Technical Analysis of Qualified Research Expenses within the Minnesota Research and Development Tax Credit Framework

Qualified Research Expenses represent the direct costs of technical innovation—primarily wages, supplies, and contractor fees—that are physically incurred during research and development activities conducted within the state of Minnesota. These expenses serve as the base metric for the Credit for Increasing Research Activities, offering a tiered tax reduction designed to incentivize businesses to maintain and expand their scientific and engineering operations within the state’s borders.1

The definition and application of Qualified Research Expenses (QREs) in Minnesota are governed by a complex intersection of state statute and federal tax law. While Minnesota Statutes § 290.068 largely incorporates the definitions provided in Section 41 of the Internal Revenue Code (IRC), the state introduces critical modifications regarding the geographic sourcing of research and the method for calculating the “base amount” over which the credit is applied.4 This regulatory environment creates a high burden of proof for taxpayers, requiring meticulous documentation to demonstrate that every dollar claimed was not only spent on a technically uncertain project but also that the effort occurred physically within the state’s jurisdiction.3 In recent years, the relevance of QREs has intensified following the passage of H.F. 9 in 2025, which transitioned the credit from a strictly nonrefundable carryforward to a partially refundable asset, significantly altering the cash flow projections for Minnesota startups and established manufacturers alike.6

The Statutory Architecture of Minnesota R&D Incentives

The Minnesota Credit for Increasing Research Activities is not an independent creation but rather a state-level refinement of the federal research credit established in 1981.8 Under Minnesota Statute 290.068, the state allows corporations, partners in partnerships, and shareholders in S-corporations to claim a credit against their income or franchise tax liability.4 The core of this claim is the identification of QREs, which the statute defines by referencing IRC Sections 41(b) and 41(e).4

A defining characteristic of the Minnesota law is its strict geographic boundary. While the federal credit applies to research conducted across the United States, Minnesota specifically excludes any expenses for research performed outside the state.4 This means that a Minnesota-based company with a secondary research facility in North Dakota must bifurcate its payroll, supply invoices, and contractor payments to ensure only the Minnesota-specific costs are included in the state filing.3 This requirement effectively turns the QRE into a “situs-based” expense, where the physical location of the person performing the work or the location where the supplies are consumed is as important as the nature of the work itself.3

The legal framework also establishes a tiered rate structure that distinguishes Minnesota from other states that utilize flat rates. This structure is designed to provide a higher marginal benefit to smaller increments of research spending.2

This two-tiered approach reflects a legislative intent to support a broad ecosystem of innovation. By offering a 10% credit on the initial $2 million of increased R&D spending, the state provides a substantial subsidy for mid-sized projects and startups, while the 4% rate for larger expenditures ensures the credit remains fiscally sustainable for the state’s General Fund as massive multinational claims scale upward.2

The Anatomy of a Qualified Research Expense

To qualify as a QRE in Minnesota, an expense must fall into one of the categories defined by the Internal Revenue Code and meet the state’s geographic requirements. The Minnesota Department of Revenue (MDOR) provides specific guidance on these categories through Schedule RD and various administrative fact sheets.1

Internal Labor and Qualifying Wages

Wages represent the largest component of QREs for most Minnesota claimants, often accounting for approximately 75% of the total qualifying spend.8 Qualifying wages are limited to the amount paid to employees for “qualified services,” which include the actual conduct of research, the direct supervision of research, or the direct support of research activities.2 In a professional setting, this includes the salary and taxable benefits of an engineer designing a medical device prototype, a software developer writing original code to solve a technical latency issue, or a laboratory manager overseeing a team of chemists.1

The MDOR is particularly stringent regarding the “direct support” and “direct supervision” definitions. Guidance suggests that while a manager overseeing a team of researchers qualifies, a high-level executive who only receives quarterly progress reports does not.1 Similarly, support staff like administrative assistants or janitorial crews are excluded, as their work does not directly contribute to the elimination of technical uncertainty.3 For an employee who splits their time between R&D and routine production, Minnesota adopts the federal “80/20 Rule”: if at least 80% of an employee’s services during the year are qualified research services, then 100% of their wages may be treated as QREs.2

