base amounts and the lack of an alternative simplified method (ASM) at the state level.3 The statutory definition of “Qualified Research Expenses” encompasses in-house research expenses, which include wages and supplies, as well as contract research expenses.5

The Meaning of Qualified Research: The Four-Part Test

To fall within the legal meaning of “Qualified Research,” an activity must satisfy four distinct criteria derived from federal regulations and enforced by the Minnesota Department of Revenue. These requirements ensure that the tax credit is applied to genuine innovation rather than routine business operations.5

The Section 174 Test

The first requirement is that the activity must qualify as a business deduction under Section 174 of the Internal Revenue Code.5 Section 174 relates to research and experimental expenditures which are incurred in connection with a taxpayer’s trade or business and represent costs in the experimental or laboratory sense.5 A critical nuance of this test is the intent behind the expenditure; the costs must be for the purpose of discovering information that would eliminate uncertainty concerning the development or improvement of a business component.5 While recent federal changes require these expenses to be capitalized and amortized over five years, the underlying definition of what constitutes an eligible R&D activity remains the qualifying threshold for the Minnesota credit.2

The Technological Information Test

Qualified research must be technological in nature, meaning the process of experimentation must rely on the principles of the physical or biological sciences, engineering, or computer science.5 This requirement excludes research in the social sciences, arts, or humanities.5 The Minnesota Department of Revenue emphasizes that the activity must seek to discover information that is not already known to the taxpayer.5 However, the information does not need to be new to the world or the industry at large; it merely needs to be information the taxpayer does not currently possess to resolve their specific technical uncertainty.5

The Business Component Test

The taxpayer must intend to use the information discovered to develop a new or improved business component.5 A business component is broadly defined as any product, process, computer software, technique, formula, or invention to be held for sale, lease, or license, or used by the taxpayer in their trade or business.5 The research must specifically relate to improving the business component’s function, performance, reliability, or quality.5 Improvements focused solely on style, taste, cosmetic design, or seasonal factors are explicitly excluded from the definition of qualified research in Minnesota.5

The Process of Experimentation Test

Perhaps the most rigorous of the four criteria is the process of experimentation test. This requires that substantially all of the activities must constitute a process designed to evaluate one or more alternatives to achieve a result where the capability or method of achieving that result—or the appropriate design of that result—is uncertain at the beginning of the research.5 This process typically involves the formulation of a hypothesis, the design and conduct of testing or simulations, and the evaluation of results to refine or discard the original hypothesis.5 The Department of Revenue guidance clarifies that there must be a technical risk of failure; if the taxpayer knows at the outset how to achieve the desired result and is merely following standard protocols, the activity does not qualify.5

Qualified Research Expenses: Defining the Spend

The financial value of the Minnesota R&D tax credit is derived from “Qualified Research Expenses” (QREs) incurred while conducting qualified research within the state.5 These expenses are generally categorized into four primary areas, each with specific rules regarding eligibility and documentation.3

Personnel Costs and Wages

Wages paid to employees for performing, supervising, or directly supporting qualified research are the primary driver of QREs for most Minnesota claimants.6 For a C-corporation, wages typically account for three-quarters of all qualified research expenses in the state.1 Qualifying wages include:

• Direct Research: Time spent by engineers, scientists, or developers conducting the actual experimentation or coding.6
• Direct Supervision: Time spent by managers directly overseeing the technical performance of the research projects.6
• Direct Support: Time spent by lab assistants, technicians, or machinists directly aiding the researchers.6

The Minnesota Department of Revenue applies the “substantially all” rule for wages: if an employee spends at least 80% of their time on qualified research activities, 100% of their W-2 wages may be included as QREs.6 If the time spent is below 80%, only the actual percentage of time dedicated to research is eligible.

