Four-Part Test

The Four-Part Test is a mandatory set of federal criteria adopted by North Dakota to identify business activities that qualify for the Research and Experimental Expenditure Tax Credit. To meet these requirements, an activity must have a permitted purpose, eliminate technical uncertainty, involve a process of experimentation, and be technological in nature.

The North Dakota Research and Experimental Expenditure Tax Credit, established under North Dakota Century Code (N.D.C.C.) § 57-38-30.5, represents a significant pillar of the state’s economic development strategy, designed to incentivize high-level innovation and technical investment within the state’s borders. While the credit is deeply integrated with federal tax standards—specifically Internal Revenue Code (IRC) Section 41—it is a distinct state-level mechanism that requires a nuanced understanding of both federal law and local administrative guidance. The “Four-Part Test” serves as the foundational barrier for entry, distinguishing between routine business activities and genuine research and development (R&D) that justifies tax relief. For a taxpayer to successfully claim this credit, every project must satisfy these four rigorous benchmarks, supported by contemporaneous documentation that survives the scrutiny of the North Dakota Office of State Tax Commissioner. This report provides an exhaustive examination of the legal definitions, the technical requirements of the Four-Part Test, the state-specific modifications to federal law, and the administrative processes required to capture and defend these valuable tax incentives.

Historical Evolution and Legislative Intent of the North Dakota R&D Credit

The trajectory of the North Dakota Research and Experimental Expenditure Tax Credit reflects the state’s long-term commitment to economic diversification and its desire to remain competitive in the global market for technology and primary sector production. Understanding the origin of these laws provides essential context for how the Four-Part Test is applied today by state auditors and revenue officials.

The Genesis of N.D.C.C. § 57-38-30.5

The credit was first introduced during the 1987 legislative session through House Bill No. 1645. At that time, North Dakota sought to model its incentive programs after successful neighbors, particularly Minnesota, which had established a robust framework for encouraging corporate R&D. The original 1987 enactment was relatively modest, providing a corporate income tax credit equal to 8% of the first $1.5 million of North Dakota-qualified research expenses in excess of base period expenses. The Legislative Assembly’s perceived goal was to stimulate new wealth creation by encouraging existing North Dakota corporations to undertake research and development rather than merely conducting standard operations.

Structural Restructuring and Expansion (2007–2019)

The credit underwent its first major restructuring in 2007 with the passage of House Bill Nos. 1412 and 1018. These amendments significantly expanded the availability of the credit beyond C corporations, allowing passthrough entities—such as partnerships, S corporations, and limited liability companies—to earn the credit and pass it through to individual shareholders or members. This shift recognized that a significant portion of innovation in North Dakota occurs within small and mid-sized entrepreneurial ventures rather than just large industrial conglomerates.

In 2013, the legislature passed Senate Bill No. 2207 to ensure the long-term stability of the program. This bill created a “safeguard” provision that protects references to federal definitions within the state law. If the federal government were to discontinue the research tax credit under IRC § 41, the North Dakota credit would remain in effect, continuing to utilize the federal definitions as they existed on a specific date. This legislative foresight highlights the state’s reliance on the federal “Four-Part Test” as a permanent standard for technical eligibility.

The most recent significant addition occurred in 2019 with House Bill No. 1111, which introduced the Alternative Simplified Computation (ASC) method. This allowed taxpayers a choice in how they calculated their credits, providing flexibility for companies with fluctuating research budgets or those lacking extensive historical records.

Legislative Milestone	Key Change Introduced	Economic/Policy Intent
1987 (HB 1645)	Initial Enactment	Patterned after MN; targeted corporate innovation.
2007 (HB 1412/1018)	Passthrough & Transferability	Expanded access to small biz; introduced $100k credit sale.
2013 (SB 2207)	Federal Safeguard	Protected definitions from federal expiration.
2017 (Audit Focus)	Record Retention	Clarified 4-year retention and project-level documentation.
2019 (HB 1111)	ASC Method	Simplified base calculation for new/fluctuating R&D.

