Detailed Analysis of Supply Expenditures within the Minnesota Credit for Increasing Research Activities

In the context of the Minnesota Research and Development tax credit, supplies are defined as non-depreciable tangible property, excluding land and its improvements, that are consumed or used directly in the performance of qualified research activities within the state. These expenditures must be integral to the process of experimentation and are strictly distinguished from capital assets, general administrative costs, and items subject to depreciation under the Internal Revenue Code.

The statutory framework governing the Minnesota Credit for Increasing Research Activities, codified under Minnesota Statutes section 290.068, provides a sophisticated incentive structure designed to foster regional innovation and technological advancement.1 To understand the specific application of “supplies” within this state-level credit, one must first recognize that Minnesota largely adopts the federal definitions of qualified research expenses (QREs) and qualified research activities (QRAs) found in Section 41 of the Internal Revenue Code (IRC).1 However, the state imposes a rigorous geographic limitation: the research must be conducted entirely within Minnesota, and the expenses must be incurred for activities performed therein.2 This geographic “nexus” is the primary filter through which all supply costs must pass. While federal law allows for credits based on research performed anywhere in the United States, Minnesota law explicitly modifies these definitions to exclude any research conducted outside the state’s borders.2

Statutory Origins and the Federal Conformity of Supply Definitions

The Minnesota Legislature established the research tax credit in 1981, patterning it after the federal credit for increasing research activities that was introduced during the same era.3 The intent was to create a tiered incentive that rewards companies for escalating their research efforts relative to their historical investment levels.1 Under Minnesota Statute 290.068, Subdivision 2, the term “qualified research expenses” is defined as those meeting the criteria of IRC Sections 41(b) and 41(e).2 This cross-reference is significant because it pulls the federal definition of “supplies” directly into the Minnesota tax code. Per IRC Section 41(b)(2)(C), supplies are defined as any tangible property other than land or improvements to land, and property of a character subject to the allowance for depreciation.9 This creates a binary classification system for research-related property: if an item is tangible and non-depreciable, it is a supply; if it is depreciable, it is capital equipment and thus excluded from the credit calculation.4

The reliance on federal conformity means that Treasury Regulations interpreting IRC Section 41 are highly persuasive in Minnesota tax disputes and audits.4 For instance, Treasury Regulation 1.41-2(b)(1) clarifies that supplies are “used in the conduct of qualified research” if they are used in the performance of qualified services by an employee.5 These services include the direct performance of research, the direct supervision of research, or the direct support of research.9 Consequently, the cost of supplies used by a laboratory technician performing a chemical titration qualifies, as does the cost of materials used by a machinist in direct support of an engineer’s prototype build.9 Conversely, supplies used for general administrative functions, such as payroll processing for the R&D department, do not qualify because they do not constitute “direct support” of the research itself.4

The Exclusion of Depreciable Property and Capital Equipment

The most frequent point of friction in the classification of supplies is the distinction between a supply and a depreciable asset. Minnesota guidance, mirroring federal rules, insists that any property with a useful life beyond one year that is subject to wear and tear, exhaustion, or obsolescence must be treated as a capital expenditure rather than a supply QRE.9 This exclusion applies even if the equipment is used exclusively for research purposes.4 For example, a medical device manufacturer in Minnesota that purchases a $500,000 laser welding system solely for developing a new cardiovascular stent cannot claim the purchase price as a supply expense.10 Instead, the system is a capital asset. However, the specialized gases, welding wire, and disposable components consumed by that machine during the R&D phase are eligible as supplies.10

This distinction ensures that the R&D credit functions as an incentive for operational research activities—the “running costs” of innovation—rather than a subsidy for capital investment, which is handled through separate mechanisms like depreciation deductions or section 179 expensing.3

State Revenue Office Guidance on Direct Consumption and Prototyping

The Minnesota Department of Revenue (MDOR) provides administrative clarity through the instructions for Schedule RD and various policy publications.4 A central theme in this guidance is the requirement for “direct consumption” or “direct use” in the research process.4 The MDOR specifies that for a supply to be claimed on Line 2 of Schedule RD, the taxpayer must demonstrate a direct nexus between the material and a project that satisfies the “Four-Part Test” of qualified research.4 This test requires that the activity be intended to eliminate technical uncertainty, be technological in nature, relate to a permitted purpose (function, performance, reliability, or quality), and involve a process of experimentation.4

