Current Law R&D Credit (Subchapter M)

The Texas Research and Development (R&D) tax credit is a statutory incentive allowing businesses to reduce their franchise tax liability or receive sales tax exemptions based on qualified research expenditures. Under current law, this mechanism is governed by Chapter 171, Subchapter M of the Tax Code, which provides a 5 percent credit for increasing research activities conducted within the state.

The landscape of corporate taxation in Texas has long been defined by a strategic effort to foster an environment conducive to technological innovation and high-value job creation. The state’s commitment to research and development (R&D) incentives is not merely a fiscal policy but a cornerstone of its broader economic development strategy, designed to attract global enterprises and support the growth of home-grown startups. Central to this strategy is the Texas Tax Code Chapter 171, specifically Subchapter M, which serves as the current legal framework for providing tax relief to entities engaged in qualified research activities. However, the regulatory environment is in a state of significant flux. The 89th Texas Legislature recently enacted Senate Bill 2206, which will repeal Subchapter M and replace it with a more robust and federally aligned Subchapter T effective January 1, 2026. This transition represents a shift from a dual-incentive elective system toward a high-rate, performance-based franchise tax credit that introduces refundability for specific categories of taxpayers. Understanding the nuances of Subchapter M is therefore essential not only for current compliance and audit defense but also for strategic planning as businesses prepare for the expanded benefits and administrative changes coming in the 2026 reporting cycle.

The Legal and Historical Context of Subchapter M

The current iteration of the Texas R&D credit, found in Subchapter M, was born out of a period of legislative re-evaluation regarding the state's competitiveness. Historically, Texas offered R&D incentives under Subchapter O, but those provisions were repealed effective January 1, 2008. The absence of a state-level R&D credit for several years was viewed by many economic analysts as a disadvantage, as competing states continued to offer aggressive incentives to the technology and aerospace sectors. In response, the 83rd Legislature passed House Bill 800 in 2013, which added Subchapter M to Chapter 171 of the Tax Code. This legislation effectively reinstated the credit for reports originally due on or after January 1, 2014, signaling a renewed commitment to the state's "innovation hubs" like Austin, Dallas, and Houston.

Under Subchapter M, the incentive structure is elective. A taxable entity engaged in qualified research in Texas must choose between two distinct benefits: a franchise tax credit based on qualified research expenses (QREs) or a sales and use tax exemption on the purchase, lease, or rental of depreciable tangible personal property used directly in the research process. This elective nature is a defining characteristic of "current law," and the statute explicitly prohibits a taxpayer from claiming both benefits for the same period. This requires tax departments to perform a yearly cost-benefit analysis to determine which incentive yields the highest net value based on their current year capital expenditures versus their projected franchise tax liability.

Defining Qualified Research under Subchapter M

To qualify for the benefits of Subchapter M, the research activities must meet stringent criteria largely derived from federal law but modified by state-specific requirements. The Texas Tax Code ties the definition of "qualified research" to Section 41(d) of the Internal Revenue Code (IRC). However, a critical nuance of the current Subchapter M law is its reliance on "fixed-date conformity." For reports due under Subchapter M, the state references the IRC as it existed on December 31, 2011. This means that subsequent changes to federal law, such as those introduced by the Tax Cuts and Jobs Act (TCJA) or other recent federal tax reforms, do not automatically apply to the Texas credit calculation unless the Texas Legislature takes specific action to update the reference date.

Under the guidance provided by the Texas Comptroller of Public Accounts, every research project must satisfy the federal "four-part test" to be eligible for the credit. This test ensures that the incentive is directed toward true innovation rather than routine business improvements.

Permitted Purpose: The research must be undertaken for the purpose of discovering information that would be useful in the development of a new or improved business component of the taxpayer. This relates to the function, performance, reliability, or quality of the product or process.

Technological in Nature: The research must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science.

Elimination of Uncertainty: The activity must be intended to discover information to eliminate uncertainty regarding the capability, method, or design of the business component.

Process of Experimentation: Substantially all of the activities must constitute a process of experimentation, which typically involves the evaluation of alternatives through modeling, simulation, or systematic trial and error.

