Schedule M1C

The Architectural Role of Schedule M1C in the Minnesota Tax System

Schedule M1C, titled “Other Nonrefundable Credits,” is a critical component of the Minnesota individual income tax return (Form M1). To appreciate its context within the R&D tax credit framework, one must first distinguish between the calculation of the credit and its application. The calculation of the Credit for Increasing Research Activities is performed at the entity level using Schedule RD, where the business identifies its qualified research expenses (QREs) and determines the incremental increase over its historical base amount. However, for an individual shareholder or partner to realize this benefit, the credit must be “passed through” from the business entity to the individual owner. This transfer is documented on Schedule KPI (for partners) or Schedule KS (for shareholders), which the individual then uses to populate Line 16 of Schedule M1C in the 2024 tax year. 1

The schedule itself acts as a collection point for a diverse array of nonrefundable credits. In the hierarchy of tax calculations, nonrefundable credits are those that can reduce a taxpayer’s liability to zero but cannot result in a refund check if the credit amount exceeds the tax owed. This distinction is vital, as it influences the sequence in which credits are applied. The Minnesota Department of Revenue (DOR) requires taxpayers to complete Schedule M1C to determine the total credit amount that will be reported on Line 16 of Form M1. 1

The Spectrum of Nonrefundable Credits on Schedule M1C

Schedule M1C is not exclusively dedicated to R&D; it is a holistic form that manages various legislative incentives. Each credit on the form has its own qualifying criteria and supporting schedules, which must be attached to the return to ensure compliance. The following table illustrates the secondary credits that share the landscape with the R&D credit on Schedule M1C, providing a broader context for how the state manages its nonrefundable tax expenditures. 1

The presence of the R&D credit on this schedule alongside social and veteran-focused credits highlights its dual role: it is both a technical business incentive and a mechanism for individual tax relief. For practitioners, this means that claiming the R&D credit on Schedule M1C requires a comprehensive view of the taxpayer’s entire tax profile, as the total credits from this schedule cannot exceed the tax liability reported on Form M1. 1

Legal Framework of the Credit for Increasing Research Activities

The legal foundation for the Minnesota R&D tax credit is found in Minnesota Statute § 290.068. While the state statute intentionally mirrors the federal R&D credit under Internal Revenue Code (IRC) Section 41, it introduces critical state-specific restrictions and rate structures that must be strictly followed to survive a Department of Revenue audit. 9

The Incremental Nature of the Credit

The Minnesota R&D credit is “incremental,” meaning it does not simply reward a business for its total research spending. Instead, it incentivizes increased spending over a baseline. This structure is designed to be a more cost-effective stimulus by only providing tax breaks for research that exceeds the “normal” or basic level of activity the business would have likely conducted anyway. 11

The core calculation involves determining the “excess” of Minnesota qualified research expenses for the taxable year over a “base amount.” This base amount is a historical benchmark calculated using the business’s Minnesota gross receipts. For startups established after 1988, the statute provides a simplified “start-up” fixed-base percentage (initially 3%) to allow new ventures to access the credit before they have an established revenue history. 11

Statutory Calculation and Tiered Rates

Minnesota employs a tiered rate structure for the credit, which distinguishes it from the federal credit’s flat percentage. For taxable years beginning after December 31, 2016, the credit is equal to the sum of:

1. 10% of the first $2,000,000 of excess QREs over the base amount. 8
2. 4% (increased from 2.5% in prior years) of all excess expenses over $2,000,000. 8

This two-tiered approach provides a significantly higher benefit to small and mid-sized research projects, offering a potent 10% credit on the initial $2 million of increased effort. For larger enterprises, the secondary 4% tier still provides substantial relief but at a lower marginal rate. 11

The mathematical formula for the total credit ($C$) can be represented as:

$$C = (0.10 \times \min(E, 2,000,000)) + (0.04 \times \max(0, E – 2,000,000))$$

Where $E$ is the excess of current-year QREs over the base amount. The base amount itself has a statutory “floor”; it cannot be less than 50% of the current year’s QREs. This floor ensures that even a business with extremely low historical spending must still show significant current investment to claim a large credit. 11