Prototype Development and Pilot Models

In the manufacturing-heavy landscape of Minnesota, prototypes represent the largest category of supply QREs.9 A prototype or “pilot model” is generally defined as any representation of a product or process that is used to evaluate its capability, method, or design.9 The costs of materials used to build these models—such as specialized polymers for a medical implant or electrical components for a new sensor—are qualifying supplies.9 The MDOR’s guidance aligns with federal changes that clarified the “ultimate fate” of a prototype does not dictate its eligibility.10 If a company builds a prototype to test its durability and that prototype is later sold to a customer or destroyed in a crash test, the material costs remain eligible because the intent at the time of construction was to eliminate technical uncertainty.10

However, the MDOR draws a sharp line at the start of commercial production.4 Once the technical uncertainties regarding the design and manufacturing method have been resolved, any subsequent materials used are considered “inventory” rather than R&D supplies.12 This transition is often audited by examining the company’s internal project logs and quality control reports.4 If the documentation shows that the design was “frozen” on June 1st, any materials purchased for production after that date will likely be disqualified from the credit, even if the first batch of products is used for market testing or promotional giveaways.4

Extraordinary Utilities as Supplies

A nuanced area of MDOR guidance concerns the inclusion of utilities as supplies. Generally, routine electricity, gas, and water costs for a research facility are treated as non-qualifying overhead.11 However, Minnesota follows federal precedent allowing for the inclusion of “extraordinary utilities”.11 These are defined as utility costs that are directly and significantly increased by a specific research project.11 For example, if a Minnesota aerospace company operates a high-speed wind tunnel that consumes an immense amount of electricity solely to test a new wing design, the incremental power cost for those tests may qualify as a supply.11 The taxpayer must be able to isolate these costs from general building operations, typically through sub-metering or detailed engineering calculations.17

Mathematical Mechanics of the Minnesota R&D Credit

Calculating the credit requires a clear understanding of the “incremental” nature of the incentive. The credit is not applied to the total amount of QREs but rather to the amount that exceeds a calculated “base amount”.1 This structure is designed to reward companies for increasing their research investment over time rather than simply maintaining a status quo.3

The credit is calculated using a two-tiered percentage applied to the excess QREs:

1. Tier 1: 10 percent of the first $2,000,000 of excess QREs.1
2. Tier 2: 4 percent of any excess QREs above the $2,000,000 threshold.1

For a taxpayer to determine their excess QREs, they must first calculate their base amount. In Minnesota, the base amount is the product of the “fixed-base percentage” and the average annual gross receipts for the four preceding years.6 A critical Minnesota-specific rule is that the “gross receipts” used in this calculation must be limited to Minnesota sales or receipts as determined by the state’s apportionment rules.1 This often results in a lower base amount for multi-state corporations compared to their federal base amount, which can lead to a higher state-level credit percentage relative to their total research spend.8

The total Minnesota QREs are expressed by the formula:

$$QRE_{Total} = Wages + Supplies + (Contracted\_Research \times 0.65) + Computer\_Lease\_Costs$$

4

The credit calculation for a taxpayer with $5,000,000 in total Minnesota QREs and a $1,000,000 base amount would follow this structure:

• Excess QREs: $\$5,000,000 – \$1,000,000 = \$4,000,000$.1
• Tier 1 Credit: $\$2,000,000 \times 0.10 = \$200,000$.1
• Tier 2 Credit: $(\$4,000,000 – \$2,000,000) \times 0.04 = \$80,000$.1
• Total Credit: $\$200,000 + \$80,000 = \$280,000$.1

Legislative Evolution and the Introduction of Partial Refundability

The utility of the Minnesota R&D credit has been significantly impacted by legislative changes regarding refundability. Historically, the credit was non-refundable, meaning it could only be used to offset a taxpayer’s current liability.1 While the credit could be carried forward for up to 15 years, it offered no immediate cash benefit to pre-revenue startups or companies experiencing temporary losses.1

There was a notable exception between 2010 and 2012 when the legislature made the credit fully refundable as a temporary economic stimulus.1 After 2012, the credit reverted to a non-refundable carryforward status until the passage of H.F. 9 in 2025.12 This landmark legislation modified Minnesota Statute 290.068 to introduce a “partial refundability” mechanism.18 Starting for tax years beginning after December 31, 2024, taxpayers may elect to receive a cash refund of a portion of their unused credits.12

This change is strategically aimed at supporting Minnesota’s burgeoning startup ecosystem in the biotechnology and software sectors, where initial R&D costs are high but taxable income may be years away.12 The state has established a target of $25 million in total annual refunds, with the MDOR authorized to adjust the refundability rate annually after 2027 to stay within this budget.12

Administrative and Documentation Requirements for Supplies

The MDOR has consistently emphasized that the burden of proof for the credit rests solely with the taxpayer.4 For supply expenses, this means maintaining a level of record-keeping that can withstand a rigorous state audit. The 2017 report by the Legislative Auditor noted that MDOR guidance was historically limited, leading to increased scrutiny and documentation requests during the audit process.3