The Comptroller’s office further clarifies that "qualified research" does not include activities conducted after the beginning of commercial production, research related to style or cosmetic design, or research conducted outside the United States and its possessions. Additionally, research in the social sciences, arts, or humanities is strictly excluded.

Under current law, the expenses that can be included in the credit base are divided into four primary categories, provided they are attributable to research conducted within the physical borders of Texas.

A significant point of administrative contention under Subchapter M involves the treatment of supplies. Comptroller Rule 3.599 historically suggested that if a supply was exempt from sales tax, it could not be counted as a QRE for the franchise tax credit. This regulatory interpretation led to significant litigation, such as the TTARA v. Hegar case, where taxpayers argued the Comptroller was overstepping statutory authority by imposing exclusions not found in the IRC. As will be discussed later, the new Subchapter T explicitly addresses and overrides this controversy.

Administrative Guidance from the Texas Comptroller

The Texas Comptroller of Public Accounts serves as the primary revenue office and provides the regulatory framework through which Subchapter M is administered. This guidance is primarily disseminated through the Texas Administrative Code (TAC), specifically 34 TAC § 3.599, and through the State Automated Tax Research (STAR) system, which contains memos and letter rulings that interpret the application of the law to specific taxpayer scenarios.

One of the most complex areas of Comptroller guidance concerns the exclusion of "funded research." Under Rule 3.599, any research funded by a grant, contract, or another person is generally excluded from the credit. The determination of whether research is funded hinges on two factors: whether the researcher retains substantial rights to the results and whether the payment is contingent upon the success of the research.

If a researcher performs work for a client but retains no substantial rights to the intellectual property, the research is considered 100% funded and ineligible for the credit, regardless of whether the researcher’s costs exceed the contract price. However, if the researcher does retain substantial rights, but the payments are not contingent on success (e.g., a time-and-materials contract where payment is guaranteed), the research is considered funded only to the extent of the payments received. In such cases, if a company spends $200,000 on research but is only paid $150,000 by the client, the remaining $50,000 may qualify as an unfunded QRE for the company’s own credit calculation.

Texas utilizes a combined reporting system for its franchise tax. Under Subchapter M, the credit is claimed by the "taxable entity," which for a combined group means the entire group. The guidance requires that QREs incurred by any member of the combined group be aggregated on the group’s return. Furthermore, an "affiliated group" is defined as entities in which a controlling interest (more than 50%) is owned by a common owner.

The Comptroller also emphasizes the "Unitary Business" principle, which defines a group as a single economic enterprise. Factors used to determine if a group is unitary include whether members are in the same line of business, the existence of a vertically integrated process (like a manufacturer and its parts supplier), or the presence of centralized management and functional integration.

Calculating the Credit under Subchapter M

The calculation of the Subchapter M credit is designed to reward increasing research activities. The credit is not based on total QREs but rather on the amount by which current year QREs exceed a historical base.

For a typical taxpayer with a three-year history of research in Texas, the credit is generally 5 percent of the difference between the qualified research expenses incurred during the period and 50 percent of the average amount of QREs incurred during the three tax periods preceding the report period.

For example, if a company has the following research history:

• Year 1 QRE: $200,000
• Year 2 QRE: $300,000
• Year 3 QRE: $400,000
• Current Year QRE: $500,000

The average of the prior three years is $300,000. The "base amount" (50% of the average) is $150,000. The credit would be 5% of the difference between $500,000 and $150,000, which equals $17,500.

Subchapter M provides enhanced incentives for collaborations with Texas institutions of higher education. If a taxable entity contracts with a public or private institution of higher education for research, the credit rate increases from 5 percent to 6.25 percent.

Furthermore, the law accommodates businesses that do not have a full three-year history of research in the state. If a taxpayer has no QREs in one or more of the three preceding periods, the credit is calculated at a reduced rate of 2.5 percent of the current period’s total QREs (or 3.125 percent if contracting with a university). This "safe harbor" ensures that new businesses or companies relocating to Texas can still access the incentive immediately.

