Credit Carryforward (Maximum 20 Consecutive Reports)

The credit carryforward for the Texas Research and Development (R&D) tax credit refers to the statutory mechanism allowing a taxable entity to apply unused portions of an accrued research credit, which exceed the fifty percent franchise tax liability limitation, toward the tax due on up to twenty subsequent consecutive franchise tax reports. This provision ensures that capital-intensive innovation and long-term research projects can eventually realize the full fiscal benefit of the incentive even if the entity’s immediate tax liability is insufficient to absorb the total credit amount in a single reporting period.

The architecture of the Texas research and development tax credit is primarily codified within Chapter 171 of the Texas Tax Code, a complex regulatory landscape that has undergone several legislative iterations to balance state revenue needs with the goal of fostering a competitive environment for high-technology industries. The evolution of these incentives—from the repealed Subchapter O to the current Subchapter M and the recently enacted Subchapter T—demonstrates a consistent policy objective: providing a durable window for credit utilization through the “20 consecutive reports” carryforward provision. This long-term carryforward is essential because the lifecycle of research and development often involves significant upfront expenditures in labor and supplies well before a product reaches commercial viability and generates taxable margin.

Historical and Legislative Context of Texas R&D Incentives

To understand the current carryforward rules, it is necessary to examine the legislative history that shaped the Texas Franchise Tax. The research credit has not always been a permanent fixture of the state’s tax code. Before 2008, the credit was governed by Subchapter O, which was repealed as part of a broader overhaul of the franchise tax system. However, the legislature recognized the importance of honoring existing commitments, allowing unused credits from Subchapter O to be carried forward. Under current administrative guidance, specifically Rule 3.593(e)(1), these legacy carryforwards will remain available for use until they expire on reports originally due before December 31, 2027.

The modern era of the Texas R&D credit began with the 83rd Legislature’s passage of House Bill 800 in 2013, which added Subchapter M to Chapter 171. This legislation created a bifurcated incentive system where taxpayers could elect either a sales and use tax exemption for depreciable tangible personal property used in qualified research or a franchise tax credit based on qualified research expenses (QREs). The inclusion of the twenty-report carryforward in Subchapter M, codified in Section 171.659, was a critical component of the bill, ensuring that the incentive remained attractive to startups and research-heavy firms that might not have immediate tax liabilities.

As Subchapter M approached its scheduled expiration on December 31, 2026, the 89th Legislature enacted Senate Bill 2206 in 2025 to create a permanent replacement: Subchapter T. Effective January 1, 2026, Subchapter T repeals the sales tax exemption option in favor of an enhanced, refundable franchise tax credit. Crucially, the twenty-consecutive-report carryforward remains the cornerstone of this new regime, providing continuity for taxpayers who have accumulated unused credits under the outgoing Subchapter M.

Legislative Milestone	Effective Date	Expiration/Repeal Date	Key Impact on Carryforwards
Subchapter O	Pre-2008	January 1, 2008	Carryforwards expire Dec 31, 2027
Subchapter M	January 1, 2014	December 31, 2025	Established 20-report carryforward and sales tax election
Subchapter T	January 1, 2026	Permanent	Increases rates; introduces refundability; preserves 20-report window

Legal Definition and Application of the Carryforward Mechanism

The term “not more than 20 consecutive reports” is a specific regulatory construct within the Texas Tax Code. In the context of the franchise tax, a “report” is the annual tax filing due on May 15, covering the activities of the preceding privilege period. Therefore, a twenty-report carryforward essentially equates to a twenty-year utilization window, provided the entity remains a viable taxpayer in the state. The “consecutive” nature of the reports is paramount; the clock does not pause during years when an entity might owe no tax or falls below the filing threshold.

The Statutory Limitation on Credit Utilization

The necessity of the carryforward arises directly from the limitation imposed by Section 171.658 (for Subchapter M) and Section 171.9207 (for Subchapter T). These sections state that the total credit claimed for any single report—including both the current year’s accrual and any carryforwards from prior years—may not exceed fifty percent of the amount of franchise tax due for that report before any other applicable tax credits are considered.

