Alternative Excess Research and Development Expenses

Alternative Excess Research and Development Expenses represent the specific portion of a taxpayer’s qualified research spending in North Dakota that exceeds fifty percent of their average qualified research expenditures from the three preceding taxable years. In the context of the North Dakota Research and Experimental Expenditure Tax Credit, this value serves as the foundational calculation base for the Alternative Simplified Computation method, providing a streamlined incentive for businesses to maintain and expand their innovative activities within the state.

The North Dakota Research and Experimental Expenditure Tax Credit is a cornerstone of the state’s economic development strategy, designed to foster a robust ecosystem for “primary sector” businesses and technological advancement. By understanding the nuances of “Alternative Excess Research and Development Expenses,” tax professionals and business leaders can effectively leverage state-level incentives to offset the high costs of innovation. This report explores the statutory definitions, the interplay between state and federal regulations, and the administrative guidance provided by the North Dakota Office of State Tax Commissioner.

Statutory Foundations and Legislative Intent

The North Dakota Research Expense Tax Credit, codified under North Dakota Century Code (N.D.C.C.) § 57-38-30.5, was established with the clear objective of stimulating economic growth through private sector investment in research and development. The legislative history of this provision reflects a multi-decade effort to refine the incentive to meet the changing needs of the state’s economy, particularly its core industries in agriculture, energy, and manufacturing.

Initially enacted in 1987 through House Bill No. 1645, the credit was originally tailored to corporate entities. The assembly viewed the credit as a vital tool to encourage both new and existing corporations to undertake research projects within North Dakota, recognizing that such activities are precursors to job creation and increased tax revenue. Over the years, the scope of the credit has been significantly broadened. Legislative sessions in 1993, 2007, and 2019 introduced critical amendments, such as extending eligibility to passthrough entities and creating the Alternative Simplified Computation (ASC) method to align with federal standards under Internal Revenue Code (IRC) § 41.

The adoption of the “Alternative Excess” concept was a strategic move by the North Dakota Legislative Assembly to simplify the compliance burden for taxpayers. Traditional R&D credit calculations often required historical data reaching back to the 1980s or complex gross-receipts-based formulas. By introducing a method based on a rolling three-year average of qualified research expenses (QREs), the state made the credit accessible to modern startups and high-growth companies that might otherwise be disqualified by the “Regular Method” base period requirements.

Defining Alternative Excess Research and Development Expenses

The term “Alternative Excess Research and Development Expenses” is a technical definition used exclusively for the Alternative Simplified Computation of the research credit. According to the North Dakota Office of State Tax Commissioner, this amount is calculated by determining the degree to which a taxpayer’s qualified research expenses incurred in North Dakota for the current tax year exceed a “base amount” equal to fifty percent of the average qualified research expenses incurred in the state for the three preceding tax years.

This methodology ensures that the credit is focused on “incremental” research—spending that is higher than half of the recent historical norm. This structure acknowledges that while baseline research is necessary for business maintenance, the state’s fiscal interest lies in incentivizing growth and sustained high-level investment. For businesses with fluctuating R&D budgets, the rolling average provides a “smoothing” effect that prevents a single year of high spending from permanently pricing them out of future credits.

The Nexus of Qualified Research Expenses

To calculate Alternative Excess, one must first identify “Qualified Research Expenses” (QREs). North Dakota law adopts the federal definitions of QREs provided in IRC § 41(b), but with a strict geographic limitation: the expenses must be incurred for research conducted within the state of North Dakota.

The state revenue office and the underlying law categorize QREs into three primary buckets:

1. In-House Research Wages: This includes the taxable wages paid to employees who are directly performing research, supervising research, or providing direct support for research activities.
2. Supplies: This covers the cost of tangible property, other than land or improvements to real property, used in the conduct of qualified research.
3. Contract Research Expenses: This typically represents 65% of the amount paid to third parties for research conducted on the taxpayer’s behalf, provided the research is performed in North Dakota.

A critical nuance in the North Dakota guidance is the treatment of “Basic Research” and “Energy Research.” While the state largely follows federal guidelines, it explicitly excludes basic research conducted outside North Dakota and any research that does not meet the “geographic nexus” established in N.D. Admin. Code § 81-03-05.1-06. This administrative rule clarifies that for the purposes of the base amount and the current year calculation, only amounts incurred in or attributable to North Dakota are relevant.

The Calculation Framework: Alternative Simplified Computation (ASC)

The Alternative Simplified Computation method, which utilizes the “Alternative Excess” definition, became available for North Dakota tax years beginning after December 31, 2018. This method is frequently preferred by companies with rapidly increasing revenues because it decouples the credit from gross receipts, focusing solely on research expenditure trends.

