Passthrough Entity

A passthrough entity is a business structure, such as a partnership or S corporation, where the entity itself pays no income tax; instead, all financial attributes, including the North Dakota Research and Experimental Expenditure Tax Credit, flow through to the individual owners. This mechanism allows the primary tax benefit of research and development activities to be realized directly on the personal or corporate income tax returns of the partners, shareholders, or members in proportion to their ownership stakes.

The North Dakota Research and Experimental Expenditure Tax Credit, primarily codified under North Dakota Century Code (N.D.C.C.) § 57-38-30.5, represents one of the most sophisticated fiscal instruments available to the state’s business community to incentivize local innovation. By aligning state definitions with federal standards while maintaining a strict focus on North Dakota-sourced expenditures, the state encourages a wide range of industries—from traditional energy extraction and agriculture to emerging biotechnology and software development—to invest in high-risk, high-reward technological advancements. For passthrough entities (PTEs), which form the backbone of the state’s primary sector businesses, understanding the nuanced interplay between entity-level calculation and owner-level limitation is essential for maximizing the return on investment for research activities. This report provides an exhaustive examination of the legal definitions, calculation methodologies, revenue office guidance, and strategic implications of the North Dakota R&D credit as it pertains to passthrough structures.

The Legal Anatomy of Passthrough Entities in North Dakota

To navigate the North Dakota tax landscape, one must first master the statutory definitions provided by the state. Under the North Dakota Century Code, the term “passthrough entity” is not merely a generic descriptor but a precise legal classification that dictates the entire reporting cycle. The definition includes any corporation that, for the applicable tax year, is treated as an S corporation under the Internal Revenue Code, as well as limited liability companies (LLCs) that are not taxed as corporations for federal income tax purposes. Furthermore, the term encompasses general partnerships, limited partnerships, limited liability partnerships (LLPs), and limited liability limited partnerships (LLLPs).

The foundational principle of the passthrough structure is the avoidance of double taxation. Unlike a C corporation, which pays tax at the corporate level before distributing dividends to shareholders (who then pay tax again), a PTE serves as a conduit. This conduit theory is especially relevant for the R&D credit because the “qualified research” is performed by the entity, but the tax relief is utilized by the humans or parent corporations that own it. The North Dakota Office of State Tax Commissioner strictly follows federal elections; for instance, if an LLC elects to be treated as a partnership for federal tax purposes, it must maintain that status for North Dakota purposes, thereby ensuring consistency across jurisdictions.

Classification and Operational Impact

The classification of an entity determines the forms required for reporting research activities. While the underlying R&D credit law remains the same, the administrative path varies.

Entity Type	Federal Designation	North Dakota Filing Requirement	Primary Reporting Schedule
S Corporation	Subchapter S	Form 60	Schedule K, Line 11
Partnership	Subchapter K	Form 58	Schedule K, Line 13
LLC (Multi-member)	Partnership	Form 58	Schedule K, Line 13
LLC (Single-member)	Disregarded Entity	Pro-forma Form 58/60	Schedule ND-1TC

For disregarded entities, such as a single-member LLC owned by an individual, the revenue office provides specific guidance: the owner must claim the credit directly, but if the entity itself has withholding or separate reporting requirements, a pro-forma return may be necessary to link the entity’s FEIN with the owner’s SSN for audit trail purposes. This ensures that the Tax Commissioner can verify that the research expenses claimed on a personal return were actually incurred by a legitimate business operation.

Statutory Basis and Legislative Intent of the R&D Credit

The Research and Experimental Expenditure Tax Credit was enacted to diversify the North Dakota economy by rewarding businesses that take the financial risk of developing new products or improving existing processes. The legislative intent, as expressed in N.D.C.C. § 57-38-30.5, is to provide a credit that mirrors the federal incentive under Section 41 of the Internal Revenue Code but limits the benefits to research performed specifically within the borders of North Dakota.

Historical Evolution of the Credit

The North Dakota R&D credit has undergone several significant transformations to become more accessible to smaller businesses and passthrough entities. Prior to 2007, the credit was largely targeted at major corporations, with different percentage thresholds and more restrictive eligibility criteria. A landmark shift occurred in 2007 when the legislature expanded the credit’s availability to individuals and passthrough entities, recognizing that innovation often starts in smaller, more agile business structures.