This fifty percent cap ensures that the R&D credit does not entirely eliminate an entity’s tax obligation to the state in a given year, maintaining a baseline level of revenue for the Texas General Revenue Fund while still providing a substantial incentive for innovation. Because research-intensive firms often generate credits that far exceed this fifty percent threshold, the carryforward provision acts as a pressure relief valve, allowing the excess “value” to be stored and used in future years as the firm’s revenue and tax liability grow.

Order of Application and Hierarchy of Credits

The Texas Comptroller of Public Accounts has provided detailed administrative guidance regarding the sequence in which credits must be utilized. This is a critical area for taxpayers with multiple credit types, as improper ordering can lead to the premature expiration of carryforwards.

According to Tax Policy Division Memorandum STAR 202501001M, the research and development credit is unique because its governing statute explicitly prescribes an order of use for its own internal carryforwards. For other credits, such as the Historic Structure Credit or the Clean Energy Project Credit, the statute is often silent, giving the Comptroller broader discretion. For R&D credits, the hierarchy is as follows:

1. Subchapter O Carryforwards: The oldest eligible credits must be used first to prevent expiration by the 2027 deadline.
2. Subchapter M Carryforwards: Unused credits from the 2014–2025 period.
3. Current Year Credits: The credit generated during the period covered by the current report.

This chronological “First-In, First-Out” (FIFO) approach is designed to maximize the taxpayer’s benefit by consuming credits with the nearest expiration date first. When an entity has other types of credits, the R&D credit’s fifty percent limitation is calculated based on the tax due before those other credits are applied. For instance, if an entity has both an R&D credit and a Historic Structure Credit, the R&D credit (and its carryforwards) are applied first to offset up to fifty percent of the tax. Any remaining tax liability can then be offset by the Historic Structure Credit, which has its own separate carryforward limit of five consecutive reports.

Credit Type	Carryforward Duration	Order in Hierarchy	Limitation
R&D (Subchapter O)	Expires Dec 31, 2027	1st (within R&D category)	50% of tax due
R&D (Subchapter M)	20 Consecutive Reports	2nd (within R&D category)	50% of tax due
R&D (Subchapter T)	20 Consecutive Reports	3rd (within R&D category)	50% of tax due
Historic Structure	5 Consecutive Reports	After R&D credits	Remaining tax due
Clean Energy Project	20 Consecutive Reports	After R&D credits	Remaining tax due

Defining Qualified Research Expenses (QREs)

To establish a credit and a subsequent carryforward, a taxpayer must first identify and calculate their Qualified Research Expenses. Texas law heavily relies on federal definitions found in Section 41 of the Internal Revenue Code (IRC), though there are significant nuances regarding geography and timing.

Federal Conformity and the 2011 IRC Date

For reports filed under Subchapter M (through 2025), Texas conforms to the IRC as it existed on December 31, 2011. This means that any federal legislative changes or IRS regulations issued after that date do not automatically apply to the Texas credit unless the state legislature or the Comptroller adopts them. This “frozen” conformity date has occasionally created challenges for taxpayers who must maintain two sets of records—one for federal purposes and one for Texas purposes—to account for items like the treatment of internal-use software or pilot models.

Under the new Subchapter T (effective 2026), this burden is reduced as the state moves toward rolling conformity with federal Form 6765, Line 48. The Texas QRE is defined as the portion of the amount reported on federal Form 6765 that is attributable to research conducted within the state of Texas.

The Four-Part Test for Qualified Research

Both the federal and Texas definitions require research activities to meet a four-part test to be considered “qualified”:

1. Permitted Purpose: The research must be intended to develop a new or improved business component, such as a product, process, software, or technique.
2. Elimination of Uncertainty: The activity must seek to discover information that would eliminate uncertainty regarding the capability, method, or design for developing the business component.
3. Process of Experimentation: Substantially all of the research activities must involve a systematic process of experimentation, such as modeling, simulation, or trial-and-error, designed to evaluate one or more alternatives.
4. Technological in Nature: The process of experimentation must rely on principles of the “hard” sciences, such as engineering, physics, biology, or computer science.

