The Statutory and Administrative Framework of Salaries in the Minnesota Credit for Increasing Research Activities

Salaries in the context of the Minnesota Research and Development tax credit are defined as the taxable wages paid to employees for the direct performance, supervision, or support of qualified research activities conducted within the state. These expenditures represent the primary mechanism for businesses to reduce their state income or franchise tax liability, rewarding investments in technical labor that drive innovation and economic growth in Minnesota.

The Minnesota Credit for Increasing Research Activities, codified under Minnesota Statutes section 290.068, represents a sophisticated intersection of state tax law, federal regulatory definitions, and rigorous administrative oversight by the Minnesota Department of Revenue. While the credit encompasses a range of qualifying research expenses including supplies and contracted services, the “salaries” component—statutorily categorized as “wages”—typically constitutes approximately 75 percent of the total qualified research expenditures claimed by Minnesota corporations.1 Because of this high concentration of value, the meaning of salaries is subject to intense scrutiny during both the preparation of tax returns and subsequent audits by state revenue officials. The legal framework relies heavily on Internal Revenue Code (IRC) Section 41, yet it introduces distinct geographic and administrative limitations that necessitate a nuanced understanding for tax practitioners and business leaders. As the state moves toward a partially refundable model in 2025, the precision with which companies define and document these salary expenses has become a critical factor in maintaining cash flow and ensuring compliance with shifting legislative priorities.3

The Statutory Definition of Salaries and Wages

The foundational legal meaning of salaries for the Minnesota R&D credit is anchored in Minnesota Statutes section 290.068, Subdivision 2, which provides that “qualified research expenses” have the meanings given in Section 41(b) and (e) of the Internal Revenue Code.5 However, the state legislature included a critical geographical constraint: the credit does not include expenses incurred for research conducted outside the state of Minnesota.5 This means that the term “salaries” in this context is inherently limited to remuneration for labor physically performed within the state’s borders.

To arrive at the technical definition of “wages,” the state conforms to IRC Section 41(b)(2)(D), which in turn points to the definition of wages found in IRC Section 3401(a).7 Under this federal guidance, which Minnesota adopts by reference, wages encompass all remuneration for services performed by an employee for their employer.9 In practical terms, this refers to the amount reported in Box 1 of the employee’s Form W-2, representing taxable income subject to federal withholding.7 This inclusion of Box 1 wages means that bonuses, commissions, and certain stock option redemptions are generally included in the salary base, provided they are taxable as compensation for services.7

This definition creates a specific boundary that excludes many common employee costs. For instance, while an employer’s contribution to a health savings account (HSA) or a retirement plan may be a significant part of a researcher’s total compensation package, these amounts are not considered “wages” for the purpose of the R&D credit because they are typically excluded from the employee’s gross income under various sections of the IRC.13 Consequently, the “salaries” qualifying for the Minnesota R&D credit represent the cash-equivalent, taxable portion of the researcher’s effort, rather than the total cost of employment.

Categorization of Qualified Services

The eligibility of an employee’s salary is not determined by their job title alone but by the nature of the “qualified services” they perform. Minnesota and federal law identify three distinct categories of labor that allow a salary to be included in the credit calculation: direct performance, direct supervision, and direct support of qualified research.15

Direct Performance of Research

Direct performance constitutes the “hands-on” work of innovation. This includes the activities of engineers, computer scientists, and lab technicians who are actively engaged in the process of experimentation to eliminate technical uncertainty.6 For a salary to qualify under this category, the employee must be involved in developing or improving a business component—such as a product, process, formula, or software—through a method that fundamentally relies on the hard sciences.6 Typical tasks in this category include writing code for a novel software architecture, conducting laboratory experiments, testing prototypes, or performing engineering calculations to determine if a design is feasible.6

Direct Supervision of Research

The salaries of managers and executives may qualify if they are providing direct supervision to those performing the research. This is often a point of contention during audits, as administrative guidance distinguishes between “technical” supervision and “administrative” management.17 To qualify, a supervisor must be involved in the technical direction of the research project, such as reviewing test results, making decisions on which design alternatives to pursue, or managing the actual experimental process.15 High-level oversight, such as managing the overall R&D budget or performing human resources duties for the research department, does not constitute qualified supervision.17

Direct Support of Research

The third category, direct support, encompasses labor that assists the researchers or their supervisors. This might include a machinist who fabricates a one-of-a-kind prototype based on an engineer’s blueprints or a lab assistant who cleans and calibrates specialized equipment specifically for use in a qualified experiment.15 Administrative and clerical support, however, is specifically excluded.8 For example, the salary of a secretary who types a research report or a janitor who cleans the research facility generally does not qualify, as their work is considered general overhead rather than direct support of the experimental process.8

