Qualified Research Expenses (QREs)

Qualified Research Expenses represent the specific internal and external costs incurred during technical activities conducted within North Dakota to develop new or improved products or processes. These expenditures form the basis of a state income tax credit designed to incentivize local innovation and economic diversification through substantial reductions in tax liability.

The North Dakota Research and Development (R&D) tax credit, technically codified as the Income Tax Credit for Research and Experimental Expenditures, serves as a cornerstone of the state’s strategic initiative to foster a high-tech economy. Governed by North Dakota Century Code (N.D.C.C.) § 57-38-30.5, the credit operates by allowing taxpayers to offset their income tax liabilities based on the volume of “Qualified Research Expenses” (QREs) they incur. While the state largely aligns its definitions with federal standards found in Section 41 of the Internal Revenue Code (IRC), it imposes a strict geographic nexus, requiring that all activities and expenses be North Dakota-sourced to qualify for the incentive. For businesses operating in the state, from traditional manufacturing and energy sectors to emerging software and biotechnology firms, the R&D tax credit is not merely a compliance task but a critical financial tool for managing the high costs and risks associated with technical innovation.

The Statutory Evolution and Purpose of North Dakota’s R&D Credit

The legislative history of the North Dakota R&D tax credit reveals a deliberate progression toward becoming one of the most competitive state-level innovation incentives in the United States. Originally enacted in 1987 via House Bill 1645, the credit was explicitly patterned after successful legislation in Minnesota, aimed at retaining technical talent and stimulating local investment. In its early form, the credit was primarily a tool for large C-corporations, but major restructuring in 2007 through House Bills 1412 and 1018 expanded the credit’s availability to include pass-through entities such as S-corporations and partnerships.

The 2007 amendments also introduced the revolutionary concept of credit transferability for small primary sector businesses, recognizing that early-stage startups often lack the tax liability to benefit from a non-refundable credit. In 2019, the legislature further modernized the program by introducing the Alternative Simplified Computation (ASC) method, providing taxpayers with a calculation option that requires less historical data than the traditional method. Today, the credit stands as a permanent fixture of the North Dakota tax code, reflecting a long-term commitment to economic growth driven by private-sector research.

Key Legislative Period	Major Provisions and Changes	Statutory Reference
Pre-2007	Limited to C-corporations; $2 million annual cap; 8% and 4% tiered rates.	HB 1645 (1987)
2007 – 2016	Inclusion of pass-through entities; introduction of transferability; tiered rates (25%/20%).	HB 1412, HB 1018
Post-2016	Uniform 8% rate for excess over $100k; Property Tax Clearance requirement added.	N.D.C.C. § 57-38-30.5
2019 – Present	Introduction of the Alternative Simplified Computation (ASC) method.	N.D.C.C. § 57-38-30.5

Defining Qualified Research Expenses (QREs)

To understand the North Dakota R&D credit, one must first master the technical definition of a Qualified Research Expense. Under N.D.C.C. § 57-38-30.5(5)(h), North Dakota adopts the federal definition provided in IRC § 41(b), with the critical exception that any expenses for basic research conducted outside the state are excluded. QREs are generally categorized into three distinct buckets: wages, supplies, and contract research.

Qualified Wage Expenses

Wages typically represent the largest component of an R&D claim. These are restricted to the compensation paid to employees for “qualified services,” which encompasses three levels of engagement: direct research, direct supervision, and direct support.

• Direct Research: This includes the hands-on work performed by engineers, scientists, and software developers. Activities such as coding, testing prototypes, designing experiments, and conducting laboratory analysis are core to this category.
• Direct Supervision: This covers the first-line managers who oversee the technical conduct of the research. To qualify, the supervisor must be involved in the technical decisions and the day-to-day oversight of the research team.
• Direct Support: This involves individuals who support the researchers, such as lab assistants who prepare materials, technicians who maintain research equipment, or staff who organize and document test results.