Consumable Research Supplies

The second major category of QREs is supplies, which encompass tangible property used in the research process.1 These are typically items that are consumed or significantly transformed during experimentation. Examples include chemicals used in laboratory tests, materials used to build mockups or physical prototypes, and electricity or water costs specifically metered for research facilities.1

However, the definition of supplies excludes several major types of business property. Land and land improvements are strictly disqualified, as is any property subject to depreciation under Section 167 of the IRC.1 This means that while the raw steel used to build a one-time prototype of a new combine harvester qualifies as a supply, the CNC machine used to cut that steel is a capital asset and its cost cannot be included as a QRE.1 Furthermore, general and administrative supplies such as office furniture, standard telephone expenses, and travel costs are explicitly prohibited by MDOR guidance.1

Third-Party Contract Research

Minnesota allows businesses to include expenses paid to outside parties for performing research, provided the work is conducted within the state.1 In alignment with federal law, only 65% of the amount paid to an unrelated third party is generally considered a QRE.8 This 35% haircut is intended to eliminate the contractor’s profit margin and overhead, focusing the tax credit on the underlying technical effort.8

For Minnesota purposes, the contract must be “at-risk,” meaning the taxpayer must pay for the research regardless of whether it succeeds.14 If the contractor is only paid upon the successful delivery of a product, the MDOR may view this as the purchase of a finished good rather than a contract for research, thereby disqualifying the expense.1 Additionally, the contractor must perform the services within Minnesota’s borders. If a Minnesota manufacturer hires a testing lab in Wisconsin to validate a new material, none of those expenses qualify for the Minnesota credit, even if they qualify for the federal credit.3

Computational Resources and Cloud Expenses

As software development has grown to dominate the innovation landscape, the “right to use computers” has become a vital QRE category. This includes payments for cloud computing environments, server time, and specialized software rentals used to conduct simulations or host development environments.1 To qualify, these resources must be utilized primarily for research. MDOR guidance requires documentation showing that the computational time was dedicated to testing new concepts or developing new software architectures rather than routine hosting or maintenance of existing commercial products.2

Nonprofit Development Contributions

A unique aspect of Minnesota law is the inclusion of “Development Contributions to a nonprofit organization” as a QRE.1 These are donations to specific Minnesota-based nonprofit corporations established under Chapter 317A that are organized for the purpose of promoting state business expansion and funding small, technologically innovative enterprises.2 This provision allows corporations to support the broader Minnesota innovation ecosystem while simultaneously generating a tax credit, provided the nonprofit aligns with the state’s strategic economic goals.2

Applying the Four-Part Test in a Minnesota Context

The classification of an expense as a QRE is entirely dependent on the nature of the activity it supports. Minnesota adopts the federal “Four-Part Test” to determine if an activity constitutes “qualified research”.1 This test is the primary tool used by MDOR auditors to challenge R&D claims, making it essential for businesses to understand the nuances of each prong.1

1. The Permitted Purpose Test

The research must be intended to develop a new or improved “business component,” which can be a product, process, computer software, technique, formula, or invention.1 The goal of the research must be to improve the functionality, performance, reliability, or quality of that component.1

Crucially, Minnesota guidance clarifies that “permitted purpose” does not extend to aesthetic or cosmetic changes. If a food manufacturer in Minneapolis changes the packaging of a product to make it look more modern, or alters the flavor profile for seasonal marketing, those activities fail the permitted purpose test because they do not improve the technical function or reliability of the product.1 Conversely, if that same manufacturer develops a new formula that extends shelf life without preservatives, the activity qualifies as it improves the product’s performance and quality.1

