The state of Michigan implemented a research and development (R&D) refundable tax credit, effective for tax year 2025, which allows small businesses to qualify for up to $250,000 in refundable R&D tax credits and large companies to a maximum of $2 million. The formula is also generous, as it rewards companies starting with their first dollar of expense. From $0 of R&D expense up to the company’s trailing-three-year-R&D-spend average, the company gets a 3% credit, and any amounts in excess of the average earn a 15% credit for small businesses (<250 employees), and large businesses receive a 10% credit rate—all much better than most any other state. This is an unprecedented opportunity, but it comes with substantiation and procedural risks that could render the credit claim invalid.

Refundability Means Heightened Risk

A refundable credit means the taxpayer does not have to have income tax to redeem the credit. Instead, all they have to do is put numbers on a few forms and get in line for a nice check. The state recognizes that programs like this invite significant abuse, much like the Employee Retention Credits (ERC). However, some taxpayers may be lulled into a false sense of safety, as they may have previously claimed federal R&D tax credits without issues—note that the current IRS and tax court rulings show growing antagonism to, and skepticism of, R&D tax credits claims than in the past. Keep in mind that the federal credit is non-refundable and can only be applied against tax liability. Additionally, there are often other limitations that prevent taxpayers from redeeming all of the credits at once, even if they have tax liability. All of which discourages fraud, which results in less government scrutiny than if it were refundable.

Routine State Scrutiny: Desk Audits

Other states offering R&D tax credits usually conduct a desk audit on each claim. This entails providing the numbers that support the R&D tax credit claim, which, among other things, means showing the breakdown of R&D conducted in the state and work done outside the state. Typically, the taxpayer must present the federal calculations and demonstrate how they reconcile with the state calculations. However, the refundable nature will likely compel the state tax commission to conduct field audits to examine the underlying activities to protect both Michigan taxpayers and the program itself.

Field Audits: Undue Stress & Business Disruptions

Field audits are conducted to answer the question of why the engineering work being claimed is considered R&D, given that the company itself may have been performing heavy engineering for years or decades. The service and the tax courts attempt to either deny engineering projects as general professional performance or only accept the first 20% of costs.

The government’s playbook is to interview (effectively cross-examine) the company’s engineers. Engineers often use technical or colloquial language that either confuses the IRS or leads auditors to draw the wrong conclusion about eligibility. The engineers’ expertise frequently works against them as it leads them to believe that the day-to-day engineering they perform is routine and therefore not eligible; however, Congress wrote the statute to encourage any engineering that develops new or improved products or processes. The novelty standard was abolished decades ago; the four-part test now controls eligibility. Today, as long as an engineer is using principles of science or engineering to figure something out, they are likely engaged in credit-eligible activities, even if they have solved similar problems before or are working within an established industry.

Written R&D Reports Equal Safety

People are naturally skeptical of oral testimony and typically interpret everything being said as self-serving. Accordingly, oral examinations have a heightened risk of all credits being denied. In contrast, written project-level reports prepared before an audit is ever called are recognized as credible accounts of the nature of the project’s activities. The result is that the IRS typically accepts the credits without requiring meetings with the engineers themselves.

Even if engineers liked writing and understood both the tax law and how to describe the activities in a way that would allow auditors to draw the correct conclusion—avoiding trigger words—businesses do not want their most productive people to spend time on administrative work. Accordingly, the companies that are most protected and get the best ROI are those that employ outside tax advisory firms; ones staffed with engineering writers—writers familiar with the tax law, with engineering speak, and experienced in reading project files such that they can write the project-level reports without tying up the company's engineers for the many project-level R&D reports needed. In short, it means no engineer needs to spend more than an hour a year on a study, a welcome relief to businesses that want to claim the credit.

Specifics on Claiming the Credit

The state will only accept claims filed by April 1st of 2026. No, this does not mean that the company return must be completed by then. Most business returns are extended to give their CPAs time to correctly prepare the return given the many moving parts. Instead, only the R&D claim must be filed with the state by the deadline, leaving the taxpayer its regular timetable to file the state return. Instead of a full tax return, taxpayers submit an online tentative refund claim. However, the name is deceiving. Many will assume this means they can file an estimate and then revise the numbers in time to put on the state return once the full study has been completed. The name emanates from the nature of the state's pool system.

$100M Credit Pool

The Michigan lawmakers set aside $100M in funds for the R&D tax credit claims, with $25M earmarked for small businesses (under 250 employees). The state opted to use a proration methodology rather than a first-come, first-served one. For instance, if $100M of credit claims are submitted, $75M for the large company pool and $25M for the small pool, everyone receives 100% of their credit claim. Because of the set aside, the state instituted a separate proration for it. Thus, even if the large pool is oversubscribed, as long as the small pool is not, small businesses will still receive 100% of their claim. The only way for a small business to have its credit claim prorated down is if there are more than $25M credits claimed by small businesses: since the program is new, it is likely that the claims will be less than $25M in year one. For subsequent years, the small pool could be oversubscribed.

Redemption Mechanics

While the credit is referred to as refundable in the legislation, the language of the code appears to be applicable only to companies paying CIT who have a tax liability exceeding their credits. For passthroughs and C-corps without sufficient CIT tax, the credits are refunded against state withholdings on a go-forward basis. In theory, the credit can be applied against all state withholdings for calendar year 2026—the same year the refund claim was filed, not 2025, which is the tax year. To clarify, the credit would have been earned in 2025, but would offset 2026 state withholdings.

It is important to note that the credit is both claimed and refunded at the entity level. Individual members, partners, or shareholders of a flow-through entity that submits a claim are not permitted to claim any portion of the credit or refund on their own Michigan returns. In other words, the benefit stays within the entity itself.

Prudently Careful vs Overly Cautious

Given the uncertainty about how intensely the state will audit credit claims, companies filing legitimate claims may be gunshy due to concerns about insufficient written substantiation. These companies may feel that the safest thing to do is to wait and see how the first year plays out, and then claim in year two. However, that not only means missing out on the year 1 credits, but also exposes the company to receiving fewer credits in year two than it could have earned in year 1. Generous new state programs attract more participants every year, which means the program soon becomes over-subscribed. Year one is likely to generate a higher rate of credits.

Given that the process is new and the filing deadline is early, April 1st, all are encouraged to start planning their study between now and the end of January to ensure enough time to successfully file a claim.

Author Information

Jenna Tugaoen is a tax attorney at Sycamore Growth Group, an Ohio-based tax advisory firm specializing in assisting businesses to attain and substantiate public economic incentives such as R&D and energy credits.

Rick Kleban is the founder and president of Sycamore Growth Group, an Ohio-based firm specializing in securing economic incentives that maximize cash flow and minimize risk.

James Bean, CPA, is a senior researcher and R&D tax controversy specialist at Sycamore Growth Group.