For tax purposes, qualified wages are defined as the amount reported in Box 1 of the employee’s Form W-2. In the case of partnerships or sole proprietorships, “wages” can also include the earned income of self-employed individuals, provided the services they perform meet the criteria for qualified research.

Qualified Supply Expenses

Qualified supply expenses include the costs of tangible property used in the conduct of research, provided that the property is not of a character subject to depreciation. This category is vital for manufacturing and energy companies in North Dakota that may build multiple physical prototypes during the development phase.

Eligible supplies often include raw materials such as metals, chemicals, or electronic components used to fabricate a prototype. If a prototype is eventually sold, its costs may still qualify, provided it was initially created for the purpose of testing and experimentation. However, general administrative supplies, utilities, and rent for research facilities are strictly excluded from the definition of QREs.

Qualified Contract Research Expenses

Many North Dakota firms leverage third-party expertise to handle specialized testing or engineering tasks. These costs are categorized as contract research expenses. Under both federal and North Dakota law, only 65% of the amount paid to an outside contractor can be included as a QRE. To include these costs, the taxpayer must demonstrate two things:

• Economic Risk: The taxpayer must pay for the research regardless of whether it is successful. If the contract stipulates payment only upon delivery of a successful result, the IRS and the state may view this as the “purchase of a product” rather than the “funding of research,” which would disqualify the expense.
• Substantial Rights: The taxpayer must retain substantial rights to the research results. While the contractor can also retain rights, the taxpayer cannot merely be a passive purchaser of intellectual property.

The Four-Part Test: The Standard for Qualified Research Activities

A cost is only a Qualified Research Expense if it is tied to a “Qualified Research Activity” (QRA). To be considered a QRA in North Dakota, an activity must satisfy the federal “Four-Part Test” as defined in IRC § 41(d).

Permitted Purpose

The activity must relate to the development of a new or improved “business component.” A business component is defined as any product, process, software, technique, formula, or invention that the taxpayer intends to hold for sale, lease, or license, or use in its own trade or business. The goal of the research must be to improve functionality, performance, reliability, or quality.

Technological in Nature

The research must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science. Activities based on social sciences, economics, or humanities do not qualify. In North Dakota, this often manifests as petroleum engineering, agricultural chemistry, or software systems for precision farming.

Elimination of Uncertainty

The taxpayer must face technical uncertainty at the outset of the project. This means they must not know for certain whether the business component can be developed, the specific method for developing it, or the most appropriate design for the component. If the path forward is already known through common industry knowledge or routine engineering, the activity is not qualified research.

Process of Experimentation

The taxpayer must engage in a systematic process designed to evaluate one or more alternatives to achieve the desired result. This typically involves modeling, simulation, systematic trial-and-error, or the testing of multiple hypotheses. The failure of an experiment is often the best evidence that a true process of experimentation occurred.

The North Dakota Nexus: Geographic Specificity

The most significant divergence between federal and North Dakota R&D guidance is the geographic limitation. N.D.C.C. § 57-38-30.5(5)(f) explicitly states that “qualified research” does not include research conducted outside the state of North Dakota. This creates a “statutory nexus” requirement that demands rigorous tracking of where labor is performed and where materials are used.

For a North Dakota company with remote employees or multi-state operations, this necessitates a “shrink-back” analysis. If a project involves a team of ten engineers, but only four are physically located in Fargo, only the wages for those four individuals can be included in the North Dakota QRE calculation. Similarly, if a North Dakota firm hires a contractor in California to perform a component test, that contract research expense is generally ineligible for the North Dakota credit, even if it is eligible for the federal credit.

Calculation Methodologies: Regular vs. Alternative Simplified Computation

North Dakota taxpayers have the flexibility to choose between two calculation methods: the Regular Method and the Alternative Simplified Computation (ASC) method. This election is made on a year-by-year basis and is binding for the year in which it is made.

The Regular Method

The Regular Method is designed to reward companies that are substantially increasing their R&D efforts over their historical baseline. The credit is calculated based on the “excess” of the current year’s QREs over a “base amount.”