The Foundational Requirement: IRC Section 174

Before an activity can even be evaluated under the Four-Part Test of IRC § 41(d), it must first satisfy the threshold requirements of IRC § 174. In federal and North Dakota tax law, Section 174 governs “research and experimental expenditures” in a broader sense than the research credit itself.

Defining Section 174 Eligibility

Research and experimental expenditures are those incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense. These are costs aimed at discovering information that would eliminate uncertainty concerning the development or improvement of a product. For a cost to be eligible under Section 174, the taxpayer must demonstrate that the information available at the time did not establish the capability or method for developing or improving the product, or the appropriate design of the product.

Historically, Section 174 allowed for the immediate expensing of these costs. However, following federal changes that North Dakota has largely adopted for taxable income purposes, these costs must now be amortized. While the amortization rules primarily affect the calculation of taxable income, the underlying eligibility of these costs remains the mandatory first step for claiming the North Dakota R&D tax credit. If an expense is not a Section 174 cost, it cannot be a “Qualified Research Expense” (QRE) for the credit.

Deep Dive: The Four-Part Test of Qualified Research

The “Four-Part Test” is the primary mechanism used by the North Dakota Office of State Tax Commissioner and the IRS to audit and verify R&D claims. To be considered “qualified research” under N.D.C.C. § 57-38-30.5, an activity must meet all four of the following criteria.

The Permitted Purpose Test (Business Component)

The research must be undertaken for a “qualified purpose,” which means it must relate to a new or improved “business component” of the taxpayer. A business component is any product, process, computer software, technique, formula, or invention to be held for sale, lease, or license, or used by the taxpayer in their trade or business.

The activity must be intended to improve the functionality, performance, reliability, or quality of the component. North Dakota revenue guidance emphasizes that research related to style, taste, cosmetic design, or seasonal factors is explicitly excluded. In practice, this means a North Dakota manufacturing firm cannot claim the credit for redesigning the aesthetic curves of a tractor cab, but they could claim it for developing a new structural frame that increases the cab’s rollover protection rating.

The Technological in Nature Test

The activity must fundamentally rely on the principles of “hard science”. Specifically, the research must rely on the principles of:

• Engineering
• Physical or biological sciences
• Computer science

The taxpayer does not necessarily need to “expand” the frontiers of science to meet this test, but the work must be technical in nature. If the research project relies on social sciences, economics, humanities, or management studies, it will be disqualified. For instance, a North Dakota bank researching the psychological impact of new loan interfaces on consumer behavior would fail this test, whereas a software firm in Fargo developing a new encryption algorithm to secure those loan interfaces would pass.

The Elimination of Uncertainty Test

Taxpayers must demonstrate that they faced “technical uncertainty” at the outset of the research project. Uncertainty exists if the information available to the taxpayer does not establish one of the following:

• Capability: Whether the taxpayer could actually achieve the desired result.
• Method: How the taxpayer would achieve the desired result.
• Design: The appropriate configuration or design of the final business component.

North Dakota auditors frequently look for evidence that the uncertainty was technical, not just commercial. For example, a company might be uncertain whether a new bio-fuel will be profitable (commercial uncertainty), but the tax credit requires uncertainty about whether the bio-fuel can achieve a specific energy density without corroding engine parts (technical uncertainty).

The Process of Experimentation Test

This is arguably the most scrutinized part of the test during a state audit. The taxpayer must engage in a “process of experimentation” designed to evaluate one or more alternatives to achieve a result. This process typically involves:

• Identifying the technical uncertainty.
• Formulating a hypothesis to resolve that uncertainty.
• Conducting systematic testing, modeling, or simulation.
• Analyzing the results to refine the hypothesis or design.

To meet the “substantially all” requirement, at least 80% of the taxpayer’s research activities for each business component must constitute a process of experimentation. A critical lesson from recent tax court cases, such as Phoenix Design Group, Inc. v. Commissioner, is that standard design processes used by engineers do not automatically qualify as a “process of experimentation” if they are merely following established industry protocols without evaluating distinct technical alternatives to solve a specific uncertainty.

