Strategic Analysis of the Minnesota Research and Development Tax Credit Refundability Rate

The refundability rate is the statutory percentage used to calculate a cash payment for taxpayers who have earned more Minnesota R&D tax credits than they have state tax liability to offset. It effectively transforms a portion of what would otherwise be a nonrefundable carryforward asset into an immediate cash infusion for companies investing in local research and development activities. 1

This fundamental shift in Minnesota’s tax policy, enacted through House File 9 in June 2025, represents a sophisticated effort to bolster the state’s innovation economy by addressing the liquidity constraints faced by high-growth, pre-revenue, or loss-generating entities. 2 Historically, the Credit for Increasing Research Activities was a nonrefundable incentive, meaning that while a company could earn significant credits through its investments in wages, supplies, and contract research, those credits provided zero immediate value if the company was not currently profitable or lacked a Minnesota tax burden. 4 The introduction of a partial refundability election, with rates starting at $19.2\%$ for the 2025 tax year and climbing to $25\%$ for subsequent years, allows these firms to monetize their innovation efforts in real-time. 1 This mechanism is particularly critical for sectors such as biotechnology, medical device manufacturing, and software development, where the timeline from initial research to commercialization—and thus profitability—can span several years. By offering a cash-out option, even at a discounted rate, Minnesota provides a competitive alternative to carryforwards, effectively acting as a state-sponsored bridge loan for innovation. 2

The Statutory Architecture of the Credit for Increasing Research Activities

The Minnesota Credit for Increasing Research Activities is governed by Minnesota Statutes Section 290.068. 8 While the state generally aligns its definitions of qualified research and expenses with the federal standards found in Internal Revenue Code (IRC) Section 41, the state statute introduces several idiosyncratic constraints and tiers that dictate the initial “pool” of credit before the refundability rate is ever applied. 1

Tiered Credit Rate Structure

The credit calculation follows an incremental model, rewarding businesses that increase their research efforts relative to a calculated “base amount.” 4 The state utilizes a two-tiered system for the resulting “excess” qualified research expenses (QREs):

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This structure creates a weighted incentive that heavily favors small to mid-sized innovation projects. A company with $\$2,000,000$ in excess QREs earns a $\$200,000$ credit, while the marginal benefit for larger expenditures drops to $4\%$, reflecting the state’s policy goal of supporting a broad base of smaller tech firms rather than just a few massive multinational corporations. 4

The Fifty-Percent Limit on the Base Amount

A critical nuance in the Minnesota statute is the “50-percent limit” applied to the base amount calculation. 4 Under the regular credit method, the base amount is the larger of two figures: a calculation involving historical research-to-sales ratios or $50\%$ of the current year’s research expenditures. 11 For many established Minnesota businesses—particularly those with large R&D operations but low in-state gross receipts—the $50\%$ floor becomes the primary constraint. 4 This effectively means the “excess” expenses eligible for the credit are often capped at $50\%$ of the total current-year R&D spend, resulting in an effective credit rate of $5\%$ ($10\% \times 50\%$) on the first few million dollars of research activity. 4

The Mechanism of Refundability: Rates and Implementation

The transformation of the credit from nonrefundable to partially refundable is not a change in the earning of the credit, but in the disposition of the unused portion. 1 The “refundability rate” serves as the discount factor for this conversion. 10

Historical Context and Legislative Evolution

The policy journey toward refundability in Minnesota has not been linear. Between 2010 and 2012, the state experimented with a refundable R&D credit specifically for partnerships and S corporations to stimulate recovery after the financial crisis. 5 That provision expired, and for over a decade, the credit returned to its status as a carryforward-only asset. 4 The 2025 omnibus tax legislation (H.F. 9) reinstated a more robust, broader version of refundability that applies across all entity types, including C corporations, individuals, and trusts. 1

Phased Refundability Rate Schedule

The legislature established a specific trajectory for the refundability rates to allow for manageable fiscal planning and corporate budgeting. 3

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The jump from $19.2\%$ to $25\%$ in 2026 signals a ramp-up period where the state anticipates higher administrative costs and lower initial adoption, followed by a steady state. 2