Tiers of the Regular Credit

For taxpayers who did not claim a credit prior to 2007, the current tiered structure is:

• 25% of the first $100,000 of excess QREs.
• 8% of the excess QREs that exceed $100,000.

The Base Amount Calculation

The base amount is generally the product of the taxpayer’s “fixed-base percentage” and the average annual North Dakota gross receipts for the four preceding tax years. However, the state imposes a “floor” rule: the base amount cannot be less than 50% of the current year’s QREs. This ensures that the credit is always calculated against an incremental increase in spending.

The Alternative Simplified Computation (ASC) Method

Introduced in 2019, the ASC method provides a streamlined approach for companies that may not have the historical data required for the Regular Method or whose North Dakota gross receipts have fluctuated significantly.

ASC Calculation Formula

The ASC credit is based on the excess of current-year North Dakota QREs over 50% of the average North Dakota QREs for the three preceding tax years.

Tiers of the ASC Credit

• 17.5% of the first $100,000 of alternative excess research expenses.
• 5.6% of the alternative excess research expenses that exceed $100,000.

If the taxpayer has zero QREs in any of the three preceding tax years, the credit is calculated as 7.5% of the first $100,000 of QREs plus 2.4% of the QREs in excess of $100,000.

Comprehensive Example: Regular vs. ASC

Consider “Fargo Tech Innovations,” a software company with the following financials for the current tax year:

• Current Year North Dakota QREs: $600,000
• Average North Dakota QREs (Prior 3 Years): $400,000
• Average North Dakota Gross Receipts (Prior 4 Years): $5,000,000
• Fixed-Base Percentage: 3%

Scenario A: Regular Method

• Calculated Base Amount: 3% × $5,000,000 = $150,000.
• Minimum Base (50% Floor): 50% × $600,000 = $300,000.
• Applicable Base: $300,000 (The higher of the two).
• Excess QREs: $600,000 – $300,000 = $300,000.
• Credit Calculation:
• 25% × $100,000 = $25,000
• 8% × $200,000 = $16,000
• Total Regular Credit: $41,000

Scenario B: ASC Method

• ASC Base: 50% × $400,000 = $200,000.
• Alternative Excess: $600,000 – $200,000 = $400,000.
• Credit Calculation:
• 17.5% × $100,000 = $17,500
• 5.6% × $300,000 = $16,800
• Total ASC Credit: $34,300

In this instance, the Regular Method provides a significantly higher benefit. However, if the company’s average prior-year QREs were lower, or if they were a newer company with zero prior QREs, the ASC might become the superior option.

Primary Sector Businesses and the Transfer of Unused Credits

A unique feature of North Dakota’s tax code is the ability for small, innovative businesses to monetize their R&D credits. This provision, found in N.D.C.C. § 57-38-30.5(9), allows “qualified research and development companies” to sell or transfer their unused credits to other taxpayers.

Qualifying for Credit Transfer

To sell or transfer credits, a company must meet a stringent set of criteria and obtain certification from the North Dakota Department of Commerce.

Primary Sector Certification

The business must be a “primary sector business” as defined in N.D.C.C. § 1-01-49. This means the company must add value to a product, process, or service through knowledge or labor, resulting in the creation of “new wealth.”

• New Wealth: Revenues generated by selling to customers outside of North Dakota or to in-state customers for products previously unavailable in the state.
• Exclusions: Production agriculture (farming and ranching) is explicitly excluded, though value-added agricultural processing is generally included.

Revenue and Research Thresholds

• The company must have annual gross revenues of less than $750,000.
• The company must be conducting qualified research in North Dakota for the first time after December 31, 2006.
• The business must be organized as an individual, C-corporation, estate, or trust. Pass-through entities like S-corporations and partnerships are not eligible to sell or transfer their credits.