Geographical Limitation: The Minnesota Constraint

Perhaps the most critical legal distinction between the federal and state credit is the geographical requirement. Pursuant to Minn. Stat. § 290.068, Subd. 2, “qualified research” and “qualified research expenses” only include those activities conducted and expenses incurred within the state of Minnesota. 8

This means that if a Minnesota-based software company employs remote developers in North Dakota or contractors in India, the wages and fees paid to those individuals must be strictly excluded from the Minnesota R&D credit calculation, even if they qualify for the federal credit. The Department of Revenue requires meticulous records—including employee locations and time-tracking logs—to prove that the research was “actually performed” in Minnesota. 8

Defining Qualified Research Expenses (QREs)

To populate Schedule RD and ultimately Schedule M1C, a taxpayer must accurately identify their QREs. Following the federal definitions in IRC § 41(b), Minnesota recognizes four primary categories of qualifying expenses, provided they are tied to research conducted in the state. 8

1. Research Wages

Wages typically account for the largest portion of a research claim, often reaching three-quarters of total expenses for many firms. Qualifying wages include the salaries, taxable bonuses, and certain benefits paid to employees for:

• Performing Research: The actual “hands-on” work of developers, engineers, and scientists. 13
• Direct Supervision: The time spent by managers overseeing the research process, reviewing technical results, and guiding the experimentation. 13
• Direct Support: The work of lab technicians, prototype builders, or even staff performing data entry for research results. 13

The DOR applies the “80% Rule”: if an employee spends at least 80% of their time on qualifying research activities, 100% of their wages can be included as a QRE. If they spend less than 80%, only the actual percentage of their time spent on research is qualifying. 13

2. Supplies Used in Research

Supplies are defined as tangible property—other than land and land improvements or depreciable property—that is “consumed” or used in the research process. Examples include:

• Materials used to build experimental prototypes or “mockups.” 13
• Chemicals, reagents, and other lab consumables. 8
• Testing equipment that does not meet the threshold for capital depreciation. 8

Importantly, general and administrative supplies, such as office furniture, travel expenses, or telephone bills, are strictly excluded from the definition of research supplies. 8

3. Contract Research Expenses

If a business hires a third party (such as a university lab or a specialized engineering firm) to conduct research on its behalf within Minnesota, it can claim 65% of the amount paid to that contractor. To qualify, the taxpayer must bear the “economic risk” of the research (meaning they must pay even if the research fails) and must retain “substantial rights” to the results of the research. 2

4. Computer and Cloud Costs

A modern addition to the R&D credit landscape involves the cost of renting or leasing computers, specifically including cloud server costs and high-performance computing resources. If a company uses cloud-based simulation software or data-processing servers specifically for research, and these resources are used at least 80% for qualified activities, these costs can be included as QREs. 13

The Four-Part Test: The Qualitative Benchmark

Meeting the financial definitions of QREs is only half the battle. Every project for which a credit is claimed must also satisfy the “Four-Part Test” derived from federal law and adopted by the Minnesota DOR. Failure to document how a project meets these tests is the most common reason for credit disallowance during an audit. 2

Part 1: Permitted Purpose (Business Component Test)

The research must be intended to develop a new or improved “business component,” which is defined as any product, process, software, technique, formula, or invention that is to be held for sale, lease, or license, or used by the taxpayer in their trade or business. The improvement must relate to function, performance, reliability, or quality. Cosmetic changes or routine seasonal improvements do not qualify. 2

Part 2: Technological in Nature

The research must rely on the “hard sciences.” This means the process must be based on the principles of engineering, computer science, biological science, or physical science. Research into social sciences, economics, or humanities—such as market research or consumer surveys—is explicitly excluded. 8

Part 3: Elimination of Uncertainty

The taxpayer must show that at the outset of the project, they faced technical uncertainty. This uncertainty can relate to the capability to develop the product, the method of achieving the result, or the appropriate design of the business component. If a company already knows exactly how to build a product using established methods, the work is considered routine and does not qualify. 2

Part 4: Process of Experimentation

To resolve the uncertainty, the taxpayer must engage in a “systematic process of experimentation.” This involves:

• Evaluating one or more alternatives. 2
• Developing and testing a hypothesis. 8
• Refining or discarding the hypothesis based on results. 8
• Constituting a technical risk where failure is a possible outcome. 8

Documentation such as test logs, lab notes, and version control for software development is essential to proving this process occurred. 2