2. The Elimination of Uncertainty Test

An activity only qualifies if there is a technical uncertainty at the outset regarding the capability of the taxpayer to develop the component, the method for doing so, or the optimal design of the final result.1 This distinguishes research from routine engineering. If a civil engineering firm is building a bridge using standard, well-documented techniques, there is no “technical uncertainty” in the eyes of the MDOR, even if the project is complex.1 However, if the firm is developing a new type of carbon-fiber composite and is uncertain if the material can withstand Minnesota’s freeze-thaw cycles, they have established technical uncertainty.1

3. The Process of Experimentation Test

The taxpayer must engage in a systematic process designed to evaluate alternatives and resolve the technical uncertainty.1 This process typically involves the development of a hypothesis, the testing of that hypothesis through modeling, simulation, or physical prototyping, and the subsequent refinement of the approach based on results.1

The MDOR looks for evidence of a “technical risk.” If a project never fails, or if there is no documented record of evaluating different approaches, auditors may conclude that a process of experimentation did not occur.1 In software development, this is often demonstrated through version control logs and bug-tracking reports that show the evolution of code as developers tried different algorithmic approaches to solve a performance bottleneck.3

4. The Technological in Nature Test

Finally, the process of experimentation must rely on the principles of the “hard sciences,” such as engineering, chemistry, biology, physics, or computer science.1 Research in the social sciences, economics, or humanities is explicitly excluded.1 This means that while a company might use sophisticated statistical modeling to perform “market research” or “consumer preference studies,” these activities are not technological in nature and do not generate QREs, even if they are vital to the business’s success.1

Calculation Mechanics: The Incremental Nature of the Credit

The Minnesota R&D credit is “incremental,” meaning it is not based on the total amount of QREs but rather on the amount by which current-year QREs exceed a calculated “base amount”.2 This structure is designed to ensure the state only subsidizes “new” research effort rather than ongoing, baseline operations.12

Determining the Base Amount

The calculation of the base amount is often the most contentious and complex part of the tax filing. It involves a historical ratio known as the “fixed-base percentage” and the taxpayer’s average gross receipts from the prior four years.2

1. Minnesota Gross Receipts: For the purposes of the credit, gross receipts must be calculated using Minnesota sales or receipts as defined under Section 290.191.4 This ensures that the base amount reflects the business’s footprint within the state.
2. Fixed-Base Percentage: For established companies, this is the ratio of their QREs to their total gross receipts for the years 1984 through 1988, capped at 16%.12
3. The Start-Up Rule: Companies that did not have both QREs and gross receipts during the 1984–1988 period follow a specialized “start-up” formula. For the first five years, the fixed-base percentage is set at 3%. It then gradually adjusts based on actual spending in later years.2
4. The 50% Minimum Base: Regardless of the historical calculation, the base amount cannot be less than 50% of the current year’s QREs.12 This “minimum base” rule effectively caps the credit at a percentage of half of the current R&D spend for companies with very low historical bases.2

Tiered Credit Calculation Example

To understand how these variables interact, consider a Minnesota manufacturer, “Gopher Industrial,” which is expanding its R&D team to develop high-efficiency electric motors.

First, the base amount is calculated: $Base\ Amount = 5\% \times \$40,000,000 = \$2,000,000$. Since this is less than 50% of current QREs ($2,500,000), the base amount remains $2,000,000.

Next, the “Excess QREs” are determined: $\$5,000,000 – \$2,000,000 = \$3,000,000$.

The credit is then calculated using the tiered rates:

• Tier 1: 10% of the first $2,000,000 = $200,000.
• Tier 2: 4% of the remaining $1,000,000 = $40,000.
• Total Credit: $240,000.