For taxpayers who established their R&D operations prior to January 1, 2007, a legacy system remains in place, which includes an annual cap of $2 million in credits. Any credit earned in excess of this $2 million cannot be carried back or forward. However, for “new” research—those businesses starting R&D after 2006—there is no such annual cap, provided they follow the standard 25%/8% rate structure.

Integration with Federal Standards

North Dakota law adopts the federal definitions of “qualified research” and “qualified research expenses” (QREs) to ensure that businesses do not have to maintain two entirely different sets of books for state and federal credits. To be considered “qualified,” the research must meet the federal “four-part test”:

1. Permitted Purpose: The research must be for the purpose of creating a new business component or improving the functionality, performance, reliability, or quality of an existing one.
2. Elimination of Uncertainty: The activity must be intended to discover information that would eliminate uncertainty regarding the capability, method, or design for developing or improving a product or process.
3. Process of Experimentation: Substantially all of the research activities must constitute a process of experimentation, involving the evaluation of alternatives through modeling, simulation, or systematic trial and error.
4. Technological in Nature: The process of experimentation must fundamentally rely on principles of physical or biological sciences, engineering, or computer science.

The critical state-level distinction is the geographic requirement. North Dakota law explicitly excludes any expenses incurred for research conducted outside the state. This means that if a North Dakota-based LLC hires a software developer in Minnesota to write code for a new product, those specific wages are ineligible for the North Dakota credit, even if they qualify for the federal R&D credit.

Multi-Step Calculation Methodologies for Passthrough Entities

The calculation of the R&D credit for a passthrough entity is performed at the entity level before any numbers are distributed to the owners. There are two primary methods available: the Regular Incremental Method and the Alternative Simplified Computation (ASC) Method.

The Regular Incremental Method

The Regular Method is the traditional approach, rewarding businesses for increasing their research spending relative to a historical “base amount”. The base amount is typically a product of the business’s fixed-base percentage and its average gross receipts for the preceding four years.

The credit is calculated based on the “excess” of current-year QREs over this base amount. The tiered rates are designed to provide a high initial incentive:

• Tier 1: 25% of the first $100,000 of excess qualified research expenses.
• Tier 2: 8% of all excess qualified research expenses exceeding $100,000.

The “base amount” calculation for North Dakota also includes a floor; it cannot be less than 50% of the current year’s qualified research expenses. This ensures that even rapidly growing companies must maintain a certain level of sustained investment to claim the higher credit percentages.

The Alternative Simplified Computation (ASC) Method

Recognizing that many small businesses and startups lack the historical data required for the regular method, North Dakota introduced the ASC method in 2019. This method is often more favorable for passthrough entities with fluctuating R&D budgets or those in high-growth phases.

Under the ASC method, the base is 50% of the average qualified research expenses for the three preceding tax years. The tiered rates for the ASC are as follows:

• ASC Tier 1: 17.5% of the first $100,000 of alternative excess expenses.
• ASC Tier 2: 5.6% of alternative excess expenses over $100,000.

If a passthrough entity did not perform research in any of the three preceding years, the state allows a simplified “startup” version of the ASC: 7.5% of the first $100,000 of current-year QREs and 2.4% of the excess.

Strategic Comparison of Calculation Methods

Choosing between these methods is a binding election for the tax year and must be made on the original return.

Metric	Regular Method	ASC Method
Data Requirement	4 years of ND gross receipts	3 years of ND QREs
Primary Rate (First $100k)	25% of excess	17.5% of excess
Secondary Rate (Excess)	8% of excess	5.6% of excess
Minimum Base	50% of current QREs	50% of 3-year avg QREs
Best Application	Low R&D intensity/High stability	Rapidly increasing R&D budgets

For a passthrough entity, the choice often hinges on the “base amount.” If a company’s R&D spending is increasing significantly, the ASC method’s use of a 3-year QRE average as a base may result in a much larger “excess” amount than the Regular Method’s receipt-based base, potentially leading to a larger total credit despite the lower percentage rates.