The Documentation Nexus

To substantiate a supply expense, a taxpayer should maintain a “project-based” accounting system that tracks the purchase and use of materials in real-time.4 MDOR guidance suggests that the following records are essential for claiming supplies on Schedule RD:

• Detailed Invoices: Every supply expense must be backed by an invoice showing the date of purchase, the vendor, the cost, and a description of the item.4
• Project Allocation Logs: If a supply is used across multiple projects, the taxpayer must provide a rational basis for allocating its cost, such as a usage log or a consumption formula.7
• Minnesota Use Verification: Records must prove that the supplies were physically used or consumed at a location within Minnesota.4
• Technical Descriptions: Documentation linking the supply to the specific technical uncertainty being addressed, such as a laboratory report or an engineering change order.4

On page 3 of Schedule RD, the MDOR requires taxpayers to disclose the method used to calculate their supply costs.13 Checking the box for “Review of contemporaneous records” indicates that the figures are based on documents created at the time the research was performed.13 If the taxpayer checks “Estimation,” they must be prepared to provide a detailed explanation of the methodology used to arrive at that estimate and demonstrate why it is a reasonable approximation of actual costs.13

Combined Reporting and Credit Sharing

Minnesota allows for the sharing of R&D credits among members of a unitary business group.1 This is particularly relevant for large corporations where research may be centralized in one subsidiary while revenue is generated by another.1 Under MDOR guidance updated in 2020, the credit must first be applied to the tax liability of the “earning member”—the entity that actually paid the qualified expenses.1 Any excess current-year credit is then allocated to other members of the combined group to reduce their Minnesota tax liability.1 If unused credit still remains, it is carried forward by the earning member for up to 15 years.1 This “sharing” rule ensures that the credit remains a viable incentive for complex corporate structures operating in the state.

Industry-Specific Applications of the Supplies Definition

The application of the supply definition varies significantly across Minnesota’s key industries, reflecting the different ways materials are used in the innovation cycle.

Medical Device Manufacturing

Minnesota is a global hub for medical device technology, an industry characterized by intensive physical prototyping and rigorous material testing.10 In this sector, supplies often include biocompatible resins, specialized alloys (such as Nitinol), electronic sensors, and chemical sterilization agents.10 These materials are consumed in creating thousands of iterations of stents, pacemakers, and surgical tools before a final design is approved for clinical trials.10 Because the medical device industry faces high regulatory hurdles, the “Elimination of Uncertainty” is often prolonged, allowing for a significant accumulation of supply QREs over several years.10

Software and Technology

In contrast to manufacturing, the software sector’s supply QREs are typically lower as a percentage of total research spend, with wages accounting for the vast majority of credits.6 However, software companies can claim the cost of “supplies” in the form of certain computer-related expenditures. While hardware is depreciable and excluded, amounts paid for the “right to use computers” to conduct research—such as cloud computing server costs (AWS, Azure)—may qualify as supply-like QREs under IRC Section 41(b)(2)(A)(iii).4 MDOR guidance allows these costs if the server capacity is used specifically for development and testing rather than hosting the final production environment for customers.4

Chemical and Industrial Processing

Minnesota’s chemical processors and refiners consume significant quantities of reagents, catalysts, and experimental batches.9 For these firms, the distinction between “supplies” and “inventory” is the primary audit risk.12 If a refiner experiments with a new catalyst during a standard production run, they must be able to isolate the cost of that catalyst and any materials that were scrapped or degraded because of the experiment.10 If the resulting product is sold as standard grade, the MDOR may argue that the materials were consumed in production rather than research, emphasizing the need for contemporaneous project logs that highlight the experimental nature of the run.4

Statistical Fiscal Impact and State Budget Projections

The Minnesota R&D tax credit represents a significant fiscal commitment by the state. According to the 2024 Tax Expenditure Budget and MDOR estimates, the cost of the credit has grown steadily, reflecting the increasing technological intensity of the Minnesota economy.8

The dramatic projected spike in 2024 is attributed to several factors, including the normalization of post-pandemic R&D activities and the anticipation of the transition to a partially refundable credit system.8 Corporate franchise tax credits account for roughly 75 to 80 percent of the total fiscal impact, highlighting that the credit is predominantly utilized by large C corporations, although the number of pass-through entities (S corporations and partnerships) claiming the credit is also rising.3

Case Study: Application of Supplies in a Minnesota Startup

To clarify the practical application of these rules, consider the example of “AeroCell MN,” a hypothetical startup in St. Paul developing a new lithium-sulfur battery for drones.