The Geographic Restriction and In-State Labor

A unique and rigorous requirement of the Minnesota R&D credit is that the qualified research must be conducted entirely within the state of Minnesota.5 This has profound implications for how salaries are calculated, especially in the era of remote work and multi-state operations. If a Minnesota-based corporation employs a software developer who lives and works in Wisconsin, the developer’s salary is ineligible for the Minnesota credit, even if it fully qualifies for the federal R&D credit.6

The Minnesota Department of Revenue requires taxpayers to track the physical location where research activities are performed.6 In instances where an employee splits their time between a Minnesota office and an out-of-state location, only the wages attributable to the hours worked in Minnesota may be considered for the credit.6 This necessitates a high degree of precision in payroll and time-tracking systems, as the state will often request employee-by-employee breakdowns of location and time spent on qualified projects during audits.6

The “Substantially All” Rule and the 80 Percent Threshold

To simplify the administration of the credit, both federal and Minnesota guidance utilize the “substantially all” rule for employee wages. This rule provides a safe harbor: if at least 80 percent of an employee’s services during the tax year constitute qualified services, then 100 percent of that employee’s wages may be included as qualified research expenses.7

If an employee’s qualified time is less than 80 percent, the business may only claim the actual percentage of the salary that corresponds to the time spent on qualified research. For example, if a chemist spends 60 percent of their time on new product development and 40 percent on routine quality control for existing products, the business may include 60 percent of the chemist’s Box 1 wages as a qualifying expense.8

The calculation of this percentage is highly sensitive to the denominator used. Administrative guidance specifies that the denominator should be the total hours spent in the “performance of services,” which generally excludes paid time off such as sick leave, vacation, and holidays.8 Consequently, the 80 percent threshold is often easier to reach for employees who take significant vacation time, as the reduction in the denominator increases the resulting percentage of qualified hours.

The Impact of Little Sandy Coal on Salary Allocation

Recent case law, specifically Little Sandy Coal Co., Inc. v. Commissioner, has tightened the interpretation of what counts toward the 80 percent threshold. The court held that while the time spent on direct performance and direct supervision can be aggregated to reach the 80 percent mark, “direct support” activities should be analyzed more cautiously.17 The decision highlighted the importance of distinguishing between the actual process of experimentation and the peripheral activities that support it. For Minnesota taxpayers, this means that claiming a full 100 percent of a supervisor’s salary requires documented evidence that their time was spent in the technical “iterative” process of research, rather than general management or administrative functions.17

Local State Revenue Office Guidance and Documentation

The Minnesota Department of Revenue (MDOR) provides extensive guidance through its publications and instructions for Schedule RD. The department emphasizes that the R&D credit is “expense driven,” and therefore, the quality of the documentation is the primary determinant of a successful claim.6

Record-Keeping Requirements for Wages

MDOR mandates that taxpayers maintain contemporary records to substantiate the salary expenses claimed. This goes beyond simple payroll reports and includes a detailed narrative and technical nexus between the employee and the research.6 Specifically, the department expects businesses to keep:

• Employee Information: A list of names, Social Security Numbers, work titles, and position descriptions for all employees included in the computation.6
• Compensation Records: Forms W-2 and payroll registers to verify Box 1 wage amounts.6
• Time and Activity Records: Timesheets or logs that track the portion of time dedicated to qualified activities, broken down by employee, year, and specific project.6
• Project Documentation: Descriptions of the technical uncertainties the employee sought to eliminate and the process of experimentation they followed.6

The Three Methods of Salary Calculation

On Schedule RD, taxpayers must explicitly state how their wage calculations were derived. The form provides three categories of calculation methods, and checking the appropriate box is a mandatory step in the filing process 24:

1. Review of Contemporaneous Records: This represents the highest standard of documentation, utilizing real-time data from timesheets or project management software that was recorded as the research occurred.24
2. Estimation: While less ideal, the department recognizes that some companies may need to use estimates to determine the percentage of time spent on research. These estimates must be based on a reasonable and documented methodology.24
3. Combination of Review and Estimation: This is often used when some departments have rigorous time-tracking while others utilize manager interviews or project logs to allocate time.24

Taxpayers who rely solely on high-level estimates are significantly more likely to face disallowance of their credits during an audit, as the state has become increasingly reluctant to accept “after-the-fact” reconstructions of time without supporting technical documentation.17

Mathematical Application and Credit Calculation

The Minnesota R&D credit is structured as an incremental credit, rewarding companies that increase their research spending relative to a historical “base amount”.27 The calculation of this base amount is complex and involves the company’s Minnesota-specific gross receipts.

