Excess Qualified Research Expenses

Excess Qualified Research Expenses are the specific dollar amounts a business spends on innovative activities within North Dakota that surpass its calculated historical baseline or “base amount.” These excess expenditures serve as the primary mathematical basis for determining the final value of the state’s research and development tax credit.

The concept of “excess” is central to the incremental nature of the North Dakota Research and Experimental Expenditure Tax Credit. Unlike a flat credit that might apply to all research spending, North Dakota utilizes an incremental model designed to incentivize growth. By rewarding only the spending that exceeds a historical or calculated average, the state ensures that tax expenditures are targeted toward companies that are actively expanding their innovation footprint rather than those merely maintaining a status quo. This mechanism reflects a broader economic strategy to transition the state’s economy from a reliance on raw commodity production in energy and agriculture toward a high-tech, value-added industrial model.

The Statutory Foundation of Excess Qualified Research Expenses

The North Dakota Research and Experimental Expenditure Tax Credit is codified under North Dakota Century Code (N.D.C.C.) § 57-38-30.5. This statute serves as the legal anchor for all definitions, eligibility criteria, and calculation methodologies associated with the credit. While the state heavily leverages the federal definitions found in Section 41 of the Internal Revenue Code (IRC), it introduces several critical geographic and administrative modifications that define the scope of “excess” expenditures in a local context.

Historically, the credit was established by House Bill No. 1645 during the 1987 legislative session. At its inception, it was patterned after a successful Minnesota law intended to encourage corporations to undertake research and development (R&D) to stimulate local economic development. The original 1987 enactment provided for a corporate income tax credit equal to 8 percent of the first $1.5 million of North Dakota qualified research expenses in excess of base period research expenses, and 4 percent of any amount exceeding that threshold. Over the following decades, the law evolved significantly, expanding its reach from C-corporations to include limited liability companies (LLCs) in 1993, and eventually individuals and passthrough entities in 2007.

The current legal framework distinguishes between different classes of taxpayers based on when they first began conducting research in the state. This temporal distinction is vital for calculating the “excess,” as the applicable percentages and caps vary significantly between legacy claimants and modern innovators. For example, taxpayers who earned or claimed a credit in taxable years beginning before January 1, 2007, are subject to a maximum annual credit cap of $2 million, with any excess earned in a given year being disallowed for carryover. Conversely, those who entered the program after 2007 operate under a tiered percentage system that lacks an overall dollar cap but imposes stricter definitions on what constitutes the base amount.

Defining the Component Parts: QREs and the Base Amount

To understand “Excess Qualified Research Expenses,” one must first decompose the variables that form the equation. The law defines the excess as the simple difference between the total Qualified Research Expenses (QREs) incurred during the tax year and the statutory “Base Amount.”

Excess QREs = (Total North Dakota QREs) – (North Dakota Base Amount)

For an expense to be included in the “Total North Dakota QREs” side of the ledger, it must satisfy the four-part test established by the federal government but restricted to the geographic boundaries of North Dakota. The activity must be technological in nature, intended to discover information to eliminate technical uncertainty, involve a process of experimentation, and be directed toward a new or improved business component. Under N.D.C.C. § 57-38-30.5(5)(h), “qualified research expenses” means expenses as defined in IRC § 41(b), but the state law explicitly excludes any expenses incurred for basic research conducted outside the state of North Dakota.

Detailed Analysis of Qualified Research Expenses (QREs)

The North Dakota Tax Department and the Office of State Tax Commissioner provide specific guidance on what constitutes a valid expense for the purpose of the credit. These expenses are generally categorized into three buckets: wages, supplies, and contract research. The integrity of the “excess” calculation depends on the accurate tracking of these costs at a granular, project-specific level.

Wage Expenditures

Wages typically represent the largest portion of QREs for most claimants. These include the salaries of employees directly performing the research, as well as those providing direct supervision or direct support of the research activities. Direct support might include a lab technician cleaning equipment used for a specific experiment, whereas general administrative tasks like human resources or accounting do not qualify. North Dakota guidance clarifies that “wages” for this purpose means the sum of gross wages before reductions for payroll taxes or elective contributions, plus the employer’s contributions to the employee’s defined contribution plan.