Eligible Costs: Labor, Supplies, and Contract Research

Only specific types of expenses qualify for the credit and the carryforward. These generally include:

• Wages: Payments made to employees for “qualified services,” which include direct performance, direct supervision, or direct support of qualified research. Administrative functions like payroll, human resources, or general janitorial services are explicitly excluded, even if the employees work in a research facility.
• Supplies: Tangible property used in the research process, provided it is not subject to depreciation. This excludes land and improvements to land.
• Contract Research: 65% of the amounts paid to third parties for research conducted on the taxpayer’s behalf in Texas. This percentage increases significantly if the contract is with a public or private institution of higher education.

Administrative Rules and Revenue Office Guidance

The Texas Comptroller’s office manages the R&D credit through Title 34, Section 3.599 of the Texas Administrative Code (TAC) and a series of interpretive memos. These guidelines provide the granular detail necessary for taxpayers to navigate the carryforward process without triggering audits or losing credits to the statute of limitations.

34 TAC § 3.599: The Rule of Record

Section 3.599 serves as the comprehensive regulatory framework for the R&D credit. It covers eligibility, calculation methods, and the mechanics of the carryforward. One of the most important aspects of the rule is the requirement for contemporaneous documentation. Taxpayers are expected to maintain records as the research occurs, including innovation logs, testing results, and time-tracking data. The Comptroller’s office has emphasized that if a taxpayer cannot prove that an expense was “directly” used in research, the credit and any associated carryforward can be denied upon audit.

Statute of Limitations and the “Closed Year” Limitation

A common point of confusion for taxpayers is the ability to claim carryforwards from years that are technically “closed” for refund purposes. In STAR 202301007M, the Comptroller clarified that a taxpayer cannot “create” a new credit in a closed year and then carry it forward into an open year. For example, if the statute of limitations has run on the 2019 report year, a taxpayer cannot amend that 2019 report to establish a credit and then claim the carryforward on their 2024 report.

However, the guidance also provides a safeguard: the Comptroller reserves the right to audit and verify QREs in a closed year for the purpose of determining the accuracy of a carryforward being used in an open year. While the tax for the closed year cannot be adjusted, the mathematical balance of the carryforward is subject to review to ensure it was calculated correctly at the time of its inception.

Combined Reporting Realities

Texas requires combined reporting for groups of entities engaged in a “unitary business”. For R&D purposes, the combined group is treated as a single taxable entity. This means:

• The credit is calculated based on the aggregate QREs and base amount of all group members.
• The fifty percent limitation is applied to the combined group’s total tax liability.
• Carryforwards are tracked at the group level. If a member leaves the group, the carryforward generally stays with the group unless the member took substantially all the assets of the research activity with it.

Mathematical Example of Credit Carryforward Application

To provide clarity on how these rules function in practice, consider the case of “Vortex Aerospace,” a fictional defense contractor based in Fort Worth. Vortex has significant research operations and has elected the franchise tax credit under Subchapter M.

Vortex Aerospace: Baseline Data

• Tax Year: 2024 (Report Year 2025).
• Total Revenue: $15,000,000.
• Franchise Tax Liability (Pre-Credit): $112,500.
• 2024 Qualified Research Expenses (QREs): $2,500,000.
• 3-Year Average QRE (2021-2023): $1,200,000.
• Existing Carryforward from 2023: $45,000.

Step 1: Calculate the Base Amount

The base amount is 50% of the average QREs from the three preceding periods.

Base Amount = $1,200,000 × 0.50 = $600,000

Step 2: Calculate the Current Year Credit

The credit is 5% of the excess of current QRE over the base amount.

New Credit = ($2,500,000 – $600,000) × 0.05 = $95,000

Step 3: Determine Total Available Credit

This includes the new credit plus the existing carryforward.

Total Available = $95,000 + $45,000 = $140,000

Step 4: Apply the 50% Tax Liability Limitation

The total credit claimed on the 2025 report cannot exceed 50% of the pre-credit tax liability.