Local Revenue Office Guidance: The PTE Conduit Mechanism

Once the passthrough entity has calculated its total allowable credit, the administrative focus shifts to the distribution of that credit to the owners. This is where the guidance from the North Dakota Office of State Tax Commissioner becomes highly specific.

Pro-Rata Allocation and the Schedule K-1

The total credit determined at the entity level must be passed through to the partners, shareholders, or members in proportion to their respective interests in the entity. This is not an elective allocation; it must follow the same ownership percentages used for the distribution of income and losses.

The primary vehicle for this communication is the North Dakota Schedule K-1. For a partnership filing Form 58, the credit amount is reported on Line 13 of the 2024 Schedule K-1. For an S corporation filing Form 60, the equivalent entry is found on Line 11. The entity is required to provide this document to the owner, who then uses that information to populate their own return, such as the individual Form ND-1.

Timing of the Credit Claim

A critical piece of guidance involves the “taxable year” alignment. A taxpayer who holds an interest in a passthrough entity may claim their share of the tax credit in the same taxable year in which the taxable year of the passthrough entity ends. For example, if a partnership has a fiscal year ending January 31, 2024, the individual partners would claim their share of the 2023-2024 R&D credit on their 2024 personal tax returns, which are filed in 2025.

The “Tax Attributable” Limitation

Perhaps the most important—and often misunderstood—piece of local guidance is the “tax attributable” limit found in N.D.C.C. § 57-38-30.5(7). For an individual or corporate owner, the R&D credit passed through from a PTE cannot exceed the amount of tax attributable to that specific portion of the taxpayer’s income.

Mathematically, this means the taxpayer must perform a separate calculation:

Limit = Total ND Tax Liability × (Income from the PTE ÷ Total ND Taxable Income)

This ensures that the R&D credit is used only to offset taxes generated by the business that performed the research. If a partner has a $50,000 tax credit from a research partnership but that partnership actually generated a tax loss for the year (resulting in zero “tax attributable”), the partner cannot use any of that $50,000 credit to offset taxes owed on their other income, such as a spouse’s salary or investment dividends. Instead, the unused credit must be carried over to future years when the partnership hopefully generates taxable income.

Comprehensive Example: The “Red River Robotics” Case Study

To illustrate the practical application of these rules, let us examine “Red River Robotics LLC,” a multi-member limited liability company based in Fargo, North Dakota, which is taxed as a partnership.

Background and Financial Data

In 2024, Red River Robotics (RRR) is owned by three individuals: Alice (40%), Bob (40%), and Charlie (20%). RRR has not performed research in North Dakota prior to this year. Their financial data for 2024 is as follows:

• ND Wages for Engineers: $500,000
• R&D Supplies (Circuit boards/Sensors): $75,000
• Contract Research with NDSU (ND-based): $100,000
• Total ND Qualified Research Expenses (QREs): $500,000 + $75,000 + (65% * $100,000) = $640,000.

Step 1: Choosing a Calculation Method

Since RRR is a new research entity with no historical QREs, they use the ASC “Startup” method to avoid complex receipt-based calculations.

• ASC Base: $0 (no prior year research)
• ASC Tier 1 Credit (7.5% of first $100k): $7,500.
• ASC Tier 2 Credit (2.4% of excess over $100k): ($640,000 – $100,000) * 0.024 = $12,960.
• Total Entity-Level Credit: $20,460.

Step 2: Allocation to Members

RRR must now issue North Dakota Schedule K-1s to its members.

Member	Ownership	Share of R&D Credit (Line 13)
Alice	40%	$8,184
Bob	40%	$8,184
Charlie	20%	$4,092

Step 3: Individual Taxpayer Application (The Alice Scenario)

Alice is a successful entrepreneur with multiple sources of income. Her 2024 North Dakota tax situation is:

• Total ND Taxable Income: $200,000
• Share of Income from RRR LLC: $50,000
• Total ND Tax Liability (before credits): $4,000

Alice must calculate her “Tax Attributable” limit:

Limit = $4,000 × ($50,000 ÷ $200,000) = $1,000

Despite having an $8,184 credit from RRR, Alice can only use $1,000 on her 2024 return. The remaining $7,184 is not lost; she will carry it back three years or forward 15 years.

