Analysis of the Two-Tiered Rate Structure within the Minnesota Research and Development Tax Credit Framework

The Minnesota Two-Tiered Rate Structure refers to a statutory formula that applies a 10 percent credit rate to the first $2 million of qualified research expenses exceeding a calculated base amount, and a 4 percent rate to any additional excess expenses. This bifurcation is designed to maximize the marginal incentive for mid-sized innovation projects while simultaneously providing a sustainable, capped incentive for large-scale corporate research and development expenditures.1

The implementation of this tiered structure signifies a sophisticated policy instrument intended to foster a competitive environment for technological growth within the state. By front-loading the tax benefit at the 10 percent level for the initial $2 million of incremental investment, the Minnesota Department of Revenue effectively lowers the cost of entry for emerging technology firms and specialized research initiatives.1 For an organization that achieves $2 million in excess qualified research expenses (QREs), the credit generates a direct $200,000 reduction in corporate franchise or individual income tax liability.1 When expenses exceed this threshold, the marginal rate drops to 4 percent, a transition that reflects the state’s dual objectives: encouraging high-volume research while managing the overall fiscal impact on the General Fund.1 This structured approach distinguishes Minnesota from many other jurisdictions that utilize a flat percentage, offering a more nuanced incentive that scales with the size and intensity of the research activity performed within the state’s borders.4

Historical Evolution and Legislative Foundation

The Minnesota Credit for Increasing Research Activities, codified under Minnesota Statutes Section 290.068, was originally established by the 1981 Legislature.3 It was patterned after the federal research credit enacted during the same era, designed to incentivize private sector investment in innovation by allowing a direct credit against tax liability rather than a mere deduction from income.2 Over the subsequent decades, the credit has undergone several critical revisions to maintain its efficacy and alignment with federal standards under Internal Revenue Code (IRC) Section 41.1

A pivotal shift occurred for taxable years beginning after December 31, 2016. During this period, the state significantly increased the rates associated with the two-tiered structure.8 Prior to these changes, the rates were established at 5 percent for the first $2 million and 2.5 percent for expenses exceeding that threshold.6 The legislative decision to double the first-tier rate to 10 percent and increase the second-tier to 4 percent underscored Minnesota’s intent to remain a leader in the Midwestern innovation corridor.10

The most recent transformative legislation, House File 9 (HF 9), signed into law in June 2025, introduced partial refundability to the credit.10 This modification, effective for tax years beginning after December 31, 2024, allows non-profitable startups and cash-intensive research firms to monetize their credits even in the absence of tax liability, fundamentally altering the value proposition of the tiered structure for the modern economy.1

The Four-Part Test: Federal Standards and Minnesota Specifics

To utilize the two-tiered rate structure, a business must first establish that its activities constitute “qualified research” under both federal and state definitions. Minnesota incorporates the federal “Four-Part Test” found in IRC Section 41(d), but with a strict geographical requirement: the research must be conducted entirely within the state of Minnesota.1

The first component of this test is the Elimination of Uncertainty, which requires that the research be undertaken to discover information that would eliminate technical uncertainty regarding the capability, method, or design for developing or improving a business component.8 This uncertainty must be technological in nature, relating to the “how” and “if” of the development process.8

Second, the activity must involve a Process of Experimentation. This is defined as a systematic process where the taxpayer evaluates one or more alternatives to achieve a result.8 This includes the development and testing of hypotheses, the refinement of designs, and the evaluation of alternative technical solutions.8

Third, the research must be Technological in Nature. This means the process of experimentation must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science.8 Research into social sciences, arts, or humanities is expressly excluded from the credit.8

Finally, the research must be for a Permitted Purpose. The objective must be to create a new or improved business component, specifically relating to its function, performance, reliability, or quality.8 Activities such as routine quality control, cosmetic or seasonal design, and the adaptation of existing components for specific customers do not qualify.8

