Funded research consists of any research activity where the taxpayer’s performance is compensated regardless of technical success or where the entity fails to retain the right to exploit the results. In the Texas R&D tax credit context, such activities are excluded to ensure the credit incentivizes only those entities bearing genuine financial and innovation risk.

Statutory and Administrative Origins of the Funded Research Exclusion

The evolution of the Texas Research and Development (R&D) tax credit is inextricably linked to the state’s broader economic goal of attracting high-paying, high-tech jobs and fostering a competitive environment for innovation. The modern era of the credit began with the 83rd Texas Legislature’s enactment of House Bill 800 in 2013, which established Tax Code Chapter 171, Subchapter M. Effective January 1, 2014, this legislation provided taxable entities with a choice between a franchise tax credit based on qualified research expenses (QREs) and a sales and use tax exemption for materials and equipment directly used in research.

Central to both the franchise tax credit and the sales tax exemption is the definition of “qualified research.” Under Section 171.651 of the Tax Code, Texas adopts the definition provided by Section 41 of the Internal Revenue Code (IRC). Crucially, the Texas statute specifically references the IRC “in effect on December 31, 2011”. This frozen conformity date is vital because it locks in the federal definitions and regulatory interpretations as they stood at that time, including the pivotal exclusion for funded research found in IRC Section 41(d)(4)(H). The funded research exclusion serves as a gatekeeper, preventing “double-dipping” by ensuring that the tax benefit is only available to the party that economically bears the cost of the research.

The administrative implementation of this exclusion is primarily governed by the Texas Comptroller of Public Accounts through Rule 3.599 for the franchise tax and Rule 3.340 for the sales tax. These rules have undergone significant amendments, most notably in 2021 and 2022, which introduced more rigorous standards for substantiation and clarified the Comptroller’s intent to follow federal case law regarding funded research while maintaining a higher burden of proof—”clear and convincing evidence”—for Texas taxpayers.

The Economic Risk Standard: Contingency and Payment Structures

The first prong of the funded research analysis focuses on who bears the financial loss if the research project fails. Under Treasury Regulation Section 1.41-4A(d), research is considered funded if the taxpayer’s right to payment is not contingent on the success of the research. This principle ensures that the entity claiming the credit is the one that would be out-of-pocket if the experimentation yielded no results. The analysis of economic risk requires a deep dive into the contractual payment structures agreed upon by the parties.

Fixed-Price and Capped Contracts

Fixed-price contracts are often viewed as the most favorable for taxpayers seeking to prove they bore the economic risk, but they are not a “safe harbor”. In a fixed-price arrangement, the researcher agrees to deliver a result for a set fee. If the research requires more effort or resources than anticipated, the researcher absorbs the extra cost. However, the Comptroller and the courts look specifically at whether the payment is tied to the success of the research. If the contract allows for progress payments that are not refundable upon failure, or if the client is obligated to pay regardless of the technical outcome, the research may still be deemed funded.

Capped contracts provide another layer of complexity. Under Rule 3.599(d)(7)(D), if a taxable entity retains substantial rights but the research is funded because payments are not contingent on success, the research is only funded to the extent of the payments received. For instance, if a company is contracted to perform research for $100,000 but ends up spending $120,000 to achieve the result, the $20,000 excess is considered unfunded and may qualify for the credit, provided all other criteria are met. This “excess expense” provision is a critical planning tool for businesses performing R&D under commercial contracts where costs often overrun estimates.

Time and Materials and Cost-Plus Agreements

Contractual arrangements such as “time and materials” or “cost-plus-fixed-fee” are generally fatal to an R&D credit claim by the researcher. Because these structures guarantee the researcher will be reimbursed for their hours and supplies regardless of whether a new product or process is successfully developed, the financial risk sits entirely with the funding party. In these scenarios, the funding party—not the researcher—is the entity entitled to the credit, provided they meet the other requirements of the Tax Code.