The Two-Tiered Rate Structure

The credit uses a tiered system that provides a higher benefit for the initial layer of research spending and a lower benefit for larger expenditures.5

• Tier 1: 10 percent of the first $2,000,000 of excess qualified research expenses over the base amount.5
• Tier 2: 4 percent of any excess expenses above the initial $2,000,000 threshold.5

The “base amount” is determined by multiplying a “fixed-base percentage” (representing the historical intensity of R&D relative to gross receipts) by the average annual Minnesota gross receipts for the prior four years.1 For startups or companies with no historical data, the fixed-base percentage is set at 3 percent.27 However, in no event can the base amount be less than 50 percent of the current year’s qualified research expenses.11

Mathematical Formula for the R&D Credit

$$\text{Credit} = (\text{Excess QRE up to } 2,000,000 \times 0.10) + (\text{Excess QRE over } 2,000,000 \times 0.04)$$

Where:

$$\text{Excess QRE} = \text{Current Year QRE} – \text{Base Amount}$$

$$\text{Base Amount} = \max( \text{Fixed Base \%} \times \text{Average Prior } 4 \text{ Years Gross Receipts}, 0.50 \times \text{Current Year QRE})$$

The 50 percent minimum base amount rule is particularly relevant for high-growth Minnesota companies. It effectively caps the credit at 5 percent of total research spending (for the first $2 million) for companies whose research efforts far outpace their historical revenue growth.27

Detailed Example: MedTech Solutions, Inc.

To illustrate the application of these rules to salaries, consider MedTech Solutions, Inc., a medical device company located in St. Paul, Minnesota. In 2025, the company is developing a new robotic surgical arm.

Employee Data and Qualification Analysis

The company identifies four employees involved in the project. Their roles and salary data are summarized below:

Analysis of Salaries:

1. Anna K.: Anna works in St. Paul and spends 95 percent of her time on qualified performance (above the 80 percent threshold). Therefore, 100 percent of her $180,000 salary is included as a QRE.8
2. David L.: Although David is a developer performing qualified research, he works in Wisconsin. Because the research is not conducted in Minnesota, his $140,000 salary is excluded entirely from the Minnesota credit calculation.5
3. Sarah P.: Sarah works in St. Paul and spends 85 percent of her time in technical supervision (above the 80 percent threshold). Her entire $200,000 salary qualifies.7
4. James M.: James works in St. Paul but only spends 70 percent of his time in direct support (below the 80 percent threshold). Only 70 percent of his salary qualifies.8

• $60,000 \times 0.70 = \$42,000$.

Total Salary QREs for MedTech Solutions:

$$\$180,000 (\text{Anna}) + \$200,000 (\text{Sarah}) + \$42,000 (\text{James}) = \$422,000$$

Calculation of the 2025 Credit

Assuming MedTech Solutions is a startup with a base amount equal to 50 percent of its current year QREs:

• Total QRE: $422,000
• Base Amount (50%): $211,000
• Excess QRE: $211,000
• Tier 1 Credit (10% of $211,000): $21,100

If the company has a tax liability of $5,000, it can use the credit to reduce that liability to zero. The remaining $16,100 of the credit is “unused.” Under the new 2025 rules, MedTech may elect to have a portion of this unused credit refunded.3

The 2025 Refundability Election and its Strategic Implications

For decades, the Minnesota R&D credit was strictly nonrefundable, allowing only for a reduction in tax liability and a 15-year carryforward of any excess.5 However, H.F. 9, enacted in June 2025, introduced a partial refundability feature for tax years beginning after December 31, 2024.3 This legislative shift is designed to provide immediate liquidity to innovation-heavy companies that are not yet profitable, such as biotech startups and software ventures in their early stages.4

Refundability Rates and Calculations

The refundable portion of the credit is calculated by multiplying the “unused” credit (the amount remaining after tax liability has been reduced to zero) by a specific “refundability rate” for that tax year.3

This election must be made on a timely filed original return (including extensions) and is irrevocable once chosen for that year.3 For companies that choose the refund, any portion of the credit that is not refunded can still be carried forward for 15 years.3

Implications for Startup Cash Flow

The introduction of the 19.2 percent refund in 2025 effectively transforms the R&D credit from a deferred tax asset into a current cash asset for pre-revenue companies. In the case of MedTech Solutions, the $16,100 in unused credits would yield a cash refund of approximately $3,091 ($16,100 x 0.192).3 This provides a direct subsidy for the salaries of the research team, lowering the net cost of local technical labor and incentivizing startups to remain in Minnesota rather than relocating to states with higher immediate tax benefits.1

Unitary Businesses and Wage Sharing

Minnesota’s corporate tax system utilizes a combined reporting requirement for “unitary” businesses—groups of related corporations that operate as a single economic unit.5 The R&D credit rules for these groups allow for the sharing of credits generated by one member’s salaries with other members of the group who may have tax liability.5