The $25 Million Annual Statewide Refund Target

Beginning in the 2028 tax year, the refundability rate becomes dynamic. The Commissioner of Revenue is tasked with managing the program so that the total aggregate refunds issued to all taxpayers do not exceed approximately $\$25,000,000$ annually. 3 This creates a “capped-pool” scenario. If the Department of Revenue projects that the sum of all refund claims at a $25\%$ rate would total $\$50,000,000$, the Commissioner would be required to lower the refundability rate to approximately $12.5\%$ to bring the total fiscal impact back to the $\$25,000,000$ target. 3

The Commissioner must publish the finalized rate for the upcoming tax year by December 15 of each year, following the November revenue forecasts. 3 This introduces a layer of market-level uncertainty for long-term R&D planning; companies cannot be entirely sure of their credit’s cash value until the state completes its aggregate forecasting. 7

Defining Qualified Research and Expenses in the Minnesota Context

To utilize the refundability rate, a business must first successfully navigate the complexities of identifying and documenting Minnesota Qualified Research Expenses. 1 The state strictly adheres to the “Four-Part Test” derived from federal IRC Section 41, but with an unwavering requirement that the activity occur within the physical borders of Minnesota. 1

The Four-Part Test for Activity Qualification

Before any costs can be tallied, the research project itself must meet four distinct criteria:

1. Elimination of Uncertainty: The research must be intended to discover information that eliminates uncertainty concerning the capability, method, or appropriate design for developing or improving a “business component”—defined as a product, process, formula, software, or technique. 1
2. Process of Experimentation: Substantially all of the activities must constitute a process of experimentation. This is not merely trial and error; it requires the systematic evaluation of alternatives, the testing of hypotheses, and the refinement or discarding of those hypotheses based on technical data. 1
3. Technological in Nature: The experimentation process must fundamentally rely on the principles of the “hard sciences,” such as engineering, biology, chemistry, computer science, physics, or metallurgy. 1
4. Permitted Purpose: The research must relate to a new or improved function, performance, reliability, or quality. It cannot be for aesthetic or cosmetic improvements. 1

Geographic and Funding Restrictions

The Minnesota credit is inherently parochial. If a Minnesota-based software engineer works from a home office in Wisconsin, their wages are generally ineligible, regardless of where the company is headquartered. 1 Furthermore, the state has recently clarified that expenditures funded by an Innovation Grant from the Minnesota Department of Employment and Economic Development (DEED) are not eligible as QREs. 1 This prevents “double-dipping” where the state would effectively be paying for the research twice—once through a direct grant and again through a refundable tax credit. 13

Categorization of Eligible Costs

Taxpayers may include three primary categories of costs in their calculation, which then feeds into the pool subject to the refundability rate:

• Internal Wages: This includes the taxable salaries and benefits for employees directly engaged in research, as well as those providing direct supervision (e.g., a CTO managing lab leads) or direct support (e.g., a technician cleaning lab equipment specifically used for the research). 4
• Research Supplies: These are tangible items consumed during the experimentation process. This includes chemicals, prototyping materials, and raw components used to build test models. It excludes land, improvements to land, capital equipment subject to depreciation, and general overhead supplies like office paper or cleaning services for the non-lab portion of a facility. 1
• Contract Research: A taxpayer may include $65\%$ of the fees paid to third parties to conduct research on their behalf, provided the research is performed in Minnesota. 5
• Computer Lease/Usage Costs: Amounts paid for the right to use computers to conduct research (e.g., cloud server costs for heavy simulation) are eligible if the computers are located in Minnesota or the service is utilized by Minnesota personnel for state-based research. 1
• Nonprofit Research Contributions: $100\%$ of contributions made to qualified Minnesota nonprofit organizations that provide grants to early-stage tech companies can be treated as QREs. 7

Procedural Governance: The Election Process and Filing Requirements

The partial refund of the R&D credit is not a default state; it requires a proactive, affirmative election on the part of the taxpayer. 1 The failure to adhere to the administrative requirements set forth by the Minnesota Department of Revenue (MNDOR) can lead to the forfeiture of the refund option for that tax year. 10