Qualified Research Expenses (QREs) within the Two-Tiered Framework

The “excess” amount to which the 10 percent and 4 percent rates apply is derived from four primary categories of Qualified Research Expenses (QREs) incurred in Minnesota.1

Wages and Compensation

Wages represent the largest component of QREs for most businesses, often accounting for approximately three-quarters of the total credit claimed.6 To be eligible, wages must be paid to employees who are directly performing research, directly supervising research, or directly supporting research.1 For tax purposes, these are generally defined by reference to Box 1 of federal Form W-2.17 It is crucial for taxpayers to maintain records that delineate the portion of an employee’s time spent on qualified activities versus non-qualified administrative tasks.8

Supplies and Tangible Materials

Supplies include tangible property that is used and consumed in the research process.1 This often encompasses materials used for the construction of prototypes, chemical reagents, and experimental components.1 General administrative supplies, utilities, and depreciable property (such as lab equipment) are excluded, as the credit is intended for operational R&D costs rather than capital expenditures.1

Contract Research Expenses

When a business engages a third party to conduct research on its behalf, 65 percent of the amount paid is eligible for the credit.1 To qualify, the research must be performed within Minnesota, and the taxpayer must retain substantial rights to the research while bearing the financial risk of the project’s success or failure.1

Development Contributions to Nonprofits

Unique to Minnesota, contributions to qualified nonprofit organizations that award grants to small, technologically innovative Minnesota firms are eligible as QREs.1 This provision encourages larger corporations to support the state’s broader innovation ecosystem while receiving a credit at their applicable tiered rate.1

Determining the Base Amount: The Incremental Requirement

The two-tiered rate structure is applied only to “excess” QREs, defined as the current-year Minnesota QREs minus a calculated “base amount”.1 This incremental nature is fundamental to the policy’s objective: it rewards companies for increasing their research efforts relative to their historical operations rather than subsidizing a static level of R&D.2

Calculation Methodology

Minnesota requires the use of the “Regular Incremental Method,” mirroring the federal approach but restricted to state-sourced data.1 Notably, Minnesota does not permit the use of the Alternative Simplified Credit (ASC) method commonly used for federal filing.8

The base amount is the product of the “fixed-base percentage” and the average annual Minnesota gross receipts for the four preceding tax years.2

$$Base\ Amount = Fixed\ Base\ Percentage \times \left( \frac{\sum Gross\ Receipts_{PY1-PY4}}{4} \right)$$

The fixed-base percentage is determined based on the company’s status 2:

• Established Companies: For firms that had both research expenses and gross receipts between 1984 and 1988, the percentage is the ratio of total QREs to total gross receipts for that period, capped at 16 percent.2
• Start-up Companies: For firms whose first year with both research expenses and gross receipts occurred after 1983, a statutory percentage (initially 3 percent) is used for the first five years, with subsequent adjustments.2

The 50-Percent Limit and Revenue Apportionment

A critical statutory safeguard is the “50-percent limit,” which states that the base amount cannot be less than 50 percent of the current year’s QREs.1 This limit frequently affects large, multi-state companies whose Minnesota research is high but whose Minnesota-sourced gross receipts are relatively low.2 For these entities, the effective credit is calculated on only half of their Minnesota research spending, regardless of historical performance.2

Under Minnesota Statute 290.191, gross receipts must be calculated using Minnesota sales or receipts as defined for tax apportionment.8 This requires a meticulous analysis of where a company’s sales are sourced to ensure the base amount accurately reflects the business’s Minnesota-specific economic footprint.8

Analysis of the 2025 Refundability Reforms (HF 9)

The enactment of House File 9 represents the most significant change to the R&D credit in over a decade.10 By introducing partial refundability, the legislature has created an immediate cash-flow benefit for pre-revenue and non-profitable companies that were previously required to carry forward credits for up to 15 years.1

The Refundability Election

Taxpayers must make an irrevocable election on a timely filed return (including extensions) to claim the refundable portion.1 The refundable amount is calculated only after the current-year credit has reduced the tax liability to zero.8