The Substantial Rights Standard: Rights to Exploitation

Even if a researcher bears 100% of the financial risk, the research is still considered “funded” if the researcher does not retain “substantial rights” to the results. This second prong ensures that the taxpayer has more than just an “incidental benefit” from the research. For the purposes of the Texas R&D credit, retaining substantial rights means having the right to use the research results in the researcher’s trade or business without paying a fee or obtaining further permission from the funder.

Defining Substantial Rights vs. Incidental Benefits

Rule 3.599 clarifies that “increased experience in a field of research” is merely an incidental benefit and does not constitute substantial rights. For example, if a software firm develops a new AI model for a client and the client owns the copyright and all underlying IP, the firm cannot claim the credit just because its engineers now know more about AI. To have substantial rights, the firm must, at a minimum, have a non-exclusive right to use the developed code or algorithms in its other business ventures.

A critical indicator of the lack of substantial rights is the requirement to pay for the use of the results. If a taxable entity performs research but must pay the funder a license fee or royalty to use the resulting technology, the entity does not retain substantial rights. The Comptroller’s guidance also emphasizes that “all agreements”—not just the primary research contract—must be considered. Non-disclosure agreements (NDAs) or separate intellectual property assignments can inadvertently strip a researcher of substantial rights even if the main contract is silent on the issue.

Comparative Rights Ownership Analysis

The following table summarizes the impact of various intellectual property (IP) clauses on credit eligibility.

Texas Comptroller Guidance and Local Revenue Office Implementation

The Texas Comptroller’s office has been assertive in its interpretation of the funded research exclusion, often using the State Automated Tax Research (STAR) system to issue memos and letter rulings that clarify its stance for auditors and taxpayers.

STAR Document 202503004M: Group Transactions

A significant area of local guidance concerns transactions between members of a combined group. In Federal law, members of a controlled group are treated as a single taxpayer, and research performed by one member for another is typically not considered funded. However, Memo 202503004M clarifies that this federal aggregation rule does not apply in the same way to Texas tax. While a combined group is treated as a single taxpayer for franchise tax purposes, each entity remains a separate taxpayer for sales tax purposes. This creates a situation where a transaction between a parent and a subsidiary might be viewed as funded research for sales tax exemption purposes, even if it is eliminated for franchise tax purposes.

Burden of Proof and Audit Techniques

In Texas, the burden of establishing the credit rests solely on the taxable entity. Rule 3.599 specifies that this must be done through “clear and convincing evidence,” which is a significantly higher standard than the “preponderance of the evidence” used in federal tax court. During an audit, Texas revenue officers are instructed to look for documentation that specifically addresses both the economic risk and substantial rights prongs. Auditors will often request:

• All master service agreements (MSAs) and statements of work (SOWs).
• Documentation of “unsuccessful” research to prove that payment was indeed contingent on success.
• Proof of IP retention, such as patent applications or internal records of technology reuse.

Statute of Limitations and Carryforwards

Comptroller Decision 202301007M addresses the interplay between the funded research exclusion and the statute of limitations. If the Comptroller determines in a later year that research performed in a now-closed year was actually funded, they cannot adjust the tax for the closed year, but they can adjust the credit carryforward available for open years. This means a historical error in classifying funded research can haunt a taxpayer for up to 20 years (the carryforward period for R&D credits in Texas).

Judicial Precedents: The 5th Circuit and Grigsby v. United States

Because Texas law conforms to the IRC and the Comptroller has indicated an intent to follow federal case law regarding the definition of funded research, the decisions of the U.S. Court of Appeals for the Fifth Circuit are paramount for Texas taxpayers. The most critical recent precedent is Grigsby v. United States (2023).

Analysis of the Grigsby Ruling

The Grigsbys, owners of Cajun Industries LLC, claimed millions in R&D credits for major construction projects, including oil refineries and flood control systems. The IRS and eventually the Fifth Circuit denied the credits, largely on the basis of the funded research exclusion. The court’s analysis focused on the specific language in the construction contracts.