Tiered Credit Rates

Under the ASC method, the credit is not a flat percentage but follows a tiered structure designed to provide substantial relief for initial tranches of excess spending while maintaining fiscal sustainability for massive projects. The credit is the sum of:

• 17.5% of the first $100,000 of North Dakota alternative excess research and development expenses.
• 5.6% of any alternative excess research and development expenses that exceed the initial $100,000.

The “Zero QRE” Rule for New Entrants

A significant challenge for many new businesses is the lack of a three-year historical average. The North Dakota legislature addressed this by providing a specialized calculation for years where the taxpayer has zero qualified research expenses in any of the three preceding tax years. In these instances, the credit is calculated as:

• 7.5% of the first $100,000 of current-year North Dakota qualified research expenses.
• 2.4% of any current-year North Dakota qualified research expenses exceeding $100,000.

This “Reduced Rate” ensures that the transition into the full ASC method is equitable and provides immediate liquidity to companies that are just beginning their North Dakota research operations. It prevents a scenario where a company must “wait” three years to receive any tax benefit for their initial R&D investments.

Comparison with the Regular Method

The choice between the ASC and the Regular Method is an annual election. Once made for a specific tax year, the election is binding for that year. The Regular Method, unlike the ASC, uses a “Base Amount” that is often linked to the taxpayer’s gross receipts and a “fixed-base percentage.”

Calculation Component	Regular Method	ASC Method (Alternative Excess)
Base Period	Historically linked to 1980s or startup years	Immediately preceding 3 tax years
Base Calculation	Gross Receipts × Fixed-Base %	50% of 3-year QRE Average
Lower Tier Rate	25% of first $100k of excess	17.5% of first $100k of alternative excess
Upper Tier Rate	8% of excess over $100k	5.6% of alternative excess over $100k
Required Data	North Dakota Gross Receipts	North Dakota QRE History

While the Regular Method offers a higher headline rate (25%), the “Alternative Excess” under the ASC is often easier to achieve for companies that are growing their top-line revenue faster than their R&D spend. In the Regular Method, the “Base Amount” can never be less than 50% of the current year’s QREs, which creates a natural ceiling on the potential credit. The ASC method’s reliance on historical QREs rather than gross receipts makes it a powerful tool for tech-intensive firms.

Strategic Example: Comprehensive Calculation Walkthrough

To better understand how “Alternative Excess Research and Development Expenses” function in a practical business environment, consider the case of a mid-sized North Dakota manufacturing firm specializing in autonomous agricultural drones. For the 2024 tax year, the company is deciding whether to elect the ASC method.

Data Collection: 4-Year Research History

First, the company must verify its North Dakota-based QREs for the three preceding years (2021-2023) and its current year (2024).

Year	North Dakota QREs	Notes
2021	$600,000	Wages for ND engineering team
2022	$750,000	Supplies for prototypes in Bismarck
2023	$750,000	Contract research with local ND university
2024	$1,500,000	Current Year Expansion

Step 1: Calculate the Average QRE

The three-year average is determined by the spending in 2021, 2022, and 2023.

Average QRE = ($600,000 + $750,000 + $750,000) / 3 = $700,000

Step 2: Determine the ASC Threshold (50% of Average)

The statutory definition of the base for Alternative Excess is half of the three-year average.

Threshold = $700,000 × 0.50 = $350,000

Step 3: Identify Alternative Excess R&D Expenses

The “Alternative Excess” is the margin of current spending over the threshold.

Alternative Excess = $1,500,000 – $350,000 = $1,150,000

Step 4: Calculate the Total Credit

Using the tiered rates of 17.5% and 5.6%, we compute the total benefit.

• First $100,000 of Alternative Excess: $100,000 × 0.175 = $17,500
• Remaining Alternative Excess: ($1,150,000 – $100,000) × 0.056 = $1,050,000 × 0.056 = $58,800

Total 2024 North Dakota Research Credit (ASC Method) = $76,300

In this narrative scenario, the company has successfully identified $1,150,000 in Alternative Excess R&D Expenses. The resulting credit of $76,300 provides a significant dollar-for-dollar offset to their state income tax liability. If the credit exceeds their total tax due for 2024, the state revenue office allows them to carry back the unused portion to the three preceding years to obtain a refund of taxes previously paid, or carry it forward for up to 15 years to offset future growth.