North Dakota-Specific Statutory Modifications

While the Four-Part Test is federal in origin, North Dakota law imposes specific constraints that narrow the scope of the credit compared to the federal version. Taxpayers must be vigilant in excluding expenses that might qualify for the federal credit but are explicitly disallowed by the Office of State Tax Commissioner.

The Territorial Requirement

The most significant modification is the North Dakota “Source” rule. Under N.D.C.C. § 57-38-30.5, both the “qualified research” and the “qualified research expenses” must be conducted and incurred within the state of North Dakota.

• In-State Research: If a company has an R&D lab in Bismarck and a satellite lab in Minneapolis, only the expenses associated with the Bismarck lab are eligible for the North Dakota credit.
• Excluded Activities: Any research conducted outside the state of North Dakota—including basic research conducted in other states or countries—must be backed out of the calculation for the state credit, even if it appears on the federal Form 6765.

Modifications to “Base Amount” Calculations

The “base amount” is the threshold of research spending a company must exceed before it can earn a credit. For the North Dakota credit, the base amount calculation mirrors the federal method under IRC § 41(c), but it is restricted to North Dakota data.

Component	North Dakota Statutory Definition	Administrative Impact
Qualified Research	IRC § 41(d) definition, restricted to ND.	Excludes all out-of-state engineering and software development.
Qualified Research Expenses (QRE)	IRC § 41(b) definition, restricted to ND.	Focuses on ND wages, supplies, and 65% of ND-based contract research.
Gross Receipts	ND-sourced gross receipts (per N.D.C.C. § 57-38.1).	Requires accurate apportionment of sales to North Dakota for the 4-year base period.
Base Amount	(Fixed-Base % × Avg. ND Gross Receipts) or 50% of current QRE.	The base amount cannot be less than 50% of the current year’s QRE.

Calculation Methodologies and Tax Rates

North Dakota offers two distinct pathways for calculating the R&D credit, providing a strategic choice for businesses depending on their historical spending and growth patterns.

The Regular Method (Tiered Credit)

The Regular Method is the default calculation for most established businesses. It uses a tiered percentage based on the amount of excess QREs (current year QREs minus the base amount).

• Tier 1: 25% of the first $100,000 in excess QREs.
• Tier 2: 8% of all excess QREs above the first $100,000.

This tiered structure is highly favorable for small and mid-sized businesses, as it provides a robust 25% credit on the initial $100,000 of incremental research spending. For larger corporations, the 8% rate on higher amounts remains competitive with other states.

The Alternative Simplified Computation (ASC) Method

Taxpayers may elect the ASC method annually. This method is often easier to calculate because it does not require decades of gross receipts data.

• ASC Base: 50% of the average North Dakota QREs for the three preceding tax years.
• ASC Tier 1: 17.5% of the first $100,000 of ASC excess.
• ASC Tier 2: 5.6% of the ASC excess above $100,000.

If the taxpayer had zero QREs in any of the three preceding tax years, a different rate applies: 7.5% of the first $100,000 of current year QREs plus 2.4% of the amount over $100,000.

Strategic Calculation Example

Imagine “Bismarck Bio-Systems,” a primary sector business with the following historical North Dakota QREs:

• Year 1: $150,000
• Year 2: $200,000
• Year 3: $250,000
• Current Year (Year 4): $400,000
• Calculated Regular Base Amount: $250,000

Regular Method:

1. Excess QREs = $400,000 – $250,000 = $150,000.

2. Credit = (25% × $100,000) + (8% × $50,000) = $25,000 + $4,000 = $29,000.

ASC Method:

1. Average of Prior 3 Years = ($150k + $200k + $250k) / 3 = $200,000.

2. ASC Base = 50% × $200,000 = $100,000.

3. ASC Excess = $400,000 – $100,000 = $300,000.

4. Credit = (17.5% × $100,000) + (5.6% × $200,000) = $17,500 + $11,200 = $28,700.

In this instance, the Regular Method provides a slightly higher credit of $29,000 compared to the ASC’s $28,700.