Supplies and Materials

Supplies include tangible property that is used or consumed in the research process.5 Common examples in Minnesota industries include chemicals, metals for prototypes, and materials used for destructive testing.5 It is important to distinguish between “supplies” and “inventory”; materials that eventually become part of a product sold to a customer are generally excluded unless they were consumed during the experimentation phase.6 Furthermore, depreciable property, land, and improvements to land are strictly ineligible for the credit.5

Contract Research Expenses

Businesses often hire third-party entities, such as engineering firms or university laboratories, to conduct research on their behalf. Minnesota allows for 65% of the payments made to unrelated third parties for qualified research to be included as QREs, provided the research is performed within Minnesota.5 If the research is performed by a qualified research organization for basic research, or by certain nonprofit organizations, the percentage may be higher, but for most commercial contracts, the 35% reduction is mandatory.5

Computer Rental and Cloud Costs

As innovation has shifted from physical labs to digital environments, the cost of computing power has become a significant research expense. Minnesota law allows for the inclusion of amounts paid to another person for the right to use computers to conduct research.5 In a modern context, this increasingly applies to cloud service providers (e.g., AWS, Azure) where the servers are used more than 80% of the time for simulation, modeling, or software development related to qualified research.6

Minnesota Revenue Office Guidance: Compliance and Forms

The Minnesota Department of Revenue provides extensive guidance to help taxpayers navigate the complexities of the Credit for Increasing Research Activities. This guidance is primarily disseminated through the instructions for Schedule RD and various tax forms tailored to different business entities.7

Documentation and Recordkeeping Standards

Taxpayers are required by law to maintain contemporaneous records that substantiate their R&D claims.5 The MDOR may request documentation for each tax period, including:

• A list of all research projects conducted during the year, detailing the technical objectives and uncertainties.5
• Project timelines and authorization records.5
• Laboratory schedules, experiment results, and trial run logs.5
• Payroll records and timesheets that link specific employee wages to the four-part test.5
• Invoices and receipts for all research supplies and contractor payments.5

Under Minnesota’s general statute of limitations, these records should be retained for at least 3.5 years, though many tax professionals recommend a retention period of 4 to 7 years, especially when carryforwards are involved.6

Entity-Specific Filing Instructions

The credit is available to a wide range of business structures, and the filing requirements vary accordingly.

For S-corporations and partnerships, the credit is typically generated at the entity level but used at the individual level by the owners to reduce their Minnesota income tax liability.1 In these cases, the partners or shareholders must include a copy of the partnership’s or S-corporation’s Schedule RD with their personal returns.3

The Incremental Nature: Calculating the Base Amount

The Minnesota R&D credit is not a flat percentage of all research spending; it is an incremental credit that only applies to the portion of current-year spending that exceeds a historical “base amount”.2 This structure is intended to ensure that the state only subsidizes the “additional” research effort a company undertakes.2

The Base Amount Calculation Methodology

The base amount is generally the product of the taxpayer’s “fixed-base percentage” and their average annual Minnesota gross receipts for the four preceding years.1

• Fixed-Base Percentage: For established companies, this is the ratio of Minnesota QREs to total Minnesota gross receipts during the 1984–1988 period, capped at 16%.2
• Start-up Rule: Companies that did not have both QREs and gross receipts during at least three years of the 1984–1988 period are assigned a 3% fixed-base percentage for their first five years of research spending after 1993.2
• 50% Minimum Rule: Regardless of the calculation, the base amount can never be less than 50% of the current year’s QREs.2 This rule is particularly impactful for high-growth Minnesota companies, effectively limiting their credit to a percentage of half their total research spend.2

Minnesota-Specific Gross Receipts

A major point of departure from federal law is the definition of gross receipts. While the federal credit uses national or global gross receipts, the Minnesota credit requires the use of Minnesota sales or receipts as defined under Statute § 290.191.3 These are the same receipts used to apportion the company’s income to Minnesota.8 This creates a unique advantage for Minnesota-based multistate businesses: because their Minnesota receipts are often a small fraction of their total sales, while their Minnesota research often relates to their entire global operation, their “base amount” remains relatively low, allowing for a larger credit.2

Internal Use Software: The High Threshold of Innovation

Software development is a major industry in Minnesota, but not all software development is treated equally under the R&D tax credit. A distinction is made between software developed for sale or lease and “Internal Use Software” (IUS).5

Defining Internal Use Software

IUS is software developed by (or for the benefit of) the taxpayer primarily for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business.12 This includes software for financial management (accounts payable, budgeting), human resources (payroll, benefits), and support services.12

The High Threshold of Innovation (HTI) Test

To qualify for the Minnesota credit, IUS must satisfy an additional three-part test in addition to the standard Four-Part Test.5 This is known as the High Threshold of Innovation test:

1. Innovation: The software must result in a reduction in cost or improvement in speed that is substantial and economically significant.12
2. Significant Economic Risk: The taxpayer must commit substantial resources to the development with no certainty that the resources will be recovered within a reasonable period.12
3. Commercial Availability: There must be no comparable third-party software available in the commercial marketplace that can be used without the same level of innovative modification.14

A specific “safe harbor” exists for dual-function software—software that serves both internal administrative purposes and allows third-party interaction (such as a customer-facing portal that also handles internal accounting).12 In such cases, if the third-party portion is interwoven with the internal portion, a taxpayer may deem 25% of the development costs as non-internal use, thus avoiding the HTI test for that portion.12

Credit Rates and Recent Legislative Changes

The Minnesota R&D credit features a tiered rate structure designed to maximize the benefit for smaller and mid-sized research investments.

The Tiered Rate Structure

For taxable years beginning after December 31, 2016, the credit is calculated as:

• 10% of the first $2,000,000 of Minnesota qualified research expenses in excess of the base amount.3
• 4% of all such excess expenses over $2,000,000.3

Prior to 2017, the second-tier rate was 2.5%, and even earlier, the first-tier rate was 5%.1 The current 10%/4% structure represents the most aggressive incentive level in the program’s history.3

The Shift to Partial Refundability (2025 Updates)

Historically, the Minnesota R&D credit has been nonrefundable, meaning it could only be used to reduce tax liability to zero, with any excess carried forward for up to 15 years.3 However, legislation enacted in June 2025 has reintroduced a partial refundability option starting with the 2025 tax year.17

This change is particularly beneficial for startups and R&D-heavy firms that may have zero or negative income and thus no immediate tax liability.6 To claim the refund, taxpayers must make an irrevocable election on a timely filed return.6

Economic Impact and Statistical Overview

The Credit for Increasing Research Activities is a significant fiscal tool, as evidenced by the data provided in state tax expenditure budgets. These reports highlight both the cost of the credit and the industries that utilize it most heavily.2

Fiscal Impact on State Revenue

The total cost of the credit—representing the amount of tax revenue the state foregoes to incentivize R&D—has risen steadily, reflecting the growth of Minnesota’s technology sector.

Note: Data sourced from the 2024 Tax Expenditure Budget.2

Distribution by Industry and Business Size

The manufacturing industry is the dominant claimant of the credit, representing 65% of all credits claimed by C-corporations.1 Within this sector, medical technology and electronic components are key drivers. Furthermore, the credit is concentrated among larger firms; between 2010 and 2014, the largest 20% of C-corporations (measured by national sales) received two-thirds of the total tax credit claimed.1 Despite this concentration, the credit is widely used by pass-through entities, with S-corporation shareholders and partners claiming approximately $16 million in credits in 2014.1

Comprehensive Example: The “Precision Medical” Case Study

To see how these rules apply in a real-world business context, we can analyze a hypothetical Minnesota-based medical device manufacturer, “Precision Medical,” during the 2025 tax year.

The Innovation Project

Precision Medical is developing a new type of biocompatible sensor for real-time monitoring of cardiac health. The project involves electrical engineering, material science (a physical science), and the development of firmware (computer science) to process the sensor data. The project meets the Four-Part Test because:

1. Section 174: It involves developing a new medical product with technical uncertainties.
2. Technological in Nature: It relies on engineering and material science.
3. Business Component: The sensor will be sold to hospitals and patients.
4. Process of Experimentation: The team is testing different polymer coatings and circuit designs to eliminate uncertainty about sensor accuracy and longevity.

Calculating the 2025 Minnesota QREs

The company is located entirely in Rochester, MN. All research is performed locally.

• Wages for R&D Engineers: $3,000,000.
• Supplies (Materials and Prototype Components): $400,000.
• Contract Research (MN-based lab): $100,000.

• Note: Only 65% of contract research qualifies, so this counts as $65,000.

• Cloud Computing (for simulations): $50,000.
• Total Current Year MN QREs: $3,515,000.

Determining the Base Amount

Precision Medical’s average Minnesota gross receipts for the prior four years (2021-2024) were $20,000,000. Their historical fixed-base percentage is 10%.

• Calculated Base Amount: $20,000,000 \times 10% = $2,000,000.
• Check 50% Minimum Rule: $3,515,000 \times 50% = $1,757,500.
• Applicable Base Amount: $2,000,000 (The higher of the two).

