Empowering the Texas Innovation Economy: A Strategic Proposal to Reform Restricted Refundability Criteria within the Research and Development Tax Credit Framework

Executive Summary of the Liquidity Challenge

Texas has long positioned itself as a global leader in business-friendly policy, leveraging a low-tax environment and a robust regulatory climate to attract high-value industries. Central to this strategy has been the Research and Development (R&D) tax incentive program, which underwent a fundamental transformation with the enactment of Senate Bill 2206 (SB 2206) during the 89th Legislative Session in 2025. This legislation, signed into law on June 22, 2025, made the state’s R&D franchise tax credit permanent and significantly increased the statutory rates to 8.722% for standard qualified research and 10.903% for research conducted in partnership with Texas higher education institutions. These changes were designed to improve the state’s competitiveness against innovation hubs like California and Massachusetts.

However, the implementation of the new Subchapter T of Chapter 171 in the Texas Tax Code has introduced a critical structural impediment known as the “Restricted Refundability Criteria”. While the legislature introduced a refundable option for certain entities, it is strictly limited to those that owe zero franchise tax—specifically startups under the $2.65 million revenue threshold and qualified new veteran-owned businesses. This binary structure creates a “carryforward trap” for small and medium businesses (SMBs) that have moved beyond the initial “no-tax-due” phase but have not yet achieved the scale required to absorb significant credit values against their tax liabilities.

For these SMBs, which are often in capital-intensive growth phases such as biotechnology, aerospace, and advanced manufacturing, the credits remain trapped as carryforwards for up to 20 years. This lack of liquidity is exacerbated by the repeal of the sales and use tax exemption for R&D equipment, effective January 1, 2026, which historically provided immediate cash-flow benefits at the point of purchase. Without a mechanism to monetize these credits, Texas risks stagnating the growth of its mid-market innovators and losing high-potential firms to states with more flexible refundability or transferability models. This whitepaper analyzes the current framework, proposes two practical solutions for the Texas Legislature, and outlines an administrative path toward a more liquid and competitive innovation ecosystem.

Evolution of the Texas Research and Development Incentive Framework

The history of R&D incentives in Texas is characterized by a shift from intermittent, temporary programs to the current permanent structure. Understanding this evolution is essential for contextualizing the modern liquidity gap. In the early 2000s, Texas utilized Subchapter O credits, which were repealed in 2008. Following a period of limited incentives, the legislature passed House Bill 800 in 2013, creating Subchapter M, which became effective in 2014.

Subchapter M allowed taxpayers to choose between a franchise tax credit and a sales tax exemption. This elective system was favored by SMBs because it allowed pre-revenue or low-margin firms to utilize the sales tax exemption for immediate savings on depreciable tangible personal property, while profitable firms could opt for the franchise tax credit to reduce their overall tax burden. However, Subchapter M was set to expire on December 31, 2026, creating uncertainty for long-term corporate planning.

Table 1: Comparative Features of Texas R&D Incentive Eras

The transition to Subchapter T via SB 2206 sought to modernize the program by simplifying administration and increasing the benefit magnitude. The most significant administrative improvement was the direct tie-in to federal qualified research expenses (QREs) as reported on IRS Form 6765. This alignment reduces the “factual determination” burden for the Comptroller and taxpayers alike, providing a more predictable audit environment. While the increased rates and permanent status were welcomed by the business community, the consolidation of the incentive into a single franchise tax credit path has inadvertently removed the liquidity “safety valve” that the sales tax exemption previously provided to SMBs.

The Mechanics of the Texas Franchise Tax and the “Margin” Calculation

To appreciate the impact of the restricted refundability criteria, it is necessary to examine the unique structure of the Texas franchise tax, often referred to as the “Margin Tax.” Unlike a traditional corporate income tax based on net profit, the Texas franchise tax is imposed on an entity’s “margin,” which can be calculated in four distinct ways. A taxable entity chooses the method that results in the lowest tax liability:

• Total revenue times 70%.
• Total revenue minus cost of goods sold (COGS).
• Total revenue minus compensation (subject to a per-employee cap of $480,000 for 2026-2027).
• Total revenue minus a standard $1 million deduction.

