In-house Research Expenses

In-house research expenses represent the internal costs of employee wages, tangible supplies, and computer utilization fees incurred directly for qualified research activities performed within Texas. These expenditures serve as the primary components of qualified research expenses used to calculate a taxable entity's eligibility for franchise tax credits.

Legislative and Regulatory Framework of Texas Research Incentives

The provision of tax incentives for research and development (R&D) in Texas is a multi-layered legal structure primarily governed by the Texas Tax Code, Chapter 171. This framework has transitioned through several iterations, moving from the initial Subchapter O to the current Subchapter M, and most recently toward the implementation of Subchapter T, which was established by the 89th Legislature through Senate Bill 2206. At its core, the Texas R&D tax credit is designed to incentivize technological innovation by allowing businesses to reduce their franchise tax liability based on the "Qualified Research Expenses" (QREs) they incur within the state.

The definition of In-house Research Expenses (IHRE) is the most critical element for most taxpayers because it typically constitutes the vast majority of the QRE total. Under the statutory definitions provided in the Texas Tax Code and further clarified by the Texas Comptroller of Public Accounts in 34 Texas Administrative Code (TAC) § 3.599, IHRE comprises three specific categories of expenditure: wages paid to employees for qualified services, amounts paid for supplies used in the conduct of qualified research, and costs incurred for the right to use computers in the conduct of research.

The state's adoption of federal definitions provides a degree of uniformity, yet the application of these rules within the Texas "nexus" requirement creates a unique set of compliance challenges for businesses. Specifically, while the Internal Revenue Code (IRC) Section 41 serves as the foundational definition, Texas law mandates that the expenses must be attributable to research actually conducted within the borders of Texas. This geographical restriction distinguishes the state credit from its federal counterpart and necessitates rigorous internal accounting to isolate Texas-based labor and material costs from a firm's global R&D spend.

The interaction between these state laws and the local revenue office—the Texas Comptroller—is defined by a series of administrative rules and policy memoranda. These documents serve as the practical handbook for how a taxpayer must identify and document IHRE to withstand the scrutiny of a state audit. The transition from Subchapter M to Subchapter T marks a significant shift from "fixed-date conformity" to "rolling conformity" with the IRC, meaning that Texas will follow the federal definitions as they exist in real-time, rather than being tethered to the 2011 version of the code.

Detailed Analysis of In-house Research Expense Categories

The composition of In-house Research Expenses is strictly defined to include only those costs directly associated with the experimental or laboratory phase of a project. This exclusion of indirect costs is a hallmark of both the federal and Texas R&D regimes, as the state seeks to reward the actual act of discovery rather than the general overhead associated with a research-intensive business.

Wages usually represent the largest portion of any R&D credit claim. In Texas, for wages to be included as IHRE, they must be paid to an employee for "qualified services" performed in the state. The Texas Comptroller, mirroring federal guidance, breaks qualified services into three distinct functional tiers: engaging in research, direct supervision, and direct support.

The first tier, engaging in qualified research, involves the actual conduct of research and experimentation. This encompasses scientists, engineers, and software developers who are actively working to resolve technological uncertainties. For instance, a chemist conducting laboratory experiments to determine the optimal molecular structure of a new compound is engaging in qualified research.

The second tier, direct supervision, refers to the immediate, first-line management of researchers. This role involves the day-to-day oversight of the experimentation process. However, the Comptroller’s guidance is clear: "direct supervision" does not extend to higher-level managers or executives to whom the first-line managers report. A Chief Technology Officer (CTO) or a Vice President of Engineering generally does not qualify unless they are directly overseeing a specific experimental task.

The third tier, direct support, is perhaps the most nuanced and frequently contested during audits. This category includes activities that are essential to the research process but do not constitute the research itself. Examples provided in TAC § 3.599 include a secretary typing reports on laboratory results, a laboratory assistant cleaning specialized equipment used in experiments, or a machinist creating a prototype part. Crucially, the Comptroller distinguishes this from "indirect support" or "general administrative services." Payroll personnel preparing salary checks for scientists, accountants tracking R&D budgets, or janitors providing general cleaning of a research facility do not qualify as direct support.

To simplify compliance, the "80 percent rule" is utilized. If an employee spends at least 80 percent of their time performing qualified services, 100 percent of their wages may be treated as IHRE. Conversely, if an employee spends less than 80 percent of their time on such tasks, only the actual proportion of their time spent on qualified services may be included.

The second category of IHRE is "supplies," which the law defines as any tangible property other than land, improvements to land, or property of a character subject to the allowance for depreciation. This definition creates a significant boundary between deductible research expenses and capital investments.

In a pivotal clarification issued in 2025, the Texas Comptroller emphasized the interplay between IRC Section 41 and IRC Section 174. While Section 174 allows for the immediate expensing of certain research expenditures, including some that might be depreciable, the Comptroller ruled that if a piece of property is "of a character subject to depreciation," it cannot be a "supply" for the purposes of the Texas R&D credit. This distinction is critical for businesses developing physical prototypes. If a prototype is used for testing and then discarded or destroyed, its materials generally qualify as supplies. However, if the prototype is a "pilot model" that eventually becomes a depreciable asset used in production, its cost may be excluded from IHRE.

The final component of IHRE involves amounts paid for the right to use computers in the conduct of qualified research. In the contemporary digital economy, this most frequently manifests as cloud computing expenses paid to providers such as Amazon Web Services (AWS), Microsoft Azure, or Google Cloud.

To qualify as IHRE, these costs must be for the "use" of the computer's processing power and must be directly linked to the performance of qualified research. If a software development firm uses cloud instances to run automated testing of new algorithms to resolve technological uncertainty, those hosting fees are generally includable as IHRE. However, the Comptroller requires that these costs be properly allocated. If a cloud server is used for both R&D and for hosting a commercial website, only the portion of the cost attributable to the R&D activity is eligible. Documentation, such as technical logs showing server utilization by research projects, is vital to substantiate these claims during a state review.

State Revenue Office Guidance and Administrative Rulings

The Texas Comptroller of Public Accounts serves as the primary arbiter of the R&D credit, and its guidance in the STAR (State Automated Tax Research) system provides the definitive interpretation of the law. Taxpayers must look to these rulings to understand how the broad language of the Tax Code is applied to specific, often complex, business scenarios.

TAC § 