Local State Revenue Office Guidance and Compliance

The North Dakota Office of State Tax Commissioner provides rigorous guidance to ensure that taxpayers claiming the R&D credit are doing so in accordance with both state law and federal definitions. One of the most critical aspects of this guidance is the adherence to the federal “Four-Part Test” for identifying qualified research.

The Four-Part Test in a North Dakota Context

To qualify as a North Dakota QRE, the activity must satisfy all four of the following requirements derived from IRC § 41(d):

1. Section 174 Test: The expenditures must be eligible for treatment as expenses under Section 174 of the Internal Revenue Code. This generally means the costs must be incurred in connection with the taxpayer’s trade or business and represent research and development costs in the experimental or laboratory sense.
2. Technological in Nature Test: The research must be undertaken for the purpose of discovering information that is technological in nature. This requires that the process of experimentation relies on the principles of physical or biological sciences, engineering, or computer science.
3. Business Component Test: The information discovered must be intended to be useful in the development of a new or improved business component. A business component can be a product, process, computer software, technique, formula, or invention to be held for sale, lease, or license, or used by the taxpayer in its own trade or business.
4. Process of Experimentation Test: Substantially all of the research activities must constitute a process of experimentation. This involves the evaluation of one or more alternatives designed to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the research activities.

The state revenue office emphasizes that research conducted after the beginning of commercial production, the duplication of existing products, or routine data collection do not meet these criteria. Furthermore, the exclusion of research conducted outside North Dakota remains the most common point of adjustment during state audits.

Filing Procedures and Required Documentation

There is no dedicated, standalone form for the calculation of the North Dakota R&D credit (unlike the federal Form 6765). Instead, the credit is claimed as a line item on the taxpayer’s primary income tax return.

• For Corporations: The credit is reported on Form 40, Schedule TC.
• For Individuals: The credit is reported on Schedule ND-1TC.
• For Passthroughs: S corporations and partnerships use Form 60 (Schedule K) or Form 58 (Schedule K) respectively to pass the credit through to their owners.

Guidance from the Tax Commissioner states that a taxpayer must attach a “schedule or worksheet” showing the detailed computation of the credit. This schedule should clearly distinguish between current-year QREs and the three-year historical average used to calculate “Alternative Excess.” Taxpayers are also expected to maintain contemporaneous records, such as time-tracking logs, project descriptions, and supply invoices, to support their claims in the event of an audit. The state generally allows a four-year window for record retention, though longer periods may be advisable if credits are being carried forward.

Specialized Provisions for Small Businesses and Primary Sector Entities

North Dakota law contains several provisions aimed at supporting emerging businesses that may not yet have the tax liability to utilize the full value of their research credits. These provisions, which include the transferability of credits, are among the most innovative aspects of the state’s tax code.

Transferability of Unused Research Credits

A “Qualified Research and Development Company” may elect to sell, transfer, or assign up to $100,000 of its unused tax credit to another North Dakota taxpayer. This provides an immediate source of non-dilutive capital for startups.

To qualify for this transfer, the selling company must meet stringent criteria:

• Primary Sector Certification: It must be certified by the North Dakota Department of Commerce as a “Primary Sector Business.” This is defined as a business that adds value to a product, process, or service, thereby producing new wealth in the state.
• Revenue Cap: It must have annual gross revenues of less than $750,000.
• Research Timeline: It must have conducted research in North Dakota for the first time after December 31, 2006.
• Certification Process: The company must apply for and receive certification as a “Research and Development Company” through the Department of Commerce using form SFN 58638.

Once certified, the transferor and the buyer (transferee) must jointly file Form CTS (Credit Transfer Statement) within 30 days of executing the purchase agreement. The buyer then claims the credit on their own tax return. It is important to note that while the original earner of the credit can carry it back three years, the buyer of a transferred credit is only permitted to carry it forward for 15 years.

The $2 Million Lifetime Cap for Certain Claimants

While the R&D credit is permanent, the state has implemented a cap for older, established entities to manage the fiscal impact on the state budget. For any taxpayer that first earned or claimed a research credit in a tax year beginning before January 1, 2007, the maximum credit that may be earned in any single year is $2 million. Any amount earned in excess of this cap is permanently disallowed and cannot be carried back or forward. This limitation does not apply to taxpayers who began their research activities in North Dakota on or after January 1, 2007.

Economic Performance and Statistical Overview

The North Dakota Research Expense Tax Credit has a documented history of driving significant economic activity. Periodic reviews by the North Dakota Legislative Council provide a window into the program’s effectiveness and its cost-benefit profile to the state.