The formula for the refund is:

$$Refundable\ Amount = Unused\ Current\ Year\ Credit \times Refundability\ Rate$$

The refundability rate is scheduled as follows:

The Commissioner’s Authority and the $25 Million Cap

Starting in 2028, the Commissioner of Revenue must evaluate the total projected refunds annually.1 If the Department determines that the total amount of refunds will exceed $25 million for the succeeding year, the refundability rate must be adjusted downward.1 This new rate must be published by December 15 of each year.1 This mechanism ensures the credit remains a predictable fiscal tool for the state while providing a valuable, albeit variable, cash incentive for researchers.1

Administrative Guidance and Schedule RD Compliance

The primary vehicle for claiming the credit is Schedule RD, Credit for Increasing Research Activities.1 This form requires a line-by-line calculation of Minnesota QREs, the base amount, and the application of the tiered rates.17

Unitary Businesses and Combined Reporting

For C corporations filing as part of a unitary group, the credit must first be used by the “earning member” to offset their specific tax liability.8 If a portion of the credit remains, it may be allocated to other members of the combined group to reduce their respective liabilities.2 Any remaining unused credit is then subject to the refundability election (for 2025+) or carried forward.8

Updated guidance from the Department of Revenue (DOR) has clarified that the credit carryforward may also be used by other members of a consolidated group, increasing the utilization rate of credits generated by specific research units within a larger corporate structure.13

Recordkeeping and Substantiation

The DOR emphasizes that the taxpayer bears the burden of proof to substantiate all QREs and the performance of qualified activities in Minnesota.8 Local state revenue office guidance recommends maintaining the following documentation for a minimum of 3.5 years (though 4-7 years is advised due to federal requirements and carryforward periods) 1:

• Project Lists: A comprehensive list of research projects and their location in Minnesota.8
• Narrative Descriptions: Detailed explanations of how each project satisfies the Four-Part Test, specifically describing the technical uncertainties and the process of experimentation.8
• Payroll Substantiation: Time-tracking records or credible estimation methods linking wages to specific research projects.8
• Supply Invoices: Invoices for materials consumed specifically in the R&D process.8
• Contractual Evidence: Contracts for third-party research showing risk and ownership rights.8

Industry-Specific Applications: Mining and Healthcare

While the general R&D credit applies to most commercial sectors, Minnesota provides specialized guidance for two of its major industries: mining and healthcare.

Mining Occupation Tax Credit

Through Revenue Notice #22-01, the Department of Revenue established that mining companies subject to the Occupation Tax are eligible to claim the Research Credit.20 Because the Occupation Tax is determined “in the same manner” as the corporate franchise tax under Section 290.02, the DOR position is that the research credit under 290.068 is fully applicable.20 This allows Minnesota’s taconite and iron ore producers to utilize the two-tiered rate structure against their unique industry-specific tax liabilities.20

MinnesotaCare Research Credit

Distinct from the general credit, a specialized MinnesotaCare Research Credit is available to healthcare providers and hospitals.22 This credit applies to receipts received from providing patient services that are used to fund or conduct qualifying research approved by a governing body.22 Unlike the general R&D credit, which uses a 10%/4% tiered structure, the MinnesotaCare credit is calculated based on a percentage determined annually by the state; for 2025, this rate is set at 0.5 percent.22 The research must be part of a formal program designed to improve the diagnosis and treatment of disease or injury and undergo peer or institutional review.22

Statistical Overview and Economic Impact

The Credit for Increasing Research Activities represents a significant portion of the state’s tax expenditure budget. In 2024, the state estimated the total cost of the credit at $144.8 million.2

The distribution of the credit is heavily concentrated in the manufacturing sector, which has historically claimed approximately 65 percent of the total benefit among C corporations.6 Furthermore, data suggests that the credit is highly effective at stimulating jobs and earnings growth, although some legislative analysts have noted that the fiscal benefits to the state offset only a portion of the tax revenue foregone.3 The implementation of the 10 percent first-tier rate is specifically intended to broaden the base of claimants by making the credit more accessible to mid-sized firms that may not reach the higher spending thresholds of large multi-national conglomerates.1

Example Calculation: The Two-Tiered Structure in Practice

To illustrate the mathematical application of the two-tiered rates and the 2025 refundability election, consider “NorthStar Biolabs,” a Minnesota-based pharmaceutical research firm filing as a C corporation.