In this scenario, Gopher Industrial would receive a $240,000 tax credit. If the company has a tax liability of $100,000, they would use the credit to zero out their tax due and have $140,000 in unused credit to carry forward or potentially receive as a refund.2

Documentation and Audit Defense Strategies

The Minnesota Department of Revenue provides limited proactive guidance, which has led to high rates of credit adjustment during audits.9 To defend a claim, businesses must move beyond simple accounting and maintain a “technical narrative” that links financial data to the scientific process.3

Mandatory Recordkeeping Targets

According to MDOR’s Fact Sheet 12 and Schedule RD instructions, taxpayers should maintain the following records for each project 1:

• List of Research Activities: A description of each new or improved product or process, including the specific location in Minnesota where the work was performed.1
• Description of Improvements: Narrative evidence explaining how each project intended to improve functionality, reliability, or performance.1
• Experimentation Documentation: Laboratory schedules, reports of experiment results, prototype photos, project checklists, and procedure manuals.1
• Personnel Records: For every employee included in the QRE wage pool, the taxpayer must document their name, location, total compensation, and the specific portion of their time dedicated to qualified activities.3
• Supply Substantiation: Invoices for all materials, along with a description of how they were used in the experimentation process.1

Common Audit Pitfalls

Auditors frequently challenge the “nexus” between the expense and the activity. A common failure occurs when companies use “percentage estimates” for employee time without contemporaneous time-tracking records.3 While the tax law does not explicitly mandate minute-by-minute time tracking, the MDOR has historically rejected high-level estimates that lack supporting documentation like calendar entries, project logs, or meeting minutes.1

Another significant risk area is the “Commercial Production” boundary. The MDOR defines research as ending once the product is ready for sale. Costs associated with “scaling up” production—such as tooling for a manufacturing line or final user-interface tweaks based on consumer feedback—are often denied because they are viewed as production or marketing expenses rather than R&D.1

Legislative Evolution: The 2025 Refundability Pivot

Perhaps the most significant change in the history of the Minnesota R&D credit occurred with the enactment of H.F. 9 in early 2025.6 For the first time since a brief period in 2010–2012, a portion of the credit is now refundable.5

The Mechanism of Partial Refundability

Beginning with tax years starting after December 31, 2024, taxpayers can elect to receive a cash refund for unused credits instead of carrying them forward to future years.6 The refund is calculated as a percentage of the credit remaining after the taxpayer’s liability has been reduced to zero.1

The “Refundability Rate” for 2028 and later is subject to annual adjustment by the Commissioner of Revenue. By December 15 of each year, the Commissioner must determine the rate for the following year based on November revenue forecasts, with the goal of keeping total state refunds at or below $25 million.2 This provides the state with a “safety valve” to prevent the credit from causing unexpected budget deficits while still providing a predictable incentive for businesses.2

Strategic Decision: Refund vs. Carryforward

The election to receive a refund is irrevocable and must be made on a timely filed original return.1 This forces businesses to make a strategic choice:

• The Refund Advantage: Provides immediate cash flow. This is ideal for startups that are burning through capital and may not be profitable for several years.2
• The Carryforward Advantage: Preserves 100% of the credit’s value. Because the refund is only partial (e.g., 19.2 cents on the dollar), a profitable company that expects to owe taxes in the near future may prefer to carry the full credit forward to offset 100% of their future tax liability.2

Unitary Business Groups and Combined Reporting

In the context of the Minnesota corporate franchise tax, related companies that function as a single business must file a “combined report”.4 This has significant implications for how QREs are utilized.