Administrative Guidance and Filing Requirements

Capturing the North Dakota R&D credit requires strict adherence to the filing protocols established by the Office of State Tax Commissioner. Unlike some other state incentives, the R&D credit is not self-executing and must be supported by specific schedules attached to the income tax return.

Filing by Entity Type

The specific form used to claim the credit depends on the taxpayer’s legal structure.

Taxpayer Entity	Primary Tax Return	Required R&D Schedule
Individual	Form ND-1	Schedule ND-1TC, Line 9a.
C Corporation	Form 40	Schedule TC (for regular) or Schedule CR (for purchased).
Partnership	Form 58	Schedule K (distributed to partners).
S Corporation	Form 60	Schedule K (distributed to shareholders).
Estate or Trust	Form 38	Schedule 38-TC, Line 9a.

Regardless of the entity type, the taxpayer must attach a “schedule or worksheet” detailing the computation of the credit. This worksheet should explicitly show the determination of the base amount and the categorization of North Dakota QREs into wages, supplies, and contract research.

Passthrough Mechanics

When a partnership, S corporation, or other passthrough entity qualifies for the credit, the entity itself does not use the credit to pay tax (since it generally pays no income tax). Instead, the credit is allocated among the partners or shareholders in proportion to their ownership interest. The credit must be claimed by the owner in the same taxable year in which the passthrough entity’s tax year ends. Owners receive their share of the credit via a North Dakota Schedule K-1, which they then use to populate their individual or corporate tax returns.

Carryback and Carryforward Provisions

North Dakota offers one of the most generous carryover periods in the nation. If the credit earned in a given year exceeds the taxpayer’s income tax liability, the unused portion is handled as follows:

• 3-Year Carryback: The unused credit must first be carried back to the three preceding tax years to offset prior tax paid and generate a refund.
• 15-Year Carryforward: Any remaining credit can be carried forward for up to 15 years to offset future North Dakota tax liabilities.

A claim to carry back the credit must be filed within three years of the due date (including extensions) of the return for the year in which the credit was earned.

The Primary Sector Business and Transferability Program

For many tech startups and R&D-heavy firms, the lack of current tax liability makes a non-refundable credit less immediately valuable. To address this, North Dakota allows “Qualified Research and Development Companies” to sell their unused credits.

Certification as a Primary Sector Business

To sell or transfer an R&D credit, the business must first be certified by the North Dakota Department of Commerce as a “primary sector business”. A primary sector business is one that adds value to a product, process, or service through the employment of knowledge or labor, creating new wealth for the state. This certification is handled through the Department of Commerce, and businesses must often provide proof of their manufacturing, agricultural processing, or technology service capabilities.

Criteria for Selling Credits

Once certified as a primary sector business, a company must meet additional criteria to become a “qualified research and development company” eligible to transfer credits.

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

2. New Research: The business must be conducting “new” research in North Dakota and must not have previously earned or claimed the R&D credit in tax years beginning before January 1, 2007.

3. Entity Limits: The transfer option is limited to individuals, C corporations, estates, and trusts. Passthrough entities like partnerships or S corporations cannot sell the credit at the entity level.

4. Transfer Cap: A qualified company may sell, transfer, or assign up to a lifetime total of $100,000 in unused R&D tax credits.

Administrative Steps for Transfer (Form CTS)

The process of selling a credit involves several administrative layers:

• Application for Certification: The business must submit SFN 58638 (Application for Certification as a Research and Development Company) to the Department of Commerce. This application requires a description of the research being conducted and federal tax information to verify revenue.
• Form CTS: Once certified, the transferor (seller) and transferee (buyer) must jointly file Form CTS (Credit Transfer Statement) with the Tax Commissioner within 30 days of the sale.
• Taxation of Proceeds: The seller must report any gross proceeds from the sale as North Dakota income for tax purposes.
• Buyer’s Restrictions: The buyer may use the purchased credit only against future or current liability; they cannot carry it back to prior years. Purchased credits also do not qualify for consolidation benefits in a combined return.