Project Description

AeroCell MN is attempting to solve the technical uncertainty of “thermal runaway” in lithium-sulfur batteries.4 Their research involves testing different electrolyte mixtures and cathode coatings to see which combination provides the highest energy density without catching fire during high-drain maneuvers.11

Expense Analysis

The company’s controller reviews their expenses for the year to identify supply QREs for Schedule RD:

1. Electrolyte Chemicals ($45,000): These chemicals are mixed in the lab and used in 100 different test cells. They are used up in the testing and cannot be recovered. Status: Qualified Supply..9
2. Cathode Copper Foil ($12,000): This foil is used to build prototype battery cells. While the foil itself is a material, it is incorporated into a non-depreciable test model. Status: Qualified Supply..9
3. Laboratory Glovebox ($65,000): An airtight chamber used to assemble the batteries in an inert atmosphere. The glovebox has an expected life of 10 years and is being depreciated on the company’s books. Status: Ineligible (Capital Equipment)..9
4. Nitrogen Gas ($8,000): Used continuously to purge the glovebox during research trials. This gas is vented and consumed. Status: Qualified Supply..9
5. Cloud Simulation Credits ($15,000): Paid to a provider to run thermal modeling simulations. These are treated as the “right to use computers” for research. Status: Qualified Supply-equivalent..4
6. Patent Attorney Fees ($25,000): While related to the research, patent filing is a legal process, not a technical one, and does not involve the consumption of tangible property for experimentation. Status: Ineligible..4

Credit Impact

By correctly identifying the $80,000 in qualifying supplies and supply-equivalent costs, AeroCell MN adds these to their R&D wages. If they have no tax liability, the introduction of partial refundability in 2025 will allow them to receive nearly 20 percent of this credit value back as a cash refund, providing critical funding for their next round of prototypes.12

The Impact of Federal Section 174 Amortization on State Credits

A recent and profound change affecting the R&D landscape is the modification of IRC Section 174.8 Prior to 2022, companies could immediately deduct R&D expenses (including supplies) in the year they were incurred.8 However, the Tax Cuts and Jobs Act of 2017 mandated that for tax years beginning after December 31, 2021, these expenses must be capitalized and amortized over five years for domestic research (or 15 years for foreign research).8

Minnesota has conformed to this federal change.8 This means that while a Minnesota taxpayer can still claim the full R&D credit for their supply expenditures in the current year, they can only deduct 10 to 20 percent of those same costs on their current-year Minnesota income tax return.8 This creates a significant “cash flow gap” where the tax liability may increase even as the R&D credit remains available.8 Taxpayers must ensure their Schedule RD filings are coordinated with their Section 174 amortization schedules to avoid discrepancies during a Department of Revenue review.4

Conclusion and Strategic Outlook

The Minnesota Credit for Increasing Research Activities remains a cornerstone of the state’s economic policy, with “supplies” acting as a vital component for companies engaged in physical innovation. The definition of supplies as non-depreciable tangible property consumed in the state creates a clear, if rigorous, boundary for what qualifies for the incentive. As Minnesota moves toward a partially refundable model in 2025, the stakes for accurate supply classification have never been higher.

For businesses to successfully navigate this landscape, they must move beyond general accounting and adopt a research-centric documentation strategy. The ability to articulate the technical uncertainty being addressed and to provide a contemporaneous audit trail linking every gram of material or kilowatt of extraordinary utility to that uncertainty is what differentiates a successful credit claim from a disallowed expense. As technological complexity increases—from the development of bio-resorbable medical implants to high-performance computing—the MDOR’s focus on substantiating the “nexus” between the expense and the experiment will likely only intensify. Taxpayers who proactively align their R&D operations with the statutory requirements of Minnesota Statute 290.068 will find the credit to be a powerful tool for fueling their next generation of technological growth.

R&D Tax Credit Preparation Services

Swanson Reed is one of the only companies in the United States to exclusively focus on R&D tax credit preparation. Swanson Reed provides state and federal R&D tax credit preparation and audit services to all 50 states.

If you have any questions or need further assistance, please call or email our CEO, Damian Smyth on (800) 986-4725.
Feel free to book a quick teleconference with one of our national R&D tax credit specialists at a time that is convenient for you.

R&D Tax Credit Audit Advisory Services

creditARMOR is a sophisticated R&D tax credit insurance and AI-driven risk management platform. It mitigates audit exposure by covering defense expenses, including CPA, tax attorney, and specialist consultant fees—delivering robust, compliant support for R&D credit claims. Click here for more information about R&D tax credit management and implementation.

Our Fees

Swanson Reed offers R&D tax credit preparation and audit services at our hourly rates of between $195 – $395 per hour. We are also able offer fixed fees and success fees in special circumstances. Learn more at https://www.swansonreed.com/about-us/research-tax-credit-consulting/our-fees/