Step 1: Establish Minnesota QREs

For the 2025 tax year, NorthStar Biolabs incurs the following in Minnesota:

• Wages for Researchers: $3,000,000
• Lab Supplies: $800,000
• Contract Research with U of M: $200,000 ($130,000 eligible at 65%) 1
• Total Minnesota QREs: $3,930,000

Step 2: Determine the Base Amount

• Average Annual Gross Receipts (prior 4 years): $20,000,000
• Fixed-Base Percentage: 10% (calculated from 1984-88 data) 2
• Calculated Base: $2,000,000
• 50% Minimum Base Floor: $3,930,000 $\times$ 0.50 = $1,965,000 1
• Final Base Amount: $2,000,000 (Greater of calculated base or floor) 17

Step 3: Calculate Excess QREs

• Excess QREs: $3,930,000 – $2,000,000 = $1,930,000

Step 4: Apply Two-Tiered Rates

• First-Tier Credit: $1,930,000 $\times$ 10% = $193,000 1
• Note: Since the excess is less than $2,000,000, the 4% second-tier rate does not apply. 1

Step 5: Tax Liability and Refundability Election (2025)

• Minnesota Tax Liability: $43,000
• Credit Used to Offset Liability: $43,000 (Tax Due = $0)
• Remaining Unused Credit: $193,000 – $43,000 = $150,000
• Refundable Election: NorthStar Biolabs elects to receive a partial refund.
• Calculation: $150,000 $\times$ 19.2% (2025 refundability rate) = $28,800 1
• Total Benefit: NorthStar Biolabs pays $0 in tax and receives a $28,800 refund.
• Carryforward: The remaining $121,200 ($150,000 – $28,800) is carried forward to 2026.1

Comparative Analysis of Minnesota’s R&D Policy

In comparison to other states, Minnesota’s 10 percent first-tier rate is highly competitive. For example, California offers a 15 percent credit rate for its Alternative Incremental Research Credit, but many standard claimants receive only around 3 percent.5 Wisconsin utilizes a flat 5.75 percent rate on expenses exceeding 50 percent of a three-year average, which lacks the aggressive front-loading of the Minnesota 10 percent tier.23

Texas provides a credit of 5 percent of the base amount (increasing to 6.25 percent in some cases), while Arizona offers a more complex system where small businesses can qualify for a 75 percent refund of excess credits, but the underlying rates are generally lower than Minnesota’s first tier for many types of research expenditures.4 The Minnesota model’s focus on the first $2 million of excess spending ensures that the most intense incentive is delivered at the exact scale where mid-market and scaling firms are making critical investment decisions.1

Conclusion

The Two-Tiered Rate Structure of the Minnesota Credit for Increasing Research Activities remains a cornerstone of the state’s economic strategy to incentivize local innovation. By providing a distinct 10 percent rate on the initial $2 million of incremental research and a 4 percent rate for larger-scale investments, the Minnesota Department of Revenue effectively balances the need for broad-based innovation support with fiscal sustainability. The 2025 reforms introducing partial refundability further enhance this system, providing a vital cash-flow mechanism for the state’s most technologically ambitious—but yet non-profitable—enterprises. For businesses operating in Minnesota, a thorough understanding of the “excess” calculation, the 50-percent floor, and the administrative requirements of Schedule RD is essential to maximizing the benefits of this sophisticated tax instrument. As the state moves toward a variable refundability rate in 2028, the importance of proactive tax planning and meticulous recordkeeping will only continue to grow for professional practitioners and business leaders alike.

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