Local State Revenue Office Audit Guidance

The North Dakota Office of State Tax Commissioner maintains rigorous audit standards to prevent the misapplication of the R&D credit. State auditors generally follow federal guidelines but place heavy emphasis on the “North Dakota Source” requirement and the “Four-Part Test”.

Documentation and Record Retention

Revenue officials recommend that taxpayers retain all records supporting the R&D claim for at least four years. Key documentation categories include:

• Project Summaries: Contemporaneous narratives describing the technical objectives, the uncertainties faced, and the specific process of experimentation for each project.
• Employee Records: Detailed time-tracking data that links specific employee hours to qualified research activities. In North Dakota, simply stating that an “Engineer” spent 50% of their time on R&D is often insufficient; auditors prefer to see project-based logs.
• Financial Substantiation: Invoices for supplies used in the research process and contracts for outside research services performed within North Dakota.

Common Audit Pitfalls: The “Phoenix Design Group” Lesson

Taxpayers often struggle with the “Process of Experimentation” and “Elimination of Uncertainty” prongs of the Four-Part Test. A common error is assuming that all engineering work is R&D. In Phoenix Design Group, Inc. v. Commissioner, a recent case involving an engineering design firm, the court denied credits because the firm could not prove it faced “design uncertainty”. The firm used a standard six-stage design process that was considered routine industry practice rather than a process of experimentation.

North Dakota auditors apply this same logic. If a business is merely “adapting” an existing product for a specific customer or performing routine quality control, it will fail the Four-Part Test. The work must involve a systematic evaluation of technical alternatives to overcome a hurdle that was not resolvable through standard knowledge.

Detailed Example: Agricultural Innovation in the Red River Valley

To synthesize the law and administrative guidance, consider “Red River Harvest Tech,” a fictional primary sector corporation in Grand Forks specializing in robotic harvester attachments.

Project: The High-Speed Grain Separator

The company attempts to develop a new separator that can handle wet grain at twice the speed of current models without damaging the hulls.

1. Technological in Nature: The project relies on mechanical engineering and physics principles (aerodynamics of grain flow). (Pass)

2. Permitted Purpose: The goal is a new “business component” with improved performance (speed and grain quality). (Pass)

3. Elimination of Uncertainty: The engineers are unsure if the specific blade angle required for speed will create too much centrifugal force for the grain hulls to survive. This is design uncertainty. (Pass)

4. Process of Experimentation: The team creates three distinct blade prototypes, tests them in a wind tunnel, logs the hull damage rates, and uses the data to build a final hybrid model. (Pass)

Financial Application (North Dakota Source Rule)

The company incurs $300,000 in total research costs:

• $200,000 in wages for engineers in Grand Forks.
• $50,000 in supplies purchased from a North Dakota vendor.
• $50,000 in contract software development paid to a firm in South Dakota.

For the North Dakota R&D Tax Credit, the “qualified research expenses” are $250,000. The $50,000 paid to the South Dakota firm is excluded because the research was not conducted within North Dakota.

Credit Calculation (Regular Method)

Assuming a base amount of $100,000:

• Excess QRE: $250,000 – $100,000 = $150,000.
• Tier 1 Credit: 25% of $100,000 = $25,000.
• Tier 2 Credit: 8% of $50,000 = $4,000.
• Total ND Credit: $29,000.

Because the company is a primary sector business with under $750,000 in revenue, if it has no tax liability, it can apply to the Department of Commerce via SFN 58638 to sell this $29,000 credit to another North Dakota taxpayer.

Economic Impact and Statistical Analysis

The North Dakota Research and Experimental Expenditure Tax Credit is more than just a regulatory framework; it is a significant fiscal commitment by the state to drive long-term growth.