The tax is then applied at a rate of 0.75% for most businesses, or a reduced rate of 0.375% for entities primarily engaged in retailing or wholesaling. Crucially, the legislature has established a “no-tax-due” threshold to protect the smallest businesses from the administrative and financial burden of the tax. For reports originally due on or after January 1, 2026, this threshold is $2,650,000.

Table 2: 2026–2027 Texas Franchise Tax Parameters

Under Subchapter T, entities below the $2.65 million threshold are eligible for the refundable R&D credit because they “owe no tax”. However, once an entity’s revenue crosses the $2,650,001 mark, it becomes a “taxable entity” that is required to file a report and pay tax based on its margin. At this point, the entity loses eligibility for the cash refund and must apply the R&D credit against its tax liability, subject to a 50% cap.

The Policy Issue: The Restricted Refundability Criteria and the Carryforward Trap

The “Restricted Refundability Criteria” found in Section 171.9205 of the Texas Tax Code represents a binary policy that ignores the economic reality of growth-stage SMBs. By limiting refunds to entities with zero tax liability, the law creates a “fiscal cliff” for businesses that are transitioning from early research to initial commercial success.

The “Carryforward Trap” for Growth-Stage SMBs

The carryforward trap is the result of three intersecting statutory provisions:

• Revenue Threshold Eligibility: Only entities with revenue at or below $2.65 million (or veteran-owned startups) can receive a cash refund.
• The 50% Liability Cap: For entities that owe tax, the total credit claimed (including carryforwards) cannot exceed 50% of the tax due for the report.
• Low Initial Tax Liabilities: Many SMBs, despite having revenue above the threshold, operate on thin margins or have heavy reinvestment costs that result in small franchise tax liabilities.

Consider a high-growth medical device company in Houston with $5 million in annual revenue. Because it is above the $2.65 million threshold, it must pay franchise tax. Using the compensation deduction, the company determines its tax liability is $10,000. During the same year, the company invested $1 million in QREs (excess over base), yielding a Texas R&D credit of $87,220.

Under current law, the company can only use $5,000 of its credit (the 50% cap). The remaining $82,220 must be carried forward. While the credit can be carried forward for 20 years, the company cannot receive a check for the balance. For an SMB, $82,220 in “trapped” tax credits is significantly less valuable than $82,220 in cash that could be used to hire an additional engineer or purchase a 3D prototype printer.

The Loss of the Sales Tax Exemption “Safety Valve”

The repeal of the R&D sales and use tax exemption (Tax Code Section 151.3182) significantly worsens this trap. Prior to 2026, the Houston medical device company mentioned above would have likely opted for the sales tax exemption instead of the franchise tax credit. This would have allowed them to avoid paying the 6.25% state sales tax (plus local taxes) on the purchase of expensive lab equipment. This exemption provided “upfront” liquidity that was not dependent on the company’s revenue or profit margins.

With the repeal effective January 1, 2026, the company must now pay the sales tax at the time of purchase and hope to recoup that cost years later through the franchise tax credit carryforward. This transition represents a shift from a pro-growth, cash-flow-positive policy to a delayed-reimbursement model that favors large, established corporations with massive tax liabilities over agile, research-intensive SMBs.

The Impact on Small to Medium Businesses and Innovation Sectors

The negative consequences of the restricted refundability criteria are not distributed evenly across the economy. Instead, they fall most heavily on “pre-profit” or “low-margin” innovation sectors that are vital to the future of Texas’s economy.

Biotechnology and Life Sciences

Biotech firms often spend years, if not decades, in the research and development phase before achieving large-scale commercial success. During the middle years of this journey, a company may generate revenue through milestone payments or early-stage diagnostic services that exceed the $2.65 million threshold. However, their R&D spend remains enormous relative to their tax liability. The carryforward trap effectively locks up capital that is crucial for funding clinical trials and securing FDA approvals.

Advanced Manufacturing and Semiconductors

With the federal CHIPS Act and the state’s Texas Semiconductor Innovation Fund (TSIF), Texas is aggressively recruiting semiconductor manufacturing and design firms. These facilities require multi-billion dollar investments in “clean rooms” and lithography equipment. SMBs in the semiconductor supply chain that provide specialized components or design services are critical to this ecosystem. These firms often have high capital expenditure requirements but moderate initial revenue, making them primary candidates for the carryforward trap.