The Mechanics of the Transfer

• Lifetime Limit: A company may only transfer up to a total of $100,000 in credits over its lifetime.
• Documentation: The transferor and transferee must jointly file Form CTS (Credit Transfer Statement) with the Office of State Tax Commissioner within 30 days of the execution of the purchase agreement.
• Reporting: The proceeds from the sale of the credit must be reported by the transferor as North Dakota income and are subject to state taxation.
• Transferee Rights: The buyer must use the credit in the year the purchase was made and may carry forward any unused portion for up to 15 years, but they cannot carry the credit back or resell it.

Local Compliance: The Property Tax Clearance Requirement

Perhaps the most unique administrative hurdle for North Dakota R&D claimants is the tax clearance mandate established by N.D.C.C. § 54-35-26. Effective after July 31, 2017, no state tax incentive, including the R&D credit, can be granted to a taxpayer who has delinquent property taxes.

The Property Tax Clearance Record (SFN 58638)

Before claiming the credit on a tax return, the taxpayer must obtain a Property Tax Clearance Record from the auditor or treasurer of every North Dakota county in which they hold a 50% or more ownership interest in real property.

• Entity Coverage: This requirement extends to any officer, partner, or managing member of a corporation or pass-through entity who is responsible for the business’s tax obligations and who holds a 50% or more interest in real property in the state.
• Annual Renewal: A new clearance record must be obtained and attached to the state tax return for every year the credit is claimed.
• Filing: If the return is filed electronically, the clearance record must be attached as a PDF.

Ownership Level	Requirement	Impact of Delinquency
≥ 50% Real Property	Must obtain clearance from the County Auditor.	Credit is disallowed until delinquency is cleared.
Responsible Officers	Must also obtain personal clearance for their property.	Prevents entity from claiming the credit.
Less than 50%	No clearance record required.	No impact on credit claim.

Guidance for Pass-Through Entities and Fiduciaries

For businesses organized as S-corporations, partnerships, or LLCs, the R&D tax credit is calculated at the entity level but used at the owner level. This requires careful coordination between the business and its shareholders or partners.

Allocation of Credits

The credit is passed through to the owners in proportion to their ownership interest in the entity. For example, if a partnership earns a $100,000 credit and has two equal partners, each partner may claim $50,000 on their individual North Dakota income tax return (Schedule ND-1TC).

Taxpayer Types and Required Forms

• Individuals/Sole Proprietors: Use Schedule ND-1TC to claim the credit.
• C-Corporations: Use Form 40 and Schedule TC.
• S-Corporations: Report on Form 60, Schedule K.
• Partnerships: Report on Form 58, Schedule K.
• Fiduciaries (Estates/Trusts): Use Form 38 and Schedule 38-TC.

Audit Readiness and Documentation Standards

The North Dakota Office of State Tax Commissioner has a three-year window to audit tax returns, which may be extended to six years if there is a substantial change in reported liability. Given that the R&D credit is an “incremental” credit based on specific technical definitions, it is a high-scrutiny area.

Recordkeeping Requirements

To defend an R&D claim, a taxpayer must maintain contemporaneous records that substantiate both the amount of the QREs and the qualification of the research activities.

• Project Documentation: Project plans, technical drawings, meeting minutes, and testing logs that prove the “Four-Part Test” was met.
• Labor Tracking: Payroll records, W-2s, and time-tracking data that clearly show the percentage of time each employee spent on qualified research.
• Financial Workpapers: Calculations showing the determination of the base amount (for the Regular Method) or the three-year average (for the ASC method).
• Supply Receipts: Invoices for raw materials and prototypes that show the items were “consumed” or used in the research process.

Taxpayers are advised to retain these records for at least four years to align with both state and federal audit windows.

Carryback and Carryforward Provisions

Because technical development often precedes profitability, North Dakota allows for the carryback and carryforward of unused R&D credits.

• 3-Year Carryback: If the credit exceeds the taxpayer’s current liability, it must first be carried back to the three preceding taxable years to offset prior taxes and generate a refund.
• 15-Year Carryforward: Any remaining credit may be carried forward for up to 15 years to offset future income tax liabilities.