Claimants and Fiscal Impact

A 2021 memorandum from the North Dakota Legislative Council provides a window into the usage of the credit. Over a ten-year study period (2007–2016), approximately 1,800 taxpayers claimed the credit. In the 2016 tax year alone, individual taxpayers (receiving the credit from passthrough entities) claimed over $4.5 million, while C corporations claimed approximately $500,000.

Performance Metrics

The Bank of North Dakota and state fiscal analysts have projected that the credit has a significant “multiplier effect” on the state’s economy.

Metric	Estimated Impact (20-Year Review)
New Jobs Added	~1,100 (Primarily in professional and technical services).
GDP Contribution	~$80 million per year.
State Revenue Generated	$213 million (Indirectly through increased economic activity).
Direct State Cost	$66 million in foregone tax revenue.
Net Budgetary Liablity	~$30 million (Including indirect costs like population service needs).

While the credit creates a net budgetary liability, the Legislative Assembly views the $80 million annual GDP contribution and the creation of 1,100 high-tech jobs as a successful trade-off for the state’s economic health.

2025 Legislative Outlook and Emerging Policy Changes

The 69th Legislative Assembly, which met in early 2025, introduced several measures that reflect a changing attitude toward tax incentive transparency and oversight in North Dakota.

Increased Transparency: Senate Bill No. 2038

One of the most consequential bills for the R&D credit was Senate Bill No. 2038, signed into law in early 2025. This legislation grants the Tax Commissioner the authority to disclose the amount of any tax credit or incentive—including the research credit—to the chairman of the legislative management or a standing committee upon request.

While the law prohibits the disclosure of the taxpayer’s name, this move toward “aggregate transparency” indicates that the state is becoming more proactive in monitoring which industries are benefiting most from these incentives. This data will likely inform future reviews by the “Tax Reform and Relief Advisory Committee,” which is tasked with assessing the competitiveness and adequacy of state incentives every six years.

The Role of the Task Force on Government Efficiency

In July 2025, North Dakota launched its “Legislative Task Force on Government Efficiency”. This group is investigating ways to streamline state programs and reduce unnecessary regulations. For the R&D tax credit, this could lead to more simplified filing requirements or a more automated certification process for primary sector businesses in future bienniums.

Federal Alignment and the OBBBA

On July 4, 2025, the signing of the federal “One Big Beautiful Bill Act” (OBBBA) solidified many tax provisions that North Dakota “piggybacks” on. While federal credit changes do not always flow directly into North Dakota’s specific R&D calculation rules, changes to the definition of “taxable income” and amortization schedules for research costs under Section 174 will directly impact the “bottom line” of North Dakota businesses.

Strategic Final Thoughts and Future Outlook

The North Dakota Research and Experimental Expenditure Tax Credit, anchored by the Four-Part Test, remains one of the state’s most powerful tools for fostering a culture of innovation. By providing a high 25% initial credit rate and the ability for small companies to monetize their research through transfers, the state has created a unique environment that supports businesses from the startup phase through maturity.

However, the complexity of the Four-Part Test and the rigor of the “North Dakota Source” rule mean that taxpayers cannot afford to be complacent. The Office of State Tax Commissioner’s emphasis on project-level documentation and the recent move toward greater legislative transparency via SB 2038 signal that future R&D claims will face more scrutiny than those of the past.

For North Dakota businesses, the path forward involves:

• Precision in Tracking: Implementing time-tracking and expense-logging systems that explicitly segregate North Dakota-based research from out-of-state activities.
• Rigor in Documentation: Moving beyond simple design notes to create a “technical paper trail” that clearly demonstrates hypotheses, experimental alternatives, and technological uncertainties.
• Active Certification: Engaging with the Department of Commerce early to secure primary sector status, ensuring that any unused credits can be turned into vital cash flow through the transfer program.

As North Dakota continues to lead in sectors like energy, agriculture, and uncrewed aircraft systems, the R&D tax credit will serve as the financial fuel for the next generation of technical breakthroughs in the state. Understanding the “Four-Part Test” is not just a matter of tax compliance—it is a strategic necessity for any business looking to compete on the frontier of innovation in the Peace Garden State.