Supplies and Consumables

Supplies include any tangible property, other than land or improvements to real property and depreciable property, that is consumed in the research process. In the context of North Dakota’s manufacturing and energy sectors, this often encompasses materials used to build prototypes, chemicals used in laboratory testing, and energy consumed specifically by research equipment. For a supply expense to contribute to the “excess,” the item must be used in the state. If a company buys materials in another state but consumes them in a North Dakota laboratory, the expense is generally considered a North Dakota QRE.

Contract Research

Contract research expenses involve payments made to third parties to perform research on the taxpayer’s behalf. Per federal rules adopted by the state, only 65 percent of these payments typically qualify as QREs. Furthermore, the research must be conducted within North Dakota for the expense to be eligible for the state credit. This creates a complex compliance environment for multistate companies that may hire out-of-state universities or laboratories to conduct specialized testing.

Mechanics of the North Dakota Base Amount

The “Base Amount” is the hurdle that research spending must clear before it is considered “excess.” North Dakota offers two primary methods for calculating this figure: the Regular Method and the Alternative Simplified Computation (ASC) method. The selection of the method is a strategic decision for a business, as it significantly alters the resulting credit value.

The Regular Method

The Regular Method is designed to measure a company’s “research intensity” relative to its historical performance. It uses a “Fixed-Base Percentage” multiplied by the “Average Annual Gross Receipts” for the four preceding years. However, a crucial safeguard in N.D.C.C. § 57-38-30.5 prevents the base amount from falling too low. Specifically, the base amount cannot be less than 50 percent of the current year’s qualified research expenses. This “50 percent rule” effectively limits the maximum amount of “excess” to half of the total research spend in any given year, protecting the state’s general fund from rapid spikes in credit claims.

The Fixed-Base Percentage for an established company is the ratio of its aggregate QREs to its aggregate gross receipts for the period between 1984 and 1988. For “startup” companies—those that did not have both gross receipts and QREs in at least three years during that 1980s window—the law provides a sliding scale. A startup begins with a 3 percent fixed-base percentage for its first five years of research, which then gradually adjusts based on its actual experience in the sixth through tenth years, eventually reaching a maximum cap of 16 percent.

The Alternative Simplified Computation (ASC) Method

Recognizing that many modern companies lack the historical records required for the 1984-1988 calculation, North Dakota introduced the ASC method for tax years beginning after 2018. The ASC method is often favored by businesses with fluctuating revenue or those that have undergone significant structural changes.

Under the ASC method, the “excess” is determined by comparing current year QREs to a rolling average of the three prior years. Specifically, the “alternative excess” is the amount of current QREs that exceeds 50 percent of the average QREs for the three preceding taxable years. If a taxpayer had zero QREs in any of those three preceding years, a special “reduced rate” calculation is used instead of the standard ASC formula.

Tiered Credit Rates and the Impact of Taxpayer History

Once the Excess Qualified Research Expenses have been isolated, North Dakota applies a tiered rate structure. This structure is intended to provide a disproportionately large benefit to smaller research projects while still offering significant support for large-scale industrial R&D.

Post-2007 Claimants

For most businesses currently operating in North Dakota, the credit rates are applied to the excess as follows:

First $100,000 of Excess QREs: A 25 percent credit rate is applied. This means the first $100,000 of incremental spending generates a $25,000 tax credit.

Excess QREs over $100,000: An 8 percent credit rate is applied. For example, if a company has $500,000 in excess QREs, it receives $25,000 for the first tier (25% of $100k) and $32,000 for the second tier (8% of $400k), for a total credit of $57,000.

These percentages have fluctuated over time due to legislative adjustments. Between 2007 and 2016, different rates were in effect for taxpayers based on when they first began research. Companies that started between 2007 and 2011, for instance, were eligible for a 20 percent rate on the second tier during that decade. The current 8 percent rate was standardized to simplify the code and manage the fiscal impact of the credit as the energy sector’s research spending accelerated.

Alternative Simplified Computation (ASC) Rates

For those electing the ASC method, the rates are naturally lower to reflect the generally lower “base amount” hurdle:

First $100,000 of Alternative Excess: 17.5 percent.