Statutory Limitations and Carryforward Provisions

Even if a company qualifies for a significant R&D credit, the amount it can actually use in a given year is subject to statutory caps. This ensures that the R&D credit does not entirely eliminate a company’s franchise tax liability in a single year.

The total credit claimed for a report, which includes both the current year credit and any carryforwards from prior years, may not exceed 50 percent of the amount of franchise tax due for the report before any other applicable tax credits are applied. For example, if a corporation owes $100,000 in franchise tax, it can only use its R&D credits to reduce that bill down to $50,000.

Because many R&D-heavy companies are pre-revenue or have low margins in their early years, they may not be able to use their full credit. Subchapter M allows for any unused credit to be carried forward for up to 20 consecutive reports. This long carryforward period is intended to provide long-term value and stability for companies making sustained investments in the state. It is important to note that the credit is generally non-transferable; it cannot be assigned or sold to another entity except in a transaction involving the transfer of substantially all of the assets of the taxable entity.

With multiple versions of the R&D credit having existed in Texas law (Subchapter O, Subchapter M, and the upcoming Subchapter T), the Comptroller has provided specific guidance on the order in which these credits must be used. According to STAR Memo 202501001M and subsequent updates, taxpayers must apply credits in the following chronological order:

Subchapter O carryforwards (repealed in 2008).

Subchapter M carryforwards (the current law).

Subchapter T carryforwards (the future law).

Current year credits.

This "first-in, first-out" approach ensures that older credits, which may have earlier expiration dates, are utilized before newer ones.

The Transition to Subchapter T: Senate Bill 2206

The most significant development in the Texas R&D space is the passage of Senate Bill 2206 during the 89th Legislature. This bill, signed by Governor Abbott in June 2025, overhauls the state's R&D tax incentives to make them more competitive and easier to administer. The primary catalyst for this change was the looming expiration of Subchapter M (scheduled for December 31, 2026) and the administrative inefficiencies associated with the elective sales tax exemption.

Effective January 1, 2026, Subchapter T will replace Subchapter M. The goal of the new law is to adhere more closely to federal standards, thereby reducing the "audit risk" and "compliance burden" for Texas businesses.

The legislative analysis for SB 2206 indicates that by repealing the sales tax exemption, the state could afford to increase the franchise tax credit rates significantly without an additional biennial cost to the treasury. This consolidation of incentives into a single, high-rate franchise credit simplifies the decision-making process for businesses and streamlines the Comptroller’s oversight.

One of the most praised aspects of Subchapter T is the shift to "rolling conformity." Instead of referencing a static 2011 IRC, the new law defines QREs as the amount reported by a taxable entity as its total qualified research expenses on Line 48 of Federal Form 6765, limited to the portion attributable to Texas research.

By tying the state credit directly to a specific line on a federal form, the legislature has eliminated the need for a separate factual determination of "what qualifies" at the state level. If an expense is accepted as a QRE by the IRS—or if it meets IRS requirements for recognition, such as adjusted Accounting Standards Codification (ASC) 730 financial statement R&D—the Texas Comptroller will now generally accept it as well. This provides a much higher degree of certainty for taxpayers and significantly reduces the amount of documentation required for a state audit.

Refundability: A Paradigm Shift for Startups

Perhaps the most transformative provision of Subchapter T is the introduction of a refundable credit for certain categories of taxable entities. Under current Subchapter M law, a startup with no franchise tax liability could only "bank" its credits for future years. Under the new law, specific entities can receive the credit as a cash refund if they are not required to pay franchise tax.

The following entities are eligible to receive their R&D credit as a refund:

New Veteran-Owned Businesses: Entities defined under Section 171.0005 that are within their first five years of operation.

No-Tax-Due Entities: Taxpayers whose total revenue is below the threshold for filing (currently $2.47 million, though this threshold is adjusted for inflation and remains $2.47 million for the 2026-2027 cycle).

Low-Liability Taxpayers: Those whose computed franchise tax is less than $1,000.