Local State Revenue Office Guidance and Compliance

The Minnesota Department of Revenue provides supplemental guidance through “Revenue Notices” and “Fact Sheets,” which interpret how the law applies to specific circumstances. For Schedule M1C filers, several of these notices are paramount. 16

Revenue Notice #22-01: Mining and Occupation Tax

A specialized application of the R&D credit concerns mining companies. Revenue Notice #22-01 clarifies that a mining company subject to the Minnesota Occupation Tax is allowed to claim the Credit for Increasing Research Activities against that tax. Because the Occupation Tax is determined “in the same manner” as the corporate franchise tax, the DOR permits the R&D credit as a valid offset. This is particularly relevant for the iron ore and taconite industries in Northern Minnesota, where significant research is conducted into more efficient refining processes. 17

Guidance for Healthcare Providers: The MinnesotaCare Research Credit

Hospitals and healthcare providers face a unique research credit landscape. While they may qualify for the standard R&D credit, they also have access to the “MinnesotaCare Research Credit.” According to Revenue Notice #06-07 and current DOR Fact Sheets, this credit applies specifically to health care providers who use receipts from patient services to fund formal programs of medical research. 19

The MinnesotaCare credit is directly applied against the MinnesotaCare tax rather than individual income tax, but it is often managed by the same finance teams that oversee Schedule M1C filings. The research must be part of a “formal program,” approved by a governing body, and designed to improve the diagnosis or treatment of disease. Importantly, providers cannot claim the MinnesotaCare credit if they already qualify for the “Health Care Research Exemption.” 19

Documentation Directives and Audit Standards

The DOR’s “Short Course Manual” and various instructional bulletins emphasize that the burden of proof is high. The Department has historically noted that Minnesota provides “limited guidance” compared to the IRS, leading to frequent disputes over what constitutes sufficient documentation. 12

To mitigate this, the DOR recommends maintaining the following records for each tax period:

• Project Lists: Describing the new or improved products and where the research took place. 8
• Time Tracking: Explicit logs showing the portion of employee time dedicated to qualified activities. 8
• Technical Proof: Lab schedules, procedure manuals, and experiment results that show the “Process of Experimentation.” 2
• Financial Reconciliation: Linking payroll records and supply invoices directly to specific research projects. 8

The 2025 Legislative Pivot: Partial Refundability (H.F. 9)

For decades, the Minnesota R&D credit was strictly nonrefundable, meaning it could only offset tax liability and never generate a refund. This was a significant hurdle for pre-revenue startups and R&D-heavy companies that were not yet profitable. Legislation enacted in 2025 via House File 9 has fundamentally changed this dynamic for tax years beginning after December 31, 2024. 13

The Refundability Election

Taxpayers can now make an irrevocable election on a timely filed return to treat a portion of their unused R&D credit as a refundable payment. This means that if the credit exceeds the tax liability reported on Form M1, the state will issue a check for a percentage of that excess. 14

The “refundability rate” is phased in as follows:

Source: Minnesota Department of Revenue and Ryan Tax Development Reports. 13

Strategic Calculation for the Election

The decision to elect refundability involves a significant trade-off. If a taxpayer elects the refund, they receive immediate cash flow but forfeit the ability to carry forward the full value of the credit. 14

Example Scenario:

A startup has a $100,000 R&D credit and $0 tax liability in 2025.

• Option A (Carryforward): The company pays $0 tax and carries $100,000 forward to offset 100% of future taxes for up to 15 years.
• Option B (Refund Election): The company receives a cash refund of $19,200 ($100,000 x 19.2%) and pays $0 tax. However, the $100,000 credit is “exhausted,” and nothing remains to carry forward.