Alternative Excess over $100,000: 5.6 percent.

If the taxpayer had zero QREs in any of the three preceding years (e.g., a pure startup or a company returning to R&D after a long hiatus), the credit is calculated as 7.5 percent of the first $100,000 of QREs plus 2.4 percent of the amount over $100,000.

Local State Revenue Office Guidance: Filing and Compliance

The North Dakota Office of State Tax Commissioner is the primary authority for administering the credit. They provide specific forms and procedural guidelines that taxpayers must follow to validate their “excess” expenditures. A failure to comply with these procedural mandates can result in the summary disallowance of the credit, even if the underlying research is valid.

Required Forms by Entity Type

North Dakota does not have a single, stand-alone form solely for the R&D credit calculation (comparable to Federal Form 6765). Instead, the credit is reported on the general tax return schedules, and taxpayers are required to attach their own worksheets detailing the “excess” calculation.

The Property Tax Clearance Requirement

A unique and often overlooked requirement for North Dakota state tax incentives is the Property Tax Clearance. Under N.D.C.C. § 57-01-15.1, any taxpayer claiming the research expense tax credit must be in good standing with all state and local tax obligations. If the taxpayer (including responsible officers of a corporation) holds a 50 percent or more ownership interest in real property in any North Dakota county, they must obtain a Property Tax Clearance Record from that county and attach it to the return.

This rule, implemented for credits claimed on or after August 1, 2017, ensures that the state does not provide incentives to entities that are delinquent on their local obligations. It effectively links the state-level income tax benefit to local-level tax compliance.

Carryback and Carryforward Provisions

Because research and development are inherently risky and often occur during years of low profitability, the credit includes flexible timing rules. If the research credit exceeds the taxpayer’s income tax liability for the year, the unused portion must first be carried back to the three preceding taxable years. This allows companies to receive immediate refunds of taxes paid in prior years, providing a vital source of liquidity.

Any credit remaining after the three-year carryback may be carried forward for up to 15 succeeding taxable years. To claim a carryback, the taxpayer must file an amended return within three years of the due date (including extensions) of the return for the year in which the credit was earned. For example, a credit earned in the 2024 tax year can be carried back to 2021, 2022, and 2023.

Monetization through Transferability: Provisions for Startups

North Dakota is one of the few states that allows certain research and development companies to monetize their credits before they have a tax liability. This is known as the “sell, transfer, or assign” provision. This feature is specifically designed to help “primary sector” startups that are in the intensive research phase and may not generate a profit—and thus a tax liability—for several years.

Eligibility for Transfer

A taxpayer may elect to transfer up to $100,000 of unused research credits if they satisfy a rigorous set of criteria verified by the North Dakota Department of Commerce:

Primary Sector Certification: The business must be a “primary sector business,” defined as one that adds value to a product, process, or service that produces new wealth in North Dakota (e.g., manufacturing, food processing, or biotechnology).

Revenue Threshold: The taxpayer must have annual gross revenues of less than $750,000.

Research Recency: The taxpayer must have conducted qualified research in North Dakota for the first time after December 31, 2006 (for older provisions) or 2016 (for modern provisions).

Entity Limitation: Only individuals, C-corporations, estates, and trusts are eligible to sell the credit. Passthrough entities like partnerships or S-corporations are not eligible to sell the credit directly, although their individual owners may potentially be able to do so depending on their specific circumstances.

The Transfer Process and Form CTS

The process of selling a credit involves two state agencies. First, the business must apply to the Department of Commerce for certification as a “Qualified Research and Development Company” using Form SFN 58638. This application must include a detailed description of the research being conducted and federal tax information to verify revenue limits.

Once certified, the seller (transferor) and the buyer (transferee) must execute a purchase agreement. Within 30 days of this agreement, they must jointly file Form CTS (Credit Transfer Statement) with the Office of State Tax Commissioner. The buyer typically purchases the credit at a discount (e.g., 85 cents on the dollar), providing the startup with immediate cash while giving the buyer a way to reduce their own North Dakota tax liability.