This shift is designed to ensure that the R&D incentive provides immediate liquidity to early-stage technology and biotech companies that are often pre-revenue but are conducting the most intensive research. For these entities, the 50 percent liability limitation does not apply to the refundable portion of the credit.

Procedural Requirements and Filing Guidance

The Texas Comptroller mandates specific procedures for claiming R&D credits to ensure accountability and data collection. These requirements apply to both Subchapter M and the upcoming Subchapter T.

To claim a franchise tax credit, a taxpayer must file a Long Form Franchise Tax Report (05-158-A and 05-158-B). In addition to the main report, the following supplemental schedules are mandatory:

Credits Summary Schedule (05-160): This form acts as a cover sheet for all types of credits claimed, including R&D, historic structure, and clean energy credits.

Research and Development Activities Credits Schedule (05-178): This is the most critical form for R&D. It requires the taxpayer to detail their QREs for the current year and the three preceding years to calculate the credit amount.

For entities claiming the sales tax exemption under the current law, the process is different. They must register online with the Comptroller to receive a Texas Qualified Research Registration Number (which begins with the prefix "RD"). Once registered, the entity must provide a properly completed Form 01-931 (Qualified Research Sales and Use Tax Exemption Certificate) to their vendors at the time of purchase. Furthermore, they must file an Annual Information Report (AIR) by March 31 of each year to maintain their registration.

The Comptroller has recently clarified that taxpayers may use statistical sampling procedures to determine their Texas QREs, provided these procedures align with IRS Revenue Procedure 2011-42. This is particularly useful for large corporations with thousands of employees and numerous research projects where identifying every individual invoice or hour of labor would be administratively prohibitive.

Despite the simplification under Subchapter T, the "burden of establishing the credit" remains with the taxpayer. Businesses must maintain contemporaneous records to support their claims. The following documentation is typically requested during a state audit:

Innovation logs and project descriptions identifying the technical uncertainties involved.

Payroll records and time-tracking data for researchers and their supervisors.

Contracts with third-party researchers or universities.

Financial records showing that the expenses were actually paid or incurred.

Illustrative Example: Comparing Subchapter M and Subchapter T

To understand the practical impact of the legislative changes, consider the following case study of "Nexus Tech Corp," an Austin-based aerospace startup with a heavy focus on propulsion systems.

Current Year (2025) QREs in Texas: $2,000,000

Average QREs (2022-2024): $1,200,000

Projected 2025 Franchise Tax Liability: $80,000

Nexus Tech Corp ownership: 100% owned by a veteran who started the business in 2023.

Under Subchapter M, Nexus Tech calculates its credit as 5% of its QREs that exceed the base amount.

Calculate Base Amount: 50% of $1,200,000 = $600,000.

Calculate Excess QREs: $2,000,000 - $600,000 = $1,400,000.

Calculate Credit: 5% of $1,400,000 = $70,000.

Apply Limitation: The credit is limited to 50% of the $80,000 tax due. Nexus Tech can only use $40,000 in 2025.

Carryforward: The remaining $30,000 is carried forward to 2026.

Sales Tax: Nexus Tech likely used the sales tax exemption for its $500,000 in lab equipment purchases in 2025, saving approximately $41,250 (at an 8.25% rate).

Assume the same R&D expenditure levels in 2026, but the company now falls under Subchapter T.

Calculate Base Amount: 50% of $1,200,000 = $600,000.

Calculate Excess QREs: $2,000,000 - $600,000 = $1,400,000.

Calculate Credit: 8.722% of $1,400,000 = $122,108.

Refundability Analysis: Because Nexus Tech is a veteran-owned business in its first five years, it may be eligible for a refund if its tax liability is eliminated.

Apply Subchapter M Carryforward: Nexus Tech must first use its $30,000 carryforward from 2025. This reduces its tax to $50,000.

Apply 2026 Credit: Nexus Tech uses its 2026 credit. Since it is eligible for refundability as a new veteran-owned business, it can receive the full remaining $122,108, with the portion not used to offset the remaining tax liability being paid out as a cash refund.

Sales Tax: Nexus Tech must now pay sales tax on its lab equipment purchases, as the exemption has been repealed.