Credit Calculation

• Excess QREs: $3,515,000 – $2,000,000 = $1,515,000.
• Tiered Rate Application:

• First $2,000,000 of excess: 10% rate.
• Amount over $2,000,000: 4% rate.

• Since the excess ($1,515,000) is below $2,000,000, the entire amount is taxed at 10%.
• 2025 Minnesota R&D Credit: $151,500.

Utilization and Refundability Election

In 2025, Precision Medical has a Minnesota corporate tax liability of $100,000.

1. The company uses $100,000 of the credit to reduce its tax liability to $0.
2. Unused Credit Remaining: $51,500.
3. Refundability Option: The company elects to treat the unused portion as refundable at the 2025 rate of 19.2%.
4. Cash Refund: $51,500 \times 19.2% = $9,888.
5. The remaining $41,612 is carried forward to the 2026 tax year.

Specialized Rules: Nonprofit Contributions and Unitary Groups

Minnesota law includes several unique provisions that differentiate its credit from the federal version, specifically regarding community investment and corporate structure.3

Contributions to Qualified Nonprofits

In an effort to stimulate early-stage innovation, Minnesota allows “Qualified Research Expenses” to include contributions to nonprofit corporations established to promote business expansion in the state.3 These contributions must be invested by the nonprofit to provide funds for small, technologically innovative Minnesota enterprises.3 This effectively allows a large corporation to claim a portion of its charitable or developmental contributions as R&D spending, provided the funds are used for state-sanctioned technological growth.8

Unitary Business Group Sharing

Under Minnesota Statute section 290.068, members of a combined unitary group can share R&D credits.3 If one member of the group generates a credit that exceeds its own liability, it must first apply that credit to its own tax, then it can allocate the excess to other members of the unitary group who have their own tax liabilities.3 This ensures that large, diversified corporate groups can fully utilize the credits generated by their R&D-heavy subsidiaries.3 If the group still has excess credits after reducing the entire group’s liability to zero, the “earning member” (the entity that actually conducted the research) is responsible for the carryforward.3

Exclusions and Non-Qualifying Research

To maintain the integrity of the credit, both state law and MDOR guidance explicitly list activities that do not meet the meaning of qualified research. These exclusions are a frequent focus of state audits.5

Commercial and Non-Technical Exclusions

Activities that are focused on the commercialization phase or business operations are generally barred:

• Research after the beginning of commercial production of a product.5
• Adaptation of an existing product for a specific customer’s requirements without resolving technical uncertainty.5
• Duplication of an existing business component through reverse engineering.5
• Management studies, efficiency surveys, and routine market research.5
• Routine quality control testing and inspection of materials or products.5

Funding Restrictions

Research is not “qualified” if it is funded by another person or entity.5 For example, if a Minnesota company receives a federal Small Business Innovation Research (SBIR) grant or an Innovation Grant from the Minnesota Department of Employment and Economic Development (DEED), the expenditures funded by those grants must be excluded from the credit calculation.5 Only the “unfunded” portion of the research spending—where the company bears the financial risk—is eligible for the credit.

Conclusion: The Strategic Value of the Minnesota R&D Credit

The meaning of “Qualified Research” in Minnesota is deeply rooted in the concept of technical risk and systematic scientific inquiry conducted within the state’s borders. For Minnesota businesses, Statute § 290.068 serves as more than just a tax break; it is a vital source of capital that supports the high-wage jobs and complex engineering projects that drive the state’s economy. The transition in 2025 to a partially refundable credit signifies a major modernization of the incentive, ensuring that it provides immediate liquidity to the most innovative—and often least profitable—startups in the medical, software, and manufacturing sectors.

Navigating the local guidance provided by the Department of Revenue requires a commitment to rigorous documentation and a clear understanding of the Four-Part Test. As the state continues to target a $25 million annual refund budget, the credit will likely remain a competitive and highly scrutinized area of tax law. Businesses that can effectively demonstrate the technical uncertainties of their work and the geographic concentration of their spending will find the Minnesota R&D tax credit to be one of the most significant financial assets available to them in the regional landscape. Through the careful application of tiered rates and the utilization of unitary group sharing, the state ensures that the incentive remains scalable for both the emerging entrepreneur in a Minneapolis co-working space and the global manufacturing giant in the Saint Paul industrial corridor.

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