Economic Impact and Statistical Trends in North Dakota

The efficacy of the Research and Experimental Expenditure Tax Credit has been a subject of significant legislative scrutiny. The 2017-2018 Interim Taxation Committee conducted a comprehensive study of the credit’s impact using data from 2007 to 2016. The findings underscore the role of the credit in shaping the state’s high-tech workforce.

Participation and Demographic Distribution

Over the ten-year period analyzed, approximately 1,800 taxpayers claimed the credit. While the majority of the dollar value of the credits is often associated with large corporations in the energy sector, the number of individual claimants is substantial, particularly due to the passthrough nature of modern business entities.

The study projected that the credit contributes approximately $80 million per year to the state’s GDP and generated about $213 million in state revenue over a 20-year cycle through indirect effects such as increased payroll and sales taxes from the technical workforce. However, the committee also noted that from a pure “direct revenue” perspective, the credit results in a budget liability, leaving the state with approximately $30 million less than it would have had if no credit existed, despite its positive impact on the broader economy.

Sector-Specific Usage: Energy and Agriculture

The energy sector, particularly the oil and gas industry in western North Dakota, has been a major driver of R&D spending. Projects often focus on environmental compliance, carbon capture, and increasing the efficiency of shale extraction. For example, the Basin Electric Power Cooperative reported an average of 529 employees engaged in R&D between 2014 and 2016. However, such large-scale operations often face challenges in utilizing the credit; the study noted that Basin Electric accumulated $10.3 million in credits that it struggled to use because large depreciation deductions already resulted in net operating losses.

Agriculture remains the other cornerstone of North Dakota innovation. Research into value-added processing (e.g., soybean crushing or biodiesel production) qualifies for the credit and aligns with the state’s goal of moving beyond raw crop exports. The Department of Commerce’s “primary sector” certification specifically targets these value-added activities.

Practical Application: Comprehensive Calculation Examples

To illustrate how Excess Qualified Research Expenses translate into tax savings, we provide two detailed scenarios. These examples assume the taxpayer began conducting research after 2011 and is using modern rates.

Example 1: Established Manufacturing Firm (Regular Method)

Company A is a North Dakota-based manufacturer of specialized agricultural drones.

2024 North Dakota QREs: $850,000

Average ND Gross Receipts (Prior 4 Years): $5,000,000

Historical Fixed-Base Percentage: 4%

Step 1: Calculate the Base Amount

First, we apply the fixed-base percentage to the average gross receipts.

0.04 × $5,000,000 = $200,000

Next, we apply the 50 percent minimum rule. The base amount cannot be less than 50% of current QREs.

0.50 × $850,000 = $425,000

Since $425,000 is greater than $200,000, the Base Amount is $425,000.

Step 2: Calculate Excess QREs

$850,000 (QREs) – $425,000 (Base) = $425,000 (Excess)

Step 3: Apply Tiered Rates

First $100,000 of Excess: $100,000 × 25% = $25,000

Remaining Excess ($325,000): $325,000 × 8% = $26,000

Total Credit: $51,000

Example 2: Tech Startup (ASC Method)

Company B is a software startup developing a new carbon monitoring platform in Fargo. It elects the ASC method for simplicity.

2024 North Dakota QREs: $300,000

Average ND QREs (2021-2023): $200,000

Step 1: Calculate the Alternative Base Amount

The ASC base is 50 percent of the prior three-year average.

0.50 × $200,000 = $100,000

Step 2: Calculate Alternative Excess QREs

$300,000 (QREs) – $100,000 (Base) = $200,000 (Alternative Excess)

Step 3: Apply ASC Tiered Rates

First $100,000 of Alternative Excess: $100,000 × 17.5% = $17,500

Remaining Alternative Excess ($100,000): $100,000 × 5.6% = $5,600

Total Credit: $23,100

If Company B is a certified Primary Sector Business with under $750,000 in revenue, it could choose to sell this $23,100 credit to another North Dakota taxpayer for cash if it has no tax liability of its own.

Audit Preparedness and Documentation Standards

The North Dakota Tax Department maintains the right to audit any credit claim for up to four years after the return is filed. Given the complexity of defining “qualified research,” the documentation of the “excess” calculation is scrutinized closely. The state generally follows the federal “Business Component” rule, meaning expenses should be tracked and justified for each specific product, process, or software being developed.