Timely Filing and Irrevocability

The election must be made on a “timely filed return,” which includes the period of any valid extensions. 1 In Minnesota, corporations receive an automatic seven-month extension to file their returns, though this is not an extension to pay any taxes owed. 20 If a taxpayer misses the filing deadline, they generally lose the right to elect the refund for that year and must instead carry the credit forward. 1

Once the election is made, it is irrevocable. 6 A taxpayer cannot amend a return later to switch from a refund to a carryforward, nor can they switch from a carryforward to a refund once the original filing period has closed. 6 This necessitates a rigorous financial forecast prior to filing, as the company is effectively locking in a cash-out at a discount that cannot be undone if the company’s tax liability unexpectedly spikes in the following year. 10

Schedule RD and Form M4 Integration

For C corporations, the election process is embedded within Schedule RD (Credit for Increasing Research Activities). 13 The 2025 draft forms introduce a specific sequence of operations:

1. Determination of Unused Credit (Line 36): This line identifies the portion of the current-year credit that remains after the taxpayer has used the credit to reduce their own Minnesota tax liability to zero and after any permitted allocations to other members of a combined unitary group. 13
2. The Election Checkbox: Crucially, there is a physical checkbox located between Line 37 and Line 38. 13 If this box is not checked, the Department will treat the entry on Line 37 as $\$0$, regardless of any math performed. 13
3. The Rate Application (Line 37): The taxpayer multiplies the figure on Line 36 by the applicable refundability rate (e.g., $19.2\%$ for 2025). 13
4. Carryover Adjustment (Line 38): The refundable amount is subtracted from the total unused credit. The remaining amount (the “lost” $80.8\%$ of that specific pool) is effectively discarded, while the non-refunded portion of the total credit remains as a 15-year carryforward. 13
5. Final Reporting: The refundable amount from Schedule RD, Line 37, is carried over to Form M4, Line 7, which is the line for refundable credits. 13

Comparative Analysis: The Alternative Simplified Credit (ASC) Method

In tandem with the refundability changes, Minnesota enacted House File 173, which introduced the Alternative Simplified Credit (ASC) method as an optional way to calculate the base amount. 9 Because the refundability rate is applied to the final credit amount, the choice of calculation method—Regular vs. ASC—can have a massive impact on the size of the check a company receives from the state. 11

Regular vs. ASC Calculations

The Regular method requires historical data from 1984–1988, which many companies find impossible to verify or which creates a very high “fixed-base percentage” that is difficult to exceed. 4 The ASC method simplifies this by focusing on recent history. 9

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The ASC method is expected to increase the total pool of creditable dollars by approximately $24\%$ statewide. 12 For a pre-revenue startup with zero historical research, the ASC base amount would be zero for the first year, potentially allowing the full $10\%$ credit on every dollar of research, significantly increasing the potential refund. 9

Practical Application: A Multi-Year Refundability Example

To fully comprehend the impact of the refundability rate, one must examine a company’s transition from a loss position to a tax-paying position. Consider “NorthStar Bio,” a fictional medical device firm in Minneapolis.

Year 1 (2025): Deep Research Phase

• Qualified Minnesota Research Expenses: $\$1,000,000$ (mostly engineering wages).
• Base Amount (ASC Method – Startup): $\$0$.
• Earned Credit: $10\% \times \$1,000,000 = \$100,000$.
• Minnesota Tax Liability: $\$0$.
• Refundability Election: Yes (Rate: $19.2\%$).
• Cash Refund Calculation: $\$100,000 \times 0.192 = \$19,200$.
• Impact on Asset: The company receives a check for $\$19,200$. The remaining $\$80,800$ of that specific year’s credit pool is forfeited. 1

Year 2 (2026): Continued Development

• Qualified Minnesota Research Expenses: $\$1,200,000$.
• Earned Credit: $\$120,000$.
• Minnesota Tax Liability: $\$0$.
• Refundability Election: Yes (Rate: $25.0\%$).
• Cash Refund Calculation: $\$120,000 \times 0.25 = \$30,000$.
• Total Two-Year Cash Benefit: $\$49,200$.