Property Tax Clearance: A Mandatory Compliance Hurdle

One of the most distinctive aspects of North Dakota revenue guidance is the “Property Tax Clearance” requirement under N.D.C.C. § 57-01-15.1. This law states that before certain state tax incentives—including the R&D credit—can be claimed, the taxpayer must demonstrate that all their property taxes in North Dakota are paid in full.

Operational Requirements for PTEs and Owners

For a passthrough entity, this requirement is two-fold. The entity itself must obtain a property tax clearance record from each county in which it holds a 50% or more ownership interest in real property. Additionally, the individual partner or shareholder claiming the credit on their personal return must also obtain a clearance if they (or their spouse) own 50% or more of any North Dakota property.

The clearance record must be attached to the North Dakota tax return. In practice, this means that a partnership must complete the Property Tax Clearance section on Schedule K of Form 58, and the individual partner must do the same on Schedule ND-1TC. Failure to provide these records is one of the most common reasons the Office of State Tax Commissioner disallows R&D credit claims during the initial processing of returns.

Liquidity for Startups: Transferability and Form CTS

For many early-stage passthrough entities, the “tax attributable” limit means they will have large credit carryforwards but no immediate tax relief. North Dakota addresses this “liquidity trap” by allowing certain small businesses to sell their unused R&D credits.

Certification as a Qualified R&D Company

To be eligible to sell a credit, the passthrough entity must be certified by the North Dakota Department of Commerce as a “Qualified Research and Development Company”. The criteria are strictly enforced:

1. Primary Sector Status: The business must be certified as a “primary sector business,” which generally means it adds value to a product or process through knowledge or labor, creating new wealth for the state.
2. Revenue Limit: Annual gross revenues must be less than $750,000.
3. New Research: The entity must have conducted research in North Dakota for the first time after 2006.

The Mechanics of the Sale (Form CTS)

If certified, the company may transfer up to $100,000 of unused tax credits over its lifetime to another North Dakota taxpayer. The transfer must be a “joint” filing; both the transferor (the PTE) and the transferee (the buyer) must complete and file Form CTS – Credit Transfer Statement within 30 days of the sale.

From a tax perspective, the proceeds from the sale are considered taxable income for the PTE and its owners. Because the credit is essentially a state-granted property right, its sale results in 100% North Dakota-sourced income that cannot be apportioned to other states. Individual owners report their share of these proceeds on Schedule ND-1CS.

Comparative Context: North Dakota in the National R&D Landscape

To understand the value of the North Dakota R&D credit for passthrough entities, it is useful to compare its structure with other states.

State	Credit Rate	ASC Method?	Carryforward	Refundable/Transferable?
North Dakota	25% / 8%	Yes	15 Years	Transferable ($100k cap)
Arizona	24% / 15%	No	15 Years	Partially Refundable (Small biz)
California	15% / 24%	Yes (AIC)	Indefinite	No
Minnesota	10% / 4%	No	15 Years	No
Connecticut	1% to 6%	No	15 Years	Refundable (65% value)

North Dakota’s 25% rate for the first $100,000 of excess expenses is among the highest in the nation, specifically designed to entice small passthrough entities to choose North Dakota for their innovation hubs. While Arizona offers a similar 24% rate, North Dakota’s inclusion of an ASC method and a structured transferability program provides a level of flexibility that many neighboring states, such as Minnesota, currently lack.

Audit Defense and Documentation for PTEs

Given the high value of the credit, R&D claims are frequently scrutinized by both state and federal tax authorities. For passthrough entities, the audit risk is magnified because a change at the entity level ripples through all the owners’ individual returns.