In three of the four representative projects (Methanex, Chevron, and Claiborne), the contracts explicitly transferred all rights to any new methods, products, or developments to the clients. The court ruled that even if Cajun Industries had performed qualified research, the lack of substantial rights made the research “funded” and thus ineligible.

For the fourth project (East Bank), which was a fixed-price contract, the court examined the risk standard. The Grigsbys argued that because it was a fixed-price contract and “inherently risky,” it should be considered unfunded. However, the court found that the contract language guaranteed Cajun was “fully compensated for all loss, damages, or risks,” meaning the company did not actually bear the financial risk of technical failure.

Lessons from Grigsby for Texas Taxpayers

The Grigsby case provides several critical warnings for professional tax planners in Texas:

• Contract Language is Paramount: Broadly worded IP clauses that transfer all rights to the client will disqualify the credit regardless of the technical complexity of the work.
• Fixed-Price Does Not Equal Unfunded: Auditors will look past the “fixed-price” label to see if there are clauses that mitigate the researcher’s risk.
• Burden of Proof: The Fifth Circuit affirmed that the taxpayer carries the burden of overcoming the presumption that the revenue office’s determination (that research was funded) is correct.

The Transformation to Subchapter T: Future of the Funded Research Exclusion

The 89th Texas Legislature’s passage of Senate Bill 2206 marks the most significant change to the Texas R&D credit since its inception. Effective January 1, 2026, the state will transition from the “frozen” conformity of Subchapter M to a new “rolling” conformity model under Subchapter T.

Alignment with Line 48 of Form 6765

Under the new law, “qualified research expense” is defined as the portion of the amount reported on Line 48 of IRS Form 6765 that is attributable to research conducted in Texas. This change is intended to streamline the audit process by tying state eligibility to federal reporting. If the federal government accepts a taxpayer’s calculation of QREs—which inherently excludes funded research—the Texas Comptroller will generally follow suit.

However, this alignment creates a “double-edged sword.” While it reduces state-specific factual disputes over what constitutes a “process of experimentation,” it makes the Texas credit entirely dependent on the taxpayer’s ability to defend the funded research exclusion during a federal audit. If the IRS disqualifies an expense as funded, that deduction is automatically lost for Texas purposes as well.

The End of the Sales Tax Exemption Option

A major component of SB 2206 is the repeal of the sales and use tax exemption for R&D property. Historically, many taxpayers with low franchise tax liability opted for the sales tax exemption to get an immediate 6.25% (plus local) benefit on equipment purchases. By 2026, this option will disappear, and the only way to recover these costs will be through the enhanced 8.722% franchise tax credit. This shifts the importance of the funded research exclusion even further, as companies will now be paying sales tax upfront and must rely on a successful “unfunded” classification to receive any tax benefit later.

Case Study: Application of the Funded Research Exclusion

To illustrate the nuances of the law and the Comptroller’s guidance, consider the following detailed example of a fictional Texas aerospace firm, Galactic Innovations, Inc.

Scenario: The Satellite Guidance System Project

Galactic Innovations is headquartered in Austin and engages in high-level R&D for satellite guidance systems. During its 2024 tax year, it had three major contracts:

1. The NASA Contract (Project Alpha): A cost-reimbursable contract where NASA pays for all labor and materials plus a fixed 10% fee. NASA retains all patent rights, though Galactic has a limited right to use the findings for other government-related work only.
2. The Commercial Partner Contract (Project Beta): A fixed-price contract with Sky-Link Corp. Galactic is paid $2 million upon successful delivery of a guidance chip that meets a 99.99% accuracy threshold. If the chip fails, Galactic receives nothing. Galactic retains a non-exclusive license to use the underlying logic in its own commercial products.
3. Internal R&D (Project Gamma): A self-funded project to develop a new propulsion method. No external funding or clients are involved.

Analysis and Application of the Law

Project Alpha (NASA)

This project is fully funded under Rule 3.599(d)(7)(A).