Analysis of the “Opportunity Cost”

If NorthStar Bio had chosen not to elect refundability, it would have entered Year 3 with $\$220,000$ in nonrefundable carryforwards. 5 If the company suddenly became profitable in Year 3 and owed $\$300,000$ in Minnesota taxes, it could have used the full $\$220,000$ to reduce its tax bill to $\$80,000$. 10 By electing the refund in Years 1 and 2, they effectively “lost” $\$170,800$ in future tax-offset value in exchange for $\$49,200$ in immediate cash. 10 For a cash-strapped startup, this “burn rate” support is often more valuable than a theoretical future tax shield. 2

Impacts Across Diverse Entity Types

The application of the refundability rate is heavily influenced by the legal structure of the taxpayer. Minnesota’s tax code treats pass-through entities and unitary business groups with significant nuance. 1

Pass-Through Entities (Partnerships and S Corporations)

For partnerships, LLCs, and S corporations, the R&D credit is calculated at the entity level but is then passed through to the owners (partners or shareholders) via Schedule KPI or Schedule KS. 1

The election for refundability is made at the individual partner or shareholder level. 1 This means that within a single partnership, Partner A (who has high Minnesota income from other sources) might choose to use the credit to offset their tax, while Partner B (who has zero Minnesota tax liability) might choose to elect the partial refund. 1 This flexibility allows the credit to be tailored to the specific tax profile of each investor, which is a major selling point for venture capital firms investing in Minnesota startups. 2

Unitary Business Groups and Combined Reporting

Minnesota requires a “unitary business”—a group of related corporations that function as a single economic unit—to file a combined report. 4 The rules for the R&D credit in this context are designed to prevent the manipulation of profits to maximize refunds. 1

• Mandatory Allocation: The corporation that actually performs the research (the “earning member”) must first use the credit to offset its own current-year tax liability. 1 If it has excess credit, it must then allocate that credit to other members of the unitary group who have tax liability. 1
• Refund Eligibility: A refund can only be elected if the entire unitary group has collectively reduced its Minnesota tax liability to zero and still has remaining current-year R&D credits. 1
• Calculation Base: The “liability for tax” used in the refundability calculation is the sum of the taxes imposed on all entities included in the combined report, reduced by other nonrefundable credits. 1

Fiscal Impact and Economic Statistics

The decision to implement a refundable R&D credit was driven by detailed fiscal modeling from the Minnesota Department of Revenue. These statistics provide insight into the expected scale of the program and the industries it aims to support. 3

Projected Revenue Impacts

The state anticipates that the combination of the ASC method and partial refundability will significantly increase the fiscal cost of the R&D credit. 3

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The revenue loss to the general fund from the corporate franchise tax alone is projected to be $\$48.1$ million in FY 2026 and $\$43.3$ million in FY 2027. 11 A significant portion of this loss stems from the new cash outlays necessitated by the refundability election. 3

Distribution of Benefits by Industry

The Department of Revenue has identified that roughly $300$ corporate taxpayers would see an immediate reduction in tax liability or a cash refund under the new ASC and refundability rules. 11 The key industries expected to utilize these provisions include:

• Advanced Manufacturing: Representing the largest share of credit claims, this sector includes medical device innovators and specialized automotive hardware producers. 2
• Life Sciences and Biotech: These firms are most likely to use the refundability option, as they often spend millions on R&D for years before receiving FDA approval for their products. 2
• Software and SaaS: With the growth of the “Silicon Prairie,” software firms with high developer payroll costs are major claimants of the credit. 1
• Agriculture and Food Science: Minnesota’s top-ranked position in soybean and corn processing is supported by substantial R&D in crop yields and automation. 2

Compliance, Audit Preparedness, and Documentation

Because the refundability election results in a direct check from the state treasury, the Department of Revenue is expected to maintain a high level of scrutiny on these claims. 7 The “refund” effectively turns the tax department into a grant-funding agency, and the burden of proof rests entirely on the taxpayer to justify every dollar. 1

Contemporaneous Recordkeeping Requirements

MNDOR guidance is explicit about the types of records required to substantiate an R&D claim. 1 Failure to produce these during an audit can result in the full clawback of any refund issued, plus interest and penalties. 7