Under MDOR guidance provided in June 2020, if the corporation that incurred the research expenses (the “earning member”) cannot use the full credit, the unused portion must be allocated to other members of the combined group to reduce their tax liabilities.19 Only after the combined group’s total tax liability is reduced to zero can the remaining credit be carried forward (or, starting in 2025, partially refunded).3

This sharing mechanism is crucial for large organizations where research labor may be centralized in a dedicated R&D subsidiary that does not generate its own revenue. By sharing the salary-based credits of the R&D subsidiary with the revenue-generating sales and manufacturing arms of the unitary group, the organization can maximize the value of the credit in the year it is generated.19

Exclusions and Funding Interplay

The definition of qualifying salaries is further restricted by rules regarding “funded” research. Under both federal and state law, if research is funded by a grant, contract, or another person, it is ineligible for the credit.6

The Exclusion of Innovation Grants

Minnesota guidance specifically notes that expenditures funded by an Innovation Grant from the Minnesota Department of Employment and Economic Development (DEED) are not eligible qualified expenses.6 If a startup uses a DEED grant to pay the salary of a lead researcher, that portion of the salary must be removed from the QRE calculation. This prevents “double-dipping,” where the state would essentially be providing both a direct grant and a tax credit for the same dollar of labor.6

Commercial Production and Routine Testing

Administrative rules also distinguish between “research” and “production.” Salaries paid for activities conducted after the beginning of commercial production are excluded.6 This includes the labor involved in routine quality control, seasonal design changes, or the adaptation of an existing product for a specific customer.6 For a salary to qualify, the labor must be focused on eliminating technical uncertainty about the capability, method, or design of the business component, rather than just executing a known manufacturing process.6

Statistical Overview of the Minnesota R&D Credit

The fiscal impact of the Minnesota R&D credit highlights its role as a significant economic policy tool. The state’s investment in the credit has grown substantially over the last decade, reflecting both inflation and a deeper concentration of research-intensive industries in the region.

Historical and Projected Expenditure Data

The growth from $50 million in 2014 to a projected $150 million in 2025 demonstrates a significant commitment by the state to support innovation.1 Furthermore, state audit data indicates that wages account for approximately three-quarters of the qualified research expenses for C-corporations in Minnesota, reinforcing the importance of the salary definition as the primary driver of these fiscal impacts.1

Business Participation and Concentration

Participation in the credit is highly concentrated among large corporations. Statistics from the Office of the Legislative Auditor show that the largest 20 percent of C-corporations (measured by sales) received two-thirds of the total tax credits claimed between 2010 and 2014.1 However, the 2025 move toward refundability is expected to broaden this base by making the credit more accessible to smaller, pre-revenue firms whose research spending is high relative to their current tax liability.3

Administrative Challenges and the Audit Landscape

The complexity of the R&D credit makes it a frequent subject of audits by the Minnesota Department of Revenue. State auditors often focus on the nexus between the claimed salary and the technical uncertainties identified in the project documentation.17

Common Audit Pitfalls for Salaries

Audits frequently result in adjustments due to the following issues:

• Lack of Contemporaneous Records: Relying on year-end estimates or interviews to reconstruct time spent on research rather than using actual timesheets.17
• Ineligible Support Personnel: Including salaries for administrative staff, janitorial services, or high-level executives whose time was not spent on technical supervision.8
• Failed Four-Part Test: Claiming salaries for activities that are considered routine product maintenance or cosmetic design rather than true experimentation.6
• Out-of-State Labor: Failing to exclude the wages of remote workers or employees who perform research at out-of-state facilities.5

The Department of Revenue has been criticized in legislative audits for providing limited guidance on the documentation necessary to substantiate these claims, leading to uncertainty for taxpayers.2 In response, the MDOR has expanded its online resources and fact sheets, emphasizing the need for detailed “innovation logs” and project checklists.6

Conclusion

The meaning of salaries within the Minnesota R&D tax credit framework is a rigorous technical definition that requires the careful alignment of payroll data with the qualitative realities of the research laboratory. By anchoring the definition to taxable wages under IRC Section 3401(a) and imposing a strict geographic requirement for labor performed within the state, Minnesota has created an incentive that is both targeted and highly effective at supporting local high-wage employment.

As the state moves toward partial refundability in 2025, the stakes for accurate salary categorization have never been higher. For startups, the ability to turn research-related wages into an immediate cash refund can mean the difference between scaling a new technology and running out of runway. For larger corporations, the ability to share salary-based credits across a unitary group remains a vital tool for managing effective tax rates and reinvesting in domestic innovation. Ultimately, the success of a Minnesota R&D credit claim depends on a company’s ability to move beyond high-level financial reporting and produce the detailed, contemporaneous documentation that proves a direct nexus between the technical labor of its employees and the elimination of technological uncertainty. In the competitive landscape of state tax incentives, the precision with which a company defines and defends its research salaries is its most valuable compliance asset.

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