For companies in dire need of capital, the 19.2% “cash-in-hand” may be more valuable than the theoretical 100% future benefit, especially considering the time value of money and the 15-year expiration window. 13

Comparative Analysis: Minnesota vs. Federal R&D Credit

While Minnesota patterns its credit after IRC § 41, several “non-conformity” areas create traps for the unwary taxpayer. These differences must be accounted for on Schedule RD before the final figures are moved to Schedule M1C. 8

1. No Alternative Simplified Credit (ASC)

At the federal level, many taxpayers use the Alternative Simplified Credit (ASC) method, which does not require historical data from the 1980s. Minnesota does not allow the ASC. All Minnesota credits must be calculated using the regular incremental method, which requires historical gross receipts and QRE data (or the use of the 3% start-up rate). 8

2. Difference in Gross Receipts

The “base amount” for the federal credit is calculated using federal gross receipts (all domestic sales). The “base amount” for the Minnesota credit is calculated using only Minnesota gross receipts, as determined by the state’s apportionment rules. This often results in a lower base amount for Minnesota companies, making it easier to generate “excess” QREs and claim a larger credit. 9

3. Expiration and Carryforward

Both the federal and Minnesota R&D credits have a 15-year carryforward period. Neither allowed for a carryback (applying the credit to previous years) for the periods covered in current guidance. 9

Comprehensive Example: A Medical Device Startup in Rochester

To illustrate the interplay between these forms and laws, let’s examine a hypothetical case of a medical device company, “MedTech LLC,” based in Rochester, Minnesota. MedTech is a partnership with three equal partners.

Phase 1: Identifying Expenses (2024 Tax Year)

In 2024, MedTech LLC undertakes a project to develop a new cardiac stent with improved flexibility. They incur the following costs:

• Wages: $1,200,000 paid to Minnesota-based engineers.
• Remote Contractor: $100,000 paid to a developer in Wisconsin (EXCLUDED from MN credit). 9
• Supplies: $150,000 in specialized alloys and polymers consumed in testing. 13
• Cloud Computing: $50,000 for server-side mechanical simulations (used >80% for research). 13

Total Minnesota QREs: $1,200,000 (Wages) + $150,000 (Supplies) + $50,000 (Cloud) = $1,400,000.

Phase 2: Calculating the Credit (Schedule RD)

MedTech is a “start-up” for credit purposes.

• Base Amount: Assume the statutory floor of 50% of current QREs applies because their historical revenue is low.
• Base Amount: $1,400,000 x 0.50 = $700,000. 11
• Excess QREs: $1,400,000 – $700,000 = $700,000.

Applying the Tiered Rate:

Since the excess is under $2,000,000, the 10% rate applies.

• Total Credit: $700,000 x 0.10 = $70,000. 8

Phase 3: Passing Through to Owners (Schedule KPI)

The $70,000 credit is divided equally among the three partners. Each partner receives a Schedule KPI showing a credit of $23,333 on Line 26. 1

Phase 4: Individual Reporting (Schedule M1C and Form M1)

Partner “A” has a total Minnesota income tax liability of $15,000 before any credits. They complete Schedule M1C:

1. Line 16 (R&D Credit): They enter $23,333. 1
2. Total Nonrefundable Credits: Assuming no other credits, the total is $23,333.
3. Application to Form M1: Schedule M1C instructions and the Form M1 limit the credit to the taxpayer’s liability. 1
4. Tax Paid: Partner A pays $0 in tax.
5. Carryforward: The unused $8,333 ($23,333 – $15,000) is recorded and carried forward to the 2025 tax year. 2

Statistical Overview and Economic Impact

The Minnesota R&D tax credit is a significant fiscal commitment for the state. Analyzing the data clusters from the House Research Department and the Department of Revenue reveals the scale of the program. 11

Projected Fiscal Impact of R&D Credits (Fiscal Years 2020-2027)

The following table summarizes the projected cost to the Minnesota General Fund. The substantial increase in 2024 and beyond is attributed to both rising R&D activity and the legislative increase in the second-tier credit rate from 2.5% to 4%. 11

Source: Compiled from Minnesota Department of Revenue Tax Expenditure Reports and House Research Data. 11

Utilization by Business Size

A report by the Office of the Legislative Auditor (OLA) highlighted a concentration of the credit among larger firms. While individual taxpayers use Schedule M1C, the bulk of the dollar value remains in the corporate sector. 12

• Top 20% of Claimants: The largest 20% of C-corporation claimants (by asset size) typically account for nearly 90% of the total corporate credit value. 12
• S-Corp and Partnership Growth: Despite the concentration in large C-corps, the number of individual filers claiming R&D credits through pass-through entities has grown by an estimated 15% since 2014, reflecting a robust startup ecosystem in the Twin Cities and Rochester. 11