• Project Lists and Technical Descriptions: Documentation must be contemporaneous (created at the time the research was performed). 1 It should describe the “technical risk” of each project—why success was not guaranteed—and the specific steps taken in the experimentation process. 1
• Personnel Activity Tracking: For wage claims, the state expects to see time-tracking data or detailed project-allocation spreadsheets. 1 It is not sufficient to simply claim that “all engineers do R&D.” 1 Documentation must identify the specific qualified activities each person performed and the percentage of their time dedicated to those activities. 1
• Supply and Contractor Substantiation: Taxpayers must retain all invoices for physical supplies used in the lab and the formal written agreements for any contract research. 1 If research is contracted, the taxpayer must be able to prove that the work was performed within Minnesota. 1
• General Record Retention: Records must be kept for at least as long as the state has the power to assess tax, generally $3.5$ years from the date the return was filed. 7 However, since credits carry forward for $15$ years, it is best practice to keep documentation for the entire life of the credit plus four years. 7

Audit Risk and the Role of the CPA

The 2025 Schedule RD includes a new section of “Additional Information” checkboxes. 13 The state now asks:

1. Did a CPA, attorney, or consultant assist in the calculation? 13
2. Was a formal R&D tax credit study conducted? 13
3. How were the wages and supplies calculated (e.g., actual time tracking vs. estimation)? 13

Checking “No” on these boxes—indicating a lack of professional oversight or a reliance on mere estimation—can serve as a “red flag” that may increase the probability of an MNDOR desk audit or field examination. 13

Strategic Decision Matrix: Refund vs. Carryforward

The fundamental decision facing a business manager is: “Is $19.2$ cents today worth more than $\$1.00$ tomorrow?” 6 This requires a sophisticated net present value (NPV) analysis. 2

Factors Favoring the Refund (Election)

• Immediate Cash Constraints: Companies in a “cash crunch” or those needing to avoid dilutive venture capital rounds will find the refund attractive. 2
• Long Horizon to Profitability: If a biotech firm does not expect to have taxable income for ten years, the present value of a $25\%$ refund today is significantly higher than the present value of a $100\%$ credit in 2035, even at a modest discount rate. 2
• Change of Ownership Risks: R&D credits can sometimes be limited or lost during a merger or acquisition (under rules similar to federal Section 382). 2 Cashing out some credits now reduces the risk of these assets becoming stranded. 2

Factors Favoring the Carryforward (No Election)

• Near-Term Profitability: If a company expects to owe Minnesota taxes next year, it is almost always better to keep the credit and use it at $100\%$ value. 10
• High Effective Tax Rates: For companies in the top corporate tax bracket, the value of the tax offset is maximized. 4
• Rising Interest Rates: If the cost of capital is low, the incentive to “cash out” at a steep discount is diminished. 2

The Future of R&D Incentives in Minnesota

The enactment of refundability is part of a broader trend of Minnesota “nonconformity” with certain restrictive federal tax changes. 23 For instance, while the federal government began requiring the amortization of R&D expenses over five years (the “Section 174” change) in 2022, Minnesota has sought ways to ease the resulting tax burden on local firms. 4 The partially refundable credit acts as a countervailing force, providing liquidity to companies that were hit by the loss of immediate R&D expensing at the federal level. 4

As the program matures, the $\$25$ million cap will be the most critical variable to watch. 3 If Minnesota becomes too successful at attracting R&D, the resulting “crowding out” effect could see the refundability rate drop significantly below $25\%$, potentially undermining the predictability that innovative firms require for long-term investment. 3

Conclusion

The Minnesota R&D tax credit refundability rate is a powerful, yet double-edged, financial tool. By offering businesses the choice to liquidate unused credits at $19.2\%$ to $25\%$ of their face value, the state has addressed a long-standing criticism of its tax code: that it only rewarded “winners” who were already profitable. This evolution ensures that the next generation of innovators—those currently in the “valley of death” between research and revenue—have the cash flow necessary to sustain their operations.

For the professional tax community, this change elevates the R&D credit from a routine compliance task to a strategic treasury function. The irrevocable nature of the election, the complexities of the ASC calculation method, and the looming statewide cap after 2027 require a proactive and data-driven approach. Businesses that maintain meticulous contemporaneous records and engage in rigorous multi-year tax modeling will be best positioned to turn their innovation into a tangible, liquid asset, thereby fueling the continued growth of Minnesota’s high-tech economy.

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