Credit Sharing and Allocation

The law allows for the sharing of research credits among members of a unitary group. Guidance issued by the MDOR in June 2020 clarified that while a credit is “earned” by a specific entity based on its own Minnesota QREs, any unused portion can be allocated to other group members to offset their liabilities.1

The sequence of credit application for a unitary group is strictly mandated:

1. The earning member applies the credit to its own tax liability first.5
2. Any remaining current-year credit is then allocated to other members of the group.1
3. Any credit still remaining after the entire group’s liability is zero is carried forward (or refunded, if elected) by the earning member.3

This “sharing” provision is vital for large Minnesota enterprises, such as medical technology conglomerates, where one subsidiary may be a loss-making research lab while another is a highly profitable distribution arm. The group can utilize the lab’s QREs to lower the distributor’s tax bill, effectively consolidating the state’s R&D incentive at the enterprise level.4

Fiscal and Economic Impact of the Credit

The Credit for Increasing Research Activities represents a major investment by the State of Minnesota in its high-tech workforce. Statistical data from the Department of Revenue’s Tax Expenditure Budget shows that the fiscal impact of the credit has nearly doubled in recent years.12

Total Tax Expenditure Forecast (2020–2027)

The following table outlines the projected and actual costs of the R&D credit to the Minnesota General Fund.

Data source: Minnesota Department of Revenue Tax Expenditure Budget.12

The dramatic increase in corporate franchise tax expenditures between 2023 and 2024—from $64 million to over $111 million—points to a significant surge in R&D investment by large Minnesota manufacturers. This trend highlights the credit’s role as a cornerstone of the state’s industrial policy.8 Despite its high cost, evaluations by the Legislative Auditor suggest that the credit contributes to job retention and attracts high-salary engineering roles to the state, even if the “net fiscal benefit” does not fully pay for itself in the short term.8

Interplay with Federal Amortization Rules (IRC Section 174)

A critical factor currently influencing the value of QREs is the change in federal law regarding the deduction of R&D costs. Following the 2017 Tax Cuts and Jobs Act, businesses can no longer immediately expense their R&D costs in the year they are incurred.12 Instead, they must amortize these expenses over five years for domestic research and fifteen years for foreign research.12

Minnesota generally conforms to these federal amortization requirements. While this change does not directly alter the calculation of the R&D credit, it significantly increases the taxable income of companies in the short term.12 For many Minnesota businesses, this has created a “tax bridge” problem where they owe more in current-year taxes because they cannot deduct their full research spend. Consequently, the R&D tax credit has become even more essential as a tool to mitigate the increased tax burden caused by federal amortization rules.12

Future Outlook: The Simplified Credit Proposal

One area of ongoing legislative debate in Minnesota is the potential adoption of the “Alternative Simplified Credit” (ASC) method. Currently, Minnesota only allows the “Regular Incremental Method,” which requires businesses to track gross receipts and R&D spending back to the 1980s.1

Proposals like H.F. 1938 and S.F. 1237 seek to introduce an ASC option, similar to the federal one, where the base amount would simply be 50% of the average R&D spend over the past three years.16 Supporters argue this would significantly reduce the compliance burden for Minnesota businesses, as they would no longer need to maintain forty-year-old financial records to justify their “fixed-base percentage”.1 While this reform was discussed in the 2025 legislative session, taxpayers must continue to follow the regular method until a formal statutory change is enacted and signed.1

Conclusion: Synthesizing the Minnesota R&D Landscape

Qualified Research Expenses are the vital currency of the Minnesota innovation economy. By providing a tiered credit that rewards the increase of these expenses within the state, Minnesota has created a robust incentive for companies to anchor their high-value engineering and scientific operations locally. The strict geographic requirements of Section 290.068 ensure that state tax dollars directly support the Minnesota workforce, while the inclusion of nonprofit contributions and cloud computing costs reflects a modern understanding of how innovation occurs in the 21st century.

However, the power of the credit is balanced by the rigor of its documentation requirements. The transition to partial refundability in 2025 provides a new, liquid benefit for the state’s burgeoning startup community, but it also increases the stakes for accuracy in filing. For professional peers in the tax and accounting space, the path forward involves a proactive approach to compliance: moving beyond year-end estimates to integrated, project-based tracking that treats every QRE as a defensible asset. As the state continues to refine its R&D policy—potentially moving toward a simplified calculation method—the core principle remains the same: Minnesota will continue to invest in those who invest in the technical future of the state.

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