• Risk Standard: Galactic has no economic risk because NASA reimburses all costs regardless of success.
• Rights Standard: Galactic does not retain substantial rights. The limited right for “government-related work” is considered an incidental benefit, and the exclusive ownership by NASA is a disqualifying factor under the Grigsby standard.
• Result: All wages, supplies, and contractor costs for Project Alpha must be excluded from the Texas R&D credit calculation.

Project Beta (Sky-Link)

This project is unfunded and qualifies for the credit.

• Risk Standard: Payment is strictly contingent on technical success (the 99.99% threshold). Galactic bears the financial loss if the research fails, meeting the Fairchild risk standard adopted by the Comptroller.
• Rights Standard: Galactic retains a non-exclusive license to use the results in its trade or business. This constitutes “substantial rights” even though it is not exclusive ownership.
• Result: QREs for Project Beta are eligible for the 5% credit (under Subchapter M) or the 8.722% credit (if this occurred under Subchapter T).

Project Gamma (Internal)

This is a “baseline” qualified research activity. Since there is no third party, the funded research exclusion does not apply. Galactic merely needs to satisfy the “Four-Part Test” (Technological in Nature, Process of Experimentation, etc.).

Impact of Group Reporting (STAR 202503004M)

If Galactic Innovations performed the research for Project Beta but its subsidiary, Galactic Parts LLC, purchased the depreciable equipment used in that research, the following would apply:

• Franchise Tax Credit: Since they file a combined report, the QREs (including the equipment cost if capitalized) can be aggregated.
• Sales Tax Exemption: Galactic Parts LLC cannot use the R&D sales tax exemption for the purchase because it is not the entity “engaged in qualified research”—the parent is. This distinction is vital for corporate groups to coordinate procurement with research activities.

Practical Compliance and Audit Defense Strategies

Given the “clear and convincing” burden of proof in Texas, taxpayers must move beyond simple accounting to robust contractual and technical documentation.

Documenting Economic Risk

Taxpayers should maintain a “Project Success Log” that tracks technical milestones. If a project is cancelled due to technical failure and no payment is received, that evidence is the strongest possible defense against a funded research challenge. Furthermore, when negotiating contracts, tax professionals should work with legal teams to ensure that “contingency on success” is explicitly stated in the SOW rather than just implied.

Substantiating Substantial Rights

Under Rule 3.599(d)(7)(E), a taxable entity must be able to identify any other person with substantial rights to the results. A best practice is to include an “IP Retention Clause” in every R&D-related contract that mirrors the language of Treasury Regulation 1.41-4A(d). This clause should explicitly state: “The Researcher retains a non-exclusive, perpetual, royalty-free right to use the results, findings, and improvements generated herein in the conduct of its trade or business.”

Managing the Transition to Subchapter T

As businesses move toward 2026, the focus must shift to the accuracy of Federal Form 6765. Because Line 48 becomes the anchor for the Texas credit, the documentation supporting the federal claim will become the primary target for Texas state auditors. Taxpayers should consider using statistical sampling, as explicitly authorized by SB 2206 and IRS Revenue Procedure 2011-42, to ensure their QRE pool is accurately identified and that funded projects are systematically excluded.

Final Thoughts

The funded research exclusion is not merely a technicality; it is a fundamental expression of the legislative intent behind the Texas R&D credit. By requiring taxpayers to bear both the economic risk and the right to exploit their innovations, Texas ensures that its tax incentives are used to build a sustainable, knowledge-based economy rather than simply subsidizing service-based contracts.

The transition to Subchapter T and the permanent extension of the credit represent a “maturing” of Texas tax policy, moving toward a simpler, more valuable, but also more federally-dependent system. For professional peers in the tax and accounting sectors, success in this new environment will require a sophisticated understanding of both the “frozen” rules of the past and the “rolling” requirements of the future. The ability to distinguish between a funded service and an unfunded innovation remains the most critical skill for maximizing the Texas R&D tax credit while minimizing the risk of a costly audit failure.