Participation and Direct Impact

According to historical data reported by the Tax Department for the decade between 2007 and 2016, the program saw broad adoption:

• Claimant Volume: Approximately 1,800 taxpayers utilized the credit during this period.
• Tax Year 2016 Totals: Individual income taxpayers claimed more than $4.5 million in credits, while corporate taxpayers claimed over $500,000.
• Accumulated Benefits: Major state entities, such as Basin Electric Power Cooperative, have utilized the credit to offset substantial investments, with some reports showing accumulated credits exceeding $10.3 million over several years of research activity.

Macroeconomic Contributions

The Legislative Council’s 2021 memorandum analyzed the long-term impact of the credit on the state’s Gross Domestic Product (GDP) and population:

• GDP Impact: The estimated annual contribution to the state’s GDP was approximately $80 million.
• Job Growth: At its peak measurement, the credit was credited with the creation of 1,100 jobs and an increase in the state’s population by approximately 1,000 individuals.
• Revenue Generation: Over a 20-year period, the state was projected to receive $213 million in tax revenue as a direct result of the economic activity stimulated by the credit.

However, the analysis also highlighted the fiscal costs. The direct cost of the credit ($66 million) combined with the indirect costs of supporting an increased population ($182 million) resulted in a net budgetary liability of $30 million compared to a scenario where no credit was offered. Despite this, the legislature has maintained the credit, viewing the “investment” in high-tech industries as essential for the state’s long-term resilience and its ability to compete for high-wage jobs in the global market.

Interaction with Federal Tax Changes: Section 174 Amortization

A significant development in the R&D landscape is the federal requirement under the Tax Cuts and Jobs Act of 2017 for businesses to amortize research and experimental (R&E) expenditures under Section 174. Starting in 2022, these expenses must be capitalized and amortized over five years (for domestic research) or 15 years (for foreign research), rather than being deducted immediately.

Because North Dakota’s tax law is “federalized,” this change directly impacts North Dakota taxable income. Taxpayers must now add back their federal R&D expense deductions and follow the amortization schedule on their North Dakota returns. However, the calculation of the Research Credit itself—including the determination of “Alternative Excess”—remains based on the total qualified expenses incurred during the year, regardless of how they are amortized for deduction purposes. This creates a complex filing environment where a company may have a higher current-year tax liability due to amortization but can use the research credit to offset that increase.

Audit Defense and Contemporaneous Documentation

As the North Dakota Office of State Tax Commissioner increases its scrutiny of high-value credits, the importance of “contemporaneous documentation” cannot be overstated. A successful claim for Alternative Excess R&D Expenses must be backed by evidence that was created at the time the research was being conducted.

Best Practices for Record Keeping

Domain experts and state guidance suggest maintaining the following documentation for at least the statutory period of four years:

1. Project Lists and Narratives: A document describing each project, the technical challenges faced, the alternatives evaluated, and the final outcome. This is essential for proving the “Process of Experimentation.”
2. Wage Allocation Models: A spreadsheet showing how much time each employee spent on qualified research versus routine tasks. If an employee spends more than 80% of their time on qualified research, 100% of their wages can typically be included (the “80% Rule” from federal guidance often applied at the state level).
3. Third-Party Contracts: Signed agreements with North Dakota-based vendors, along with invoices and proof of payment.
4. Supply Logs: Detailed lists of supplies consumed during the development of prototypes.

The state revenue office warns that the credit may be disallowed if the taxpayer fails to provide documentation that aligns with the federal IRC § 41 standards. Common pitfalls include failing to exclude “out-of-state” expenses or claiming routine quality control as research.

Final Thoughts: The Strategic Value of Alternative Excess R&D

The concept of Alternative Excess Research and Development Expenses is a vital mechanism that aligns North Dakota’s fiscal incentives with the reality of modern business growth. By providing the Alternative Simplified Computation method, the state has moved away from the rigid, historical base periods of the past and toward a model that rewards recent and sustained innovation.

For companies operating in North Dakota’s primary sectors—from the software developers in the Fargo tech corridor to the energy engineers in the Bakken and the agricultural innovators across the Red River Valley—the R&D tax credit is more than just a calculation; it is a strategic asset. The ability to carry credits back for immediate refunds or transfer them for upfront capital provides the liquidity necessary to take risks and develop the “next big thing.”

As the state continues to review and refine its incentive programs, the Research Expense Tax Credit remains a permanent and powerful tool. By mastering the calculation of Alternative Excess and adhering to the rigorous documentation standards set by the Office of State Tax Commissioner, North Dakota businesses can ensure they are maximizing their return on investment and contributing to the enduring economic vitality of the Peace Garden State.