How to Claim the Texas R&D Credit for Your Business

The Texas Research and Development (R&D) Credit is an incentive for businesses engaging in innovation within the state. It is designed to foster technological advancement by reducing a company’s franchise tax burden. The program encourages companies to invest in developing new products, processes, and software by allowing them to recover a portion of their research-related expenditures.

Determining Business Eligibility

To qualify for the Texas R&D credit, a business must be a taxable entity subject to the state’s franchise tax, such as a corporation or limited liability company. The requirement is that the entity has a franchise tax responsibility, as the credit is applied directly against this liability. Any entity, including a combined group, that claims the credit must file a Texas franchise tax report.

The credit is available to businesses across numerous industries if their activities meet the definition of qualified research. It is not limited to companies with formal R&D departments, as eligibility is determined by the nature of a company’s activities and expenses.

While businesses could previously choose between the franchise tax credit and a sales and use tax exemption, the exemption is being repealed. It will not be available for reports due on or after January 1, 2026.

Identifying Qualified Research Activities

For an activity to be considered qualified research, it must pass a “four-part test” aligned with federal guidelines in Internal Revenue Code Section 41. All four conditions must be met for the associated expenses to be eligible, and the research activities must physically take place within Texas.

The first part is the permitted purpose requirement. The research must be undertaken to create a new or improved business component in terms of its function, performance, reliability, or quality. This component can be a product, process, software, or invention that the company intends to hold for sale, lease, license, or use in its business. For example, a project to redesign a manufacturing process to reduce waste would meet this standard.

The second condition is that the research must be technological in nature. The process of experimentation must rely on the principles of hard sciences, such as engineering, computer science, or physical sciences. For instance, a software company using computer science principles to develop a new encryption algorithm would qualify.

The third part involves the elimination of uncertainty. At the project’s outset, the business must face uncertainty concerning the capability, method, or appropriate design of the business component. Research is intended to discover information that resolves this technical uncertainty, such as determining if a new material can withstand specific temperature requirements.

Finally, the activity must involve a process of experimentation. This requires the business to evaluate one or more alternatives to achieve the desired result through methods like modeling, simulation, or systematic trial and error. An example is a food science company testing multiple formula variations to achieve a specific shelf life.

Calculating the Credit Amount

The Texas R&D credit calculation is based on totaling Qualified Research Expenses (QREs). These expenses fall into three main categories: in-house research wages, supply costs, and contract research expenses. In-house wages include salaries for employees performing, supervising, or supporting qualified research, but only if at least 80% of their services are for R&D.

Supply costs are expenses for tangible property used in research, such as materials for building prototypes or lab supplies. For contract research expenses, which are payments to a third party, 65% of the amount is includable as QREs.

For reports due on or after January 1, 2026, the credit is 8.722% of the amount by which the current year’s QREs exceed the base amount. The base amount is 50% of the average QREs from the three preceding tax periods. The total credit claimed in a single year, including carryforwards, cannot exceed 50% of the franchise tax due for that period.

Required Forms and Documentation

Claiming the credit requires filing Form 05-178, the Texas R&D Activities Credits Schedule, with the annual Texas Franchise Tax Report. On this form, a business reports its total Texas QREs for the current and three preceding periods to establish the base amount. The calculated credit is then carried to Form 05-160, the Credits Summary Schedule.

Businesses must maintain documentation to substantiate the claim in an audit. Records should provide clear evidence of the qualified research activities and expenses. Documents should include project accounting records that track QREs, payroll records for R&D employees, and invoices for supplies and contract research. Technical project narratives, lab notebooks, and meeting minutes are also recommended.

How to Claim the Credit

The process of claiming the credit is part of the annual franchise tax filing. After completing the required forms, a business must file the Long Form Franchise Tax Report. The necessary schedules must be attached to this report, which can be filed electronically through the Comptroller’s Webfile system or with approved tax software. Any unused credit amount can be carried forward for up to 20 consecutive report years.