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

Statistical Overview and Economic Impact

North Dakota’s commitment to the R&D tax credit is reflected in the state’s broader fiscal health and industrial composition. In 2024, the state’s total expenditures were $8.4$ billion, with oil and gas extraction serving as a primary economic engine, contributing 9.8% to the state’s GDP. However, industries such as farms, machinery manufacturing, and wholesale trade also overperform relative to national averages, and these are the sectors where the R&D credit has its most significant impact.

Usage in Agriculture and Energy

The tiered credit structure—offering a 25% rate on the first $100,000 of excess QREs—is specifically designed to benefit smaller projects in the state’s traditional sectors. Agricultural firms developing new processing techniques or energy companies experimenting with carbon capture technologies often find that the state credit, when combined with the federal credit, can reduce the “after-tax cost” of innovation by more than 30%.

The Pre-2007 Cap

For large, legacy firms that earned credits prior to 2007, the state imposes a “Pre-2007 Cap” of $2 million per year. Any credit earned in excess of this amount in a single year is not allowed to be carried forward or back and is permanently lost. For companies that began research after 2007, no such annual cap exists, though they are still limited by their net tax liability.

Calculating the Federal and State Combined Benefit

North Dakota allows businesses to claim both the federal R&D tax credit (IRC § 41) and the state credit. While the state definitions are similar to the federal ones, the credit rates and calculation of the base amount can differ, leading to different credit amounts.

Year	Total ND QREs	Federal Credit	North Dakota Credit	Combined Relief
Year 1	$500,000	$33,000	$41,000	$74,000
Year 2	$750,000	$49,500	$61,000	$110,500
Year 3	$1,000,000	$66,000	$81,000	$147,000

Note: Calculations are hypothetical and assume a fixed-base percentage of 3% and the Regular Method.

Strategic Considerations for North Dakota Businesses

The complexity of the North Dakota R&D tax credit necessitates a proactive approach to tax planning. Businesses should consider the following strategic imperatives:

• Analyze Calculation Methods Early: Every company should perform a comparative analysis between the Regular and ASC methods before the tax deadline. For companies with rising R&D budgets but stagnant gross receipts, the Regular Method is often superior. For those with established research programs and high revenues, the ASC method may be more advantageous.
• Secure Commerce Certification: Small primary sector businesses should apply for certification from the Department of Commerce as a “qualified research and development company” as soon as they begin R&D activities. Even if they don’t plan to sell credits immediately, having the certification in place ensures they can capitalize on the $100,000 transfer limit if their financial situation changes.
• Manage Geographic Allocation: For companies with employees in nearby states like Minnesota or South Dakota, rigorous tracking of work location is essential. Only the hours spent physically working within North Dakota borders should be included in the state claim.
• Maintain Property Tax Compliance: The Property Tax Clearance requirement is a “binary” obstacle. A single delinquent parcel can block a multi-million dollar credit claim. Companies must verify the tax status of all relevant real property parcels and responsible officers well in advance of the filing season.

Final Thoughts

The North Dakota R&D tax credit is a powerful economic development tool that offers substantial financial benefits to companies committed to innovation within the state. By aligning state incentives with federal standards while maintaining a strong local nexus, North Dakota encourages the creation of “new wealth” and the diversification of its economy. However, the path to claiming the credit is governed by strict statutory definitions of Qualified Research Expenses and rigorous administrative requirements, such as the Property Tax Clearance mandate and Department of Commerce certification.

For business owners and tax professionals, the meaning of a “Qualified Research Expense” in North Dakota is inseparable from the state’s broader goal of industrial transformation. Whether through the direct reduction of tax liability for established firms or the transfer of credits for startups, the incentive provides the liquidity needed to turn technical uncertainty into commercial success. As the state continues to refine its tax policies to meet the needs of a changing economy, the R&D credit will remain an essential asset for any North Dakota business seeking to maintain a competitive edge in the global market.