Contemporaneous Record Keeping

The term “contemporaneous” is critical. Taxpayers should not attempt to reconstruct research activities years after the fact. Successful claimants typically maintain:

Project Accounting: Sub-ledger systems that tag employee time and material purchases to specific R&D project codes.

Technical Documentation: Lab notebooks, design specifications, and test results that prove a “process of experimentation” occurred to resolve a “technological uncertainty.”

Geographic Proof: For employees working remotely or at multiple sites, records must show the time specifically spent at North Dakota locations. This is particularly important for the oil and gas sector where employees may rotate between ND and other basins.

Interaction with Federal Audit Changes

Under N.D.C.C. § 57-38-38, if the IRS audits a taxpayer’s federal R&D credit and makes changes to the QREs, the taxpayer is legally obligated to file an amended North Dakota return (Form 40X for corporations) within 90 days. Because the North Dakota credit uses the federal definition of QREs, any federal disallowance of an expense (such as a project failing the four-part test) will almost certainly result in a corresponding state disallowance of the “excess” expenditures.

The Role of the Department of Commerce in Credit Certification

While the Tax Commissioner handles the numbers and the returns, the North Dakota Department of Commerce acts as the gatekeeper for specialized features of the R&D credit, particularly transferability. This inter-agency cooperation is a defining characteristic of North Dakota’s approach to business incentives.

Primary Sector Business Certification

The “Primary Sector” designation is the prerequisite for many state benefits, including the ability to transfer R&D credits. A business must demonstrate that it “acts as a catalyst in the state’s economy” by producing a product or service that brings new wealth into the state. Retail businesses, professional service firms (like standard law or accounting firms), and most localized service providers do not qualify as primary sector businesses. However, a software company selling its product globally or a manufacturing plant exporting goods from the state are prime candidates.

The certification process requires the submission of an application to the Division of Economic Development and Finance. The Department of Commerce evaluates the company’s business plan, its workforce, and its revenue sources before issuing a certification letter, which the taxpayer must then provide to the Tax Department when claiming or transferring the credit.

Strategic Planning: Timing and Method Election

The ability to choose between the Regular Method and the ASC method on an annual basis provides a powerful planning tool. This choice is binding only for the year in which it is made.

When to Choose the Regular Method

The Regular Method is generally superior for companies with very low gross receipts but high R&D spending (high research intensity). Because the base amount is tied to gross receipts, a company with declining revenues or a startup with minimal sales will find the “excess” over the base amount to be much larger under this method. Furthermore, the 25 percent tier rate is significantly higher than the 17.5 percent ASC tier rate.

When to Choose the ASC Method

The ASC method is advantageous for established companies with high historical gross receipts that would result in a prohibitively large base amount under the Regular Method. It is also the only viable option for companies that have undergone mergers or acquisitions where the historical records of the acquired entities are unavailable. Finally, companies with very stable R&D budgets might find the ASC method more predictable, as the base amount is simply 50 percent of the three-year rolling average of QREs.

Final Thoughts

The North Dakota Research and Experimental Expenditure Tax Credit is more than just a reduction in tax liability; it is a meticulously structured incentive designed to drive the state’s economic evolution. The concept of Excess Qualified Research Expenses ensures that the state’s financial support is directly linked to incremental innovation conducted within its borders.

For the business professional, mastering the nuances of the “excess”—from the selection of the calculation method to the rigorous property tax clearance requirements—is essential for capturing the full value of the credit. While the 25 percent rate on the first tier of excess spending offers a compelling reward for innovation, the administrative burden of proof remains high. By aligning R&D activities with the state’s “primary sector” goals and maintaining rigorous project-based accounting, North Dakota businesses can effectively leverage this credit to fuel their growth and contribute to the state’s technological future.

As the global economy continues to prioritize high-tech manufacturing and sustainable energy solutions, the North Dakota R&D tax credit will remain a cornerstone of the state’s competitive strategy, ensuring that the “excess” spending of today becomes the industrial standard of tomorrow.