In this example, the "New Law" provides a significantly higher credit amount ($122,108 vs. $70,000) and provides immediate liquidity via refundability, although the company loses the upfront sales tax exemption.

Strategic Planning and Implementation Delays

The transition to the new law is not without its hurdles. While SB 2206 was signed in 2025, the Texas Comptroller’s office is currently tasked with creating the necessary forms, detailed instructions, and administrative procedures to manage the new regulations. Acting Comptroller Kelly Hancock has noted that the office is managing 12 new programs from the 89th Legislature, including the R&D overhaul.

Taxpayers should be aware of a specific "implementation delay" regarding certain other tax policy changes. For instance, the Comptroller indefinitely delayed the implementation of a new policy related to processed materials (e.g., sand and gravel) that was originally set for October 2025. While the R&D transition has a firm statutory date of January 1, 2026, the administrative rules (TAC 3.599) will need to be substantially amended or replaced by a new rule for Subchapter T.

Equipment Procurement: Businesses relying on the sales tax exemption for expensive R&D equipment should look to finalize these purchases and take possession before December 31, 2025.

Documentation Alignment: Since 2026 will rely on Line 48 of the federal Form 6765, businesses should ensure their federal R&D studies are robust and that their "Texas-apportioned" methodology is well-documented.

University Partnerships: With the rate jumping to nearly 11 percent for university-contracted research, 2025 is an ideal time to negotiate or renew research contracts with Texas higher education institutions.

Comparative State Analysis: Texas in the National Context

The enhancement of the Texas R&D credit through SB 2206 is a direct response to a "national race" for technology investment. Approximately 29 other states offer some form of R&D tax credit. By moving to a rate of 8.722 percent, Texas positions itself significantly above the 5 percent standard common in many states, and closer to aggressive states like Iowa, which also recently modernized its R&D program.

Furthermore, the introduction of refundability for certain entities is a critical differentiator. While many states offer non-refundable credits that only benefit established, profitable corporations, the Texas "refund option" for small businesses and veterans directly addresses the capital constraints of startups. This makes Texas an even more attractive destination for venture capital-backed firms that are traditionally "tax-shielded" due to early losses but are nonetheless driving significant innovation.

Interaction with Other Franchise Tax Provisions

The R&D credit does not exist in a vacuum; it interacts with other components of the Texas "Margin Tax." For instance, Texas allows businesses to subtract either the "Cost of Goods Sold" (COGS) or "Compensation" to arrive at their taxable margin.

A recent legislative change (SB 263, effective immediately in 2025) allows television and radio broadcasters to claim a COGS reduction, a benefit previously limited to those selling tangible property. This illustrates the constant evolution of the franchise tax. Taxpayers must ensure that the expenses they claim for the R&D credit are not also being used to create a "double benefit" in a way that violates other sections of the Tax Code. However, the new Subchapter T explicitly states that supplies properly included in federal QREs cannot be excluded by the state simply because they were also exempt from sales tax—a major win for manufacturing-heavy R&D.

Final Thoughts and Recommendations for Tax Professionals

The transition from Subchapter M to Subchapter T marks the most significant change to Texas R&D policy in over a decade. While "Current Law" (Subchapter M) remains the governing authority for reports due through 2025, the sunset of the sales tax exemption and the rise of higher, refundable credits in 2026 require a shift in corporate strategy.

Tax departments must move away from the "fixed-date" 2011 IRC mindset and prepare for a "rolling conformity" era where federal audit adjustments will automatically trigger state adjustments. The elimination of the sales tax exemption in 2026 means that capital expenditure planning for 2025 is critical. Simultaneously, the promise of cash refunds for small businesses and veteran-owned entities provides a new avenue for non-dilutive capital that was previously unavailable.

The Comptroller's office continues to provide guidance through updated forms and tax policy news, and staying abreast of these changes is essential for maintaining compliance. By aligning state law more closely with the federal Form 6765, the Texas Legislature has delivered a framework that is both more generous and less burdensome—a rare combination in the world of corporate taxation that should sustain the state's status as a leader in global innovation.