Administrative Complexity and Auditor Concerns

The Minnesota R&D credit has faced criticism for its complexity and “ill-defined purpose.” A 2017 OLA report noted that Minnesota law does not explicitly state the goals of the credit—whether it is intended to create jobs, attract new businesses, or simply increase research volume. 12

From a compliance standpoint, this lack of clarity can lead to aggressive auditing. The DOR often challenges the “Process of Experimentation” for software companies, arguing that routine bug fixes and feature updates do not constitute qualified research. The 2017 report recommended that the DOR improve the information available to taxpayers, yet as of 2024, the documentation standards remain a high hurdle for many small businesses. 12

Record-Keeping Best Practices for Individual Filers

Because an individual claiming the credit on Schedule M1C is often one step removed from the actual research (as a shareholder or partner), they are at a higher risk of being unable to produce documentation during a personal audit. It is recommended that individual filers:

1. Request a “Research Credit Package” from the entity’s CFO or tax manager annually. This package should include the entity-level Schedule RD and a summary of the 4-part test documentation. 2
2. Verify Minnesota-Source Income: Ensure that the Schedule KPI or KS correctly distinguishes between Minnesota QREs and total QREs, especially for multi-state operations. 9
3. Monitor Carryforward Balances: Maintain a multi-year spreadsheet to track the 15-year expiration of each year’s credit layer, especially if switching between nonrefundable and refundable (post-2025) elections. 9

Special Topics: Unitary Businesses and Carryforward Sharing

For C-corporations, a significant change in DOR guidance occurred on June 17, 2020. This update affects how credit carryforwards are handled within “unitary business” groups (groups of related corporations that file a combined return). 9

The Earning Member Rule Change

Before 2020, the DOR required that only the “earning member”—the specific corporation within the group that actually performed the research—could use a carryforward credit. If that specific member had no tax liability in a future year, the credit went unused, even if the rest of the group owed millions in taxes. 9

The updated guidance now allows R&D credit carryovers to be shared among all members of the combined group. This aligns the treatment of carryforwards with how current-year credits are handled. This change was effective for tax years beginning after December 31, 2012, and the DOR applied it to all open audits and refund claims. For individuals who are shareholders of such C-corporations, this increased the internal value of the corporation and, in some cases, led to amended returns and retroactive tax savings. 22

Interaction with Other M1C Credits: The Hierarchy of Application

When an individual taxpayer has multiple credits on Schedule M1C, the sequence of application is important because some credits have different carryforward or refundability rules. 1

1. Nonrefundable, No Carryforward: Credits like the Marriage Credit must be used in the current year or they are lost forever. These are typically applied first. 1
2. Nonrefundable with Carryforward: The R&D credit and the SEED capital credit fall into this category. They are applied next. 4
3. Refundable Credits: These are not on Schedule M1C; they are on Schedule M1REF. They are applied last because they will result in a refund even if the tax liability is already zero. 7

The R&D credit’s 15-year carryforward makes it a flexible tool, but taxpayers must ensure they aren’t letting shorter-lived credits expire by using the R&D credit too aggressively in a single year. 9

Conclusion: Navigating the Future of Innovation Incentives in Minnesota

Schedule M1C remains the ultimate destination for the Credit for Increasing Research Activities on the individual tax return, but it is merely the “tip of the iceberg” of a vast regulatory and statutory framework. The shift toward partial refundability in 2025 represents a landmark change in Minnesota tax policy, signaling a renewed commitment to supporting early-stage, cash-intensive technology ventures. However, this increased accessibility comes with a corollary of increased accountability.

For the business owner, the developer, or the investor, success in claiming the R&D credit requires a meticulous bridge between the technical laboratory and the tax form. By understanding the “Minnesota-only” constraint of QREs, the rigor of the Four-Part Test, and the complex math of the incremental base amount, taxpayers can effectively utilize Schedule M1C to drive growth. As the state continues to refine its guidance and audit practices, the integration of contemporaneous documentation with proactive tax planning remains the only sure path to maximizing the value of Minnesota’s most important innovation incentive. The R&D credit, when properly managed through the multi-stage process of Schedule RD, Schedule KPI, and finally Schedule M1C, provides a powerful engine for both corporate competitiveness and individual tax efficiency in the North Star State. 1

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