Max Credit Allowed = $112,500 × 0.50 = $56,250

Step 5: Determine Credit Used and Carryforward

Per the order of application, Vortex must use the oldest credits first.

• Year 1 Carryforward Used: $45,000 (fully exhausted).
• Current Year Credit Used: $56,250 – $45,000 = $11,250.
• Remaining Carryforward to 2026: $95,000 – $11,250 = $83,750.

Vortex will report the $56,250 as a credit on its 2025 report and move the $83,750 to the “Research and Development Activities Credit carried forward from prior years” line on its 2026 report (Form 05-178, Item 13). This $83,750 carryforward has 19 remaining consecutive reports before it expires.

Reporting Requirements and Documentation Compliance

Navigating the administrative requirements of the Texas R&D credit is as critical as the technical research itself. The Comptroller’s office requires a specific suite of forms to be filed annually to establish the credit and track the carryforward.

The Essential Forms Suite

Taxpayers claiming an R&D credit must submit the following as part of their franchise tax filing:

1. Form 05-158 (Franchise Tax Long Form): The primary return where the final tax liability is calculated.
2. Form 05-160 (Credits Summary Schedule): This form aggregates all credits, including R&D, and applies the fifty percent limitation.
3. Form 05-178 (Research and Development Activities Credits Schedule): This is the most important document for carryforward tracking.

Form 05-178 requires the taxpayer to detail their QREs for the current year and the three preceding years to justify the credit calculation. It also contains dedicated fields for the entry of carryforwards from prior years. Failure to file Form 05-178 in conjunction with Form 05-160 will result in the denial of the credit, as the Comptroller uses the schedule to verify the mathematical eligibility of the claim.

Electronic Filing and Signature Requirements

For report years beginning in 2024, Texas has transitioned toward more rigorous electronic filing requirements. Taxable entities, particularly those with complex credits like the R&D incentive, are encouraged to use the Webfile system or approved tax software. Electronic submission satisfies the signature requirements, provided it is authorized by an officer, director, or partner of the taxable entity.

Strategic Implications of the Transition to Subchapter T

The enactment of Subchapter T (SB 2206) represents a paradigm shift in how Texas treats research credits, particularly for small businesses and startups. While the twenty-report carryforward remains, its role for certain entities will diminish in favor of immediate liquidity.

Refundability: A New Alternative to Carryforward

Starting in 2026, an entity that incurs QREs but owes no tax—either because it is below the revenue threshold or has significant deductions—may receive the R&D credit as a cash refund. In these instances, the entity no longer needs to worry about the fifty percent cap or the twenty-report clock; they receive the benefit immediately.

This change is specifically designed to support the state’s innovation hubs in Austin, Dallas, and Houston, where many biotechnology and software startups operate at a loss for years while perfecting their technology. By providing a refund, the state allows these companies to reinvest capital into new equipment or additional research staff rather than carrying an intangible tax asset on their books.

Higher Credit Rates and University Incentives

Subchapter T also significantly increases the credit rates, making the Texas incentive one of the most generous in the nation. The standard rate moves from 5% to 8.722%, and the rate for university-contracted research increases from 6.25% to 10.903%.

Credit Tier (No University)	Subchapter M (Current)	Subchapter T (2026)
Standard Excess QRE	5.0%	8.722%
No Prior QRE History	2.5%	4.361%

Credit Tier (University)	Subchapter M (Current)	Subchapter T (2026)
Standard Excess QRE	6.25%	10.903%
No Prior QRE History	3.125%	5.451%

This rate hike means that taxpayers will likely generate even larger credit amounts, potentially exceeding their tax liabilities more frequently. Consequently, the twenty-consecutive-report carryforward will remain a vital tool for mid-sized and large corporations that are not eligible for the “no tax due” refundability provisions.

Compliance and Audit Preparedness

The long lifespan of a credit carryforward—up to twenty years—requires an exceptional level of document retention. A carryforward used in Year 15 might be traced back to research activities performed over a decade earlier.

Document Retention Best Practices

The Comptroller’s office has the authority to request documentation for any credit being claimed or carried forward. Best practices for Texas R&D credit compliance include:

• Contemporaneous Documentation: Capturing technical challenges and experimentation results at the time they occur.
• Wage Tracking: Utilizing project codes in payroll systems to link employee time directly to qualified research tasks.
• Supplier Evidence: Maintaining invoices that specifically describe the materials used in laboratory or testing environments.
• Federal Audit Alignment: Under Subchapter T, Texas will adopt IRS audit determinations for QREs automatically. Taxpayers should preserve all federal audit correspondence and Form 6765 workpapers.

The Role of Statistical Sampling

Both the IRS and the Texas Comptroller allow the use of statistical sampling to determine QREs, particularly for large companies with thousands of employees. Following IRS Revenue Procedure 2011-42, taxpayers can use sampling to estimate the percentage of time spent on qualified activities across a large population. If the Comptroller accepts this sampling methodology, it serves as sufficient evidence to support the credit and its carryforward.

Assignment and Non-Transferability of Credits

A key legal restriction on the R&D credit carryforward is the prohibition on assignment and transfer. Unlike some other states where R&D credits can be sold to other taxpayers for cash, the Texas credit is essentially “locked” to the entity that incurred the expense.

The “All Assets” Exception

Section 171.660 (and 171.9208 in the future) provides only one path for a credit to change hands: the sale of the business. If a company is acquired, and “substantially all of the assets” of the taxable entity are transferred in the transaction, the acquiring entity takes possession of the accumulated carryforwards. This prevents companies from “selling off” tax attributes while retaining their core operations, ensuring the incentive stays with the research activity it was meant to foster.

Nuances of University Collaboration

The Texas legislature has placed a high premium on partnerships between private industry and the state’s institutions of higher education. These institutions include public universities, health science centers, and technical colleges governed by the Higher Education Coordinating Act of 1965.

When an entity contracts with such an institution, the credit rate increases by twenty-five percent (from 5% to 6.25% under Subchapter M, and from 8.722% to 10.903% under Subchapter T). This higher rate applies to all QREs incurred under the contract. Because these contracts often involve multi-year research initiatives, they are primary drivers of significant credit carryforwards.

Economic Impact and Future Outlook

The Tax Exemptions & Tax Incidence Report issued by the Comptroller highlights the significant role that research and development incentives play in the Texas economy. For fiscal year 2025, aggregate exemptions and credits are estimated in the billions of dollars, with R&D incentives serving as a major contributor to the state’s manufacturing and technology growth.

The move to make the credit permanent through Subchapter T reflects a long-term strategic vision. By eliminating the expiration date that haunted Subchapter M, the state allows businesses to engage in decadal planning. A company planning to build a major research hub in Dallas or Austin can now rely on the twenty-consecutive-report carryforward as a stable financial asset, knowing that the credits they generate in 2026 will be available to offset taxes through 2046.

Final Thoughts

The Texas R&D tax credit carryforward is a robust fiscal instrument that bridges the gap between today’s innovation and tomorrow’s profitability. Its mechanics—the twenty-consecutive-report window, the fifty percent liability cap, and the strict FIFO order of application—provide a predictable framework for taxpayers.

As the state transitions to Subchapter T, the carryforward remains the primary vehicle for large-scale corporate research centers to manage their tax liabilities. Meanwhile, the introduction of refundability for smaller entities ensures that the incentive is inclusive of the entire technological ecosystem. For any entity engaged in research in Texas, success requires not only technological breakthrough but administrative diligence in tracking every labor hour and supply invoice to preserve the full value of the credit over its twenty-year lifecycle.

The “20 consecutive reports” provision is more than a simple accounting rule; it is a promise of long-term economic partnership between the State of Texas and the industries driving its future. By understanding the interaction between state statutes, revenue office guidance, and the evolving legislative landscape, taxpayers can ensure that their innovation efforts are fully supported by the state’s tax code.