The IRS Audit Techniques Guide (ATG)

The North Dakota revenue office largely follows the IRS Research Credit Claims Audit Techniques Guide. Examiners typically look for three phases of documentation:

1. Project Feasibility: Records showing that a project was undertaken with the intent to solve a specific technical uncertainty.
2. Execution Evidence: Lab notebooks, email correspondence, testing results, and time-tracking data that show the actual “process of experimentation”.
3. Compilation Detail: Mathematical workpapers that tie the labor and supply costs back to the general ledger and specifically to North Dakota activities.

Common Audit Red Flags for PTEs

• Estimated Time: Using “rough estimates” (e.g., “all engineers spent 50% of their time on R&D”) without contemporaneous records is a primary cause of credit disallowance.
• Non-ND Wages: Accidentally including wages for employees working remotely from other states.
• Supply vs. Capital: Including the cost of permanent equipment (which should be depreciated) as a research supply.
• Qualified Small Business Misalignment: Claiming transferability benefits without obtaining the mandatory certification from the Department of Commerce.

Economic Impact and Statistical Reality

The R&D tax credit is more than a legal statute; it is a driver of North Dakota’s economic engine. In the 2024 fourth-quarter collections report, Tax Commissioner Brian Kroshus noted that the manufacturing sector—a primary user of R&D credits—posted a 4.8% gain, outperforming the general retail sector. This suggests that innovation-led industries are providing a buffer against fluctuations in commodity prices for energy and agriculture.

Statistical evaluations from the Legislative Council indicate that while the credit reduces general fund revenue in the short term, the capital investment associated with these incentives often exceeds $1 billion annually across various state programs. For passthrough entities, which represent a significant portion of the “primary sector” growth, these credits are often the difference-maker in deciding whether to expand a research facility in Grand Forks or move it across the border.

Strategic Planning for Passthrough Owners

For a business professional or tax advisor, managing the North Dakota R&D credit requires a holistic view of the taxpayer’s entire portfolio.

Multi-Year Carryover Strategies

Since most owners will face the “tax attributable” limit, the 15-year carryforward is a valuable asset. Taxpayers should model their future income projections from the PTE to determine when they will be able to “unlock” these credits. In some cases, it may be beneficial to accelerate income into a specific year to utilize expiring credits.

Structuring for Transferability

If a passthrough entity is in its “burn phase” (high research costs, low revenue), owners should prioritize obtaining the Department of Commerce certification early. Being a “Qualified Research and Development Company” allows the entity to convert up to $100,000 of credits into immediate cash, which can then be reinvested into more engineers or lab equipment, fueling further growth.

Interaction with the North Dakota Automation Credit

North Dakota also offers an “Automation Tax Credit” for purchasing machinery to automate manufacturing processes. While distinct from the R&D credit, these two incentives often overlap. Revenue guidance is clear: the same expense cannot be used for both credits. A PTE must strategically decide whether a new piece of equipment is primarily for “research” (R&D credit) or for “production automation” (Automation credit), as the rates and carryover rules differ significantly.

Final Thoughts

The treatment of passthrough entities under the North Dakota Research and Experimental Expenditure Tax Credit is a masterful integration of federal definitions and state-specific economic priorities. By allowing credits to flow through to owners, North Dakota ensures that the financial benefits of innovation are accessible to the entrepreneurs and investors who drive the state’s economy. However, this accessibility comes with the responsibility of rigorous compliance. From the initial entity-level calculation using the Regular or ASC method to the owner-level “tax attributable” limitations and the mandatory Property Tax Clearance, every step of the process is governed by specific legislative mandates and revenue office guidance.

For the modern North Dakota business, the R&D credit is not merely a year-end tax adjustment but a strategic capital allocation tool. Whether it is a small ag-tech startup utilizing the $100,000 transferability provision to secure early-stage funding or a mature manufacturing partnership using the 25% tiered rate to modernize its production line, the passthrough structure remains the ideal vehicle for realizing these incentives. As the state continues to refine its tax code and respond to the evolving needs of the primary sector, the R&D credit will undoubtedly remain a cornerstone of North Dakota’s commitment to a future defined by technological excellence and economic resilience. Owners of passthrough entities must remain vigilant, maintaining the meticulous records and proactive certifications required to ensure that their investment in today’s research becomes the tax-advantaged success story of tomorrow.