Table 3: Economic Profile of SMBs Impacted by the Carryforward Trap

The “liquidity gap” created by current policy acts as a drag on the very industries the JETI Act and other state incentives are designed to attract. If the goal of Texas policy is to become the “top destination for innovation,” the tax code must recognize that for an SMB, a dollar of cash today is worth more than five dollars of carryforwards in 2045.

Comparative Policy Analysis: Solutions from Other Innovation Hubs

Texas is not the only state grappling with how to incentivize innovation in pre-profit or growth-stage firms. Other states have developed mature mechanisms to ensure that R&D credits provide immediate liquidity, even for entities with low tax liabilities.

Connecticut: The Refundable Credit Exchange (The “Haircut” Model)

Connecticut’s approach is specifically designed for SMBs with gross income of $70 million or less. Under the “Partial Refund Exchange” program, a qualified small business that cannot use its R&D credits because it has no tax liability (or low liability) can trade those credits back to the state for a cash refund. The state applies a “haircut” to the refund: standard SMBs receive 65% of the credit’s value, while biotechnology firms receive 90%. This model provides immediate cash to the company while providing a 10-35% savings to the state treasury.

New Jersey: The Technology Business Tax Certificate Transfer Program

New Jersey utilizes a market-based transferability model. Unprofitable technology and biotechnology firms with fewer than 225 U.S. employees can sell their unused R&D tax credits to other profitable corporate taxpayers in the state. The credits must be sold for at least 80% of their value. This program allows SMBs to monetize their credits at a slight discount, while larger profitable companies buy the credits to reduce their own New Jersey Corporation Business Tax (CBT) liabilities. New Jersey caps this program at $75 million annually, providing a predictable fiscal impact for the state.

Massachusetts: Targeted Industry Refundability

Massachusetts offers a suite of refundable credits through the Massachusetts Life Sciences Center (MLSC). Certified life sciences companies are eligible for a 90% refund of excess Section 38M research credits. This refund is contingent on meeting specific job creation targets, ensuring that the state’s cash outlay is directly tied to employment growth in a high-value sector.

Table 4: National State-Level R&D Liquidity Models

The current Texas model is the least flexible for growth-stage SMBs because it offers no “middle ground” between a full 100% refund for the smallest entities and a 20-year carryforward for everyone else.

Solution 1: The Texas SMB Refundable Credit Exchange (TSRCE)

To resolve the carryforward trap, the Texas Legislature should implement a “Refundable Credit Exchange” program, drawing inspiration from the Connecticut model but tailored to the Texas franchise tax structure.

Mechanism and Design

The TSRCE would allow taxable entities with total annualized revenue between $2.65 million and $50 million to elect to receive a cash refund in lieu of a carryforward. This election would apply only to the portion of the credit that exceeds the 50% liability cap.

To ensure fiscal responsibility, the refund would be issued at a discounted rate. A standard refund rate of 70% of the credit value would provide substantial liquidity to the SMB while delivering a 30% “discount” to the state’s long-term tax expenditure. For priority sectors identified in the JETI Act or TSIF (such as semiconductors and biotech), the legislature could authorize an enhanced refund rate of 85%.

Administrative Flow

• Application: The SMB files its franchise tax report and calculates its R&D credit under Subchapter T.
• Utilization: The SMB applies the credit against its tax due, up to the 50% cap.
• Election: The SMB completes a new Comptroller form (e.g., Form 05-185, Election for SMB R&D Credit Exchange) to request a refund for the excess.
• Verification: The Comptroller verifies the QREs based on the already mandated alignment with federal Form 6765.
• Disbursement: The Comptroller issues a refund check or direct deposit for the discounted amount.

Benefit to the SMB: This solution converts “dead” carryforward balances into active working capital. A company with an $80,000 excess credit would receive a check for $56,000 (at a 70% rate). This provides immediate funding for payroll, research supplies, or loan repayments, significantly reducing the “cost of capital” for Texas innovators.

Solution 2: The Texas Innovation Credit Transfer Program (TICTP)

An alternative solution that avoids direct state outlays is a market-based “Credit Transfer” program, similar to the New Jersey model. This program would leverage the large population of profitable “Tier 1” corporations in Texas to provide liquidity to the “Tier 2” SMB innovators.

Mechanism and Design

The TICTP would authorize the Comptroller to issue “Transferable Credit Certificates” to SMBs with verified R&D credits that they cannot immediately utilize due to the 50% cap. The SMB could then sell these certificates to any other entity subject to the Texas franchise tax.

The market would determine the price, but the legislature should set a “floor” of 75 cents on the dollar to prevent predatory pricing. The purchaser would then use the certificate to offset its own franchise tax liability, subject to the same 50% cap that applies to all credits.

Administrative Flow

• Certification: The SMB applies to the Comptroller for certification of its unused R&D credits.
• Issuance: The Comptroller issues a unique certificate number and records the amount in a secure registry.
• Market Transaction: The SMB finds a buyer (e.g., a large energy company or retailer) and enters into a private sale agreement.
• Reporting: Both parties report the transfer to the Comptroller using a standardized form.
• Claim: The purchaser claims the credit on their next franchise tax report.

Benefit to the State: The TICTP is virtually cost-neutral to the state Treasury in the long run. The revenue offset simply moves from the SMB’s future tax return to the large corporation’s current tax return. However, the economic impact is accelerated. The “trapped” capital is released into the hands of the growth-stage company when it needs it most, fostering a dynamic innovation ecosystem where large firms effectively “subsidize” the growth of their smaller suppliers and collaborators through the tax credit market.

Administrative Implementation and Fraud Prevention

Expanding refundability or transferability requires robust safeguards to ensure that state funds are used for legitimate research and to prevent the rise of “credit mills” or fraudulent claims.

Leveraging Federal Compliance

The most potent defense against fraud is the existing alignment with federal law under Subchapter T. Texas should require any entity seeking a refund or transfer to provide a complete copy of their federal Form 6765 and their federal income tax return. Because the IRS has significantly increased its scrutiny of R&D credits, Texas can leverage federal audit outcomes. Current Texas law already requires taxpayers to file amended reports if an IRS audit results in a change to their federal QREs. This “federal audit flow-through” should be strictly enforced for all refundable claims.

The Role of the Comptroller’s Audit Division

The Comptroller should implement a “Risk-Based Verification” process for all refundable or transferable credit applications.

• Mandatory Review for Large Claims: Any refund or transfer exceeding $50,000 should undergo a “desk audit” before approval.
• Texas Nexus Verification: Auditors should verify that the research was actually conducted in Texas, requiring documentation of employee locations and laboratory addresses.
• Qualified Expenses Verification: The Comptroller should utilize existing Form 00-750 (Audit Questionnaire) and request payroll records to ensure that only “direct” research wages (not administrative or marketing support) are included.

Professional Accountability and Ethics

To prevent aggressive promoters from filing inflated claims, the legislature should mandate that any application for a refundable or transferable credit be signed by a Certified Public Accountant (CPA) or a qualified tax attorney. Furthermore, the state should explicitly prohibit “contingency fee” arrangements for these applications, mirroring the federal restrictions in Circular 230. This ensures that the professional preparing the claim has a fiduciary duty to the taxpayer and a professional obligation to the state to maintain accuracy.

Table 5: Fraud Prevention and Oversight Framework

Cost-Benefit Analysis: The ROI of Innovation Liquidity

A dynamic cost-benefit analysis reveals that the initial outlay for a refundable R&D credit program for SMBs is not a “sunk cost” but a high-yield investment in the state’s future tax base.

Initial Cost Outlay

The fiscal impact of expanding refundability would be moderate. According to the Baker Institute, the entire expansion of the R&D credit under SB 2206 is estimated to cost $661.4 million in FY2026. Expanding refundability to SMBs (revenue up to $50 million) at a discounted rate (e.g., 70%) would likely represent a fraction of this amount. Furthermore, the discounted “haircut” on refunds actually reduces the state’s total long-term liability, as a $1.00 carryforward (which would eventually be used at 100% value) is settled today for $0.70.

Future Benefits and Revenue Offsets

The economic multiplier for R&D spending is among the highest of any policy tool. The Baker Institute study indicates that every dollar of foregone tax revenue from the R&D credit generates $12.47 in additional Gross State Product (GSP) over 20 years.

• Property Tax Relief Fund Protection: SB 2206 already includes a mechanism requiring the Comptroller to deposit enough franchise tax revenue into the Property Tax Relief Fund to offset any decreases resulting from the R&D credit. Expanded liquidity for SMBs would accelerate the growth of these firms, leading to higher property valuations and increased sales tax revenue, which would further bolster state and local funds.
• Job Creation and Wages: The R&D credit expansion is projected to create more than 113,000 new jobs by 2035, generating $8.5 billion in additional wages. These high-paying jobs represent a sustainable source of future tax revenue that will more than pay for the initial liquidity provided to SMBs.
• Multiplier Effect: By providing cash to an SMB today, the state captures the “velocity of money.” An SMB will spend that refund immediately on Texas-based payroll and supplies, whereas a carryforward sits idle on a balance sheet for a decade.

Table 6: Long-Term Economic Projections (Rice University Baker Institute)

The conclusion of the cost analysis is clear: the question is not whether Texas can afford to provide liquidity to SMB innovators, but whether it can afford not to, given the massive potential for economic expansion and future revenue generation.

Importance of the Policy Change and Consequences of Inaction

Texas is currently in a “Global Ante” for innovation leadership. While the state has successfully built a massive economy, its performance in R&D investment has historically lagged behind other states relative to its size.

Strategic Importance

The transition to a permanent R&D credit was a critical first step in signaling that Texas is a “top destination” for technology and advanced manufacturing. However, a permanent credit that is “trapped” as a carryforward is an incomplete tool. Reforming the restricted refundability criteria is essential to:

• Level the Playing Field: Ensuring that SMBs, which are the primary engines of disruptive innovation, have access to the same liquidity benefits as large corporations or pre-revenue startups.
• Mitigate the Repeal of the Sales Tax Exemption: Replacing the lost immediate cash-flow benefit of the sales tax exemption with a liquid franchise tax credit.
• Support Vital Supply Chains: Bolstering the mid-market firms in the semiconductor and aerospace industries that are essential to national security and state economic resilience.

Consequences of Inaction

If the carryforward trap is not addressed, Texas face several negative consequences:

• Innovation Flight: High-potential SMBs in the biotech and tech sectors may relocate to Connecticut, New Jersey, or Massachusetts, where they can receive immediate cash for their research efforts.
• Stunted Mid-Market Growth: Companies reaching the $2.65 million revenue threshold may “sandbag” their growth or bifurcate their entities to remain below the threshold, creating economic inefficiencies.
• Reduced Competitiveness: As other states (roughly 29 of which offer R&D credits) continue to modernize their incentives, Texas will appear less attractive for the “first phase” of product development, where ideas are turned into solutions.
• Lost ROI: The state will fail to realize the full 8,790% ROI projected by the Baker Institute if the primary drivers of that ROI—the high-growth SMBs—cannot access the capital they need to expand.

Final Policy Recommendations for the Texas Legislature

To preserve and enhance the Texas Innovation Economy, the following legislative actions are recommended for the upcoming session:

• Amend Section 171.9205: Expand the eligibility for refundable credits to include taxable entities with total annualized revenue up to $50 million, provided the refund is issued at a discounted rate (e.g., 70% for standard, 85% for priority sectors).
• Authorize Credit Transferability: Establish a framework for the “Texas Innovation Credit Transfer Program,” allowing SMBs to sell certified, unused R&D credits to other franchise taxpayers at a minimum price of 75% of value.
• Mandate Professional Vetting: Require all refundable or transferable credit applications to be certified by a CPA or tax attorney and prohibit contingency fee arrangements to protect state revenue from fraudulent claims.
• Strengthen Audit Oversight: Provide additional resources to the Comptroller’s Audit Division to conduct pre-certification desk audits of all large refundable claims, focusing on Texas nexus and QRE eligibility.

By taking these steps, Texas can convert its permanent R&D credit into a high-velocity economic engine, ensuring that the next generation of technological breakthroughs is researched, developed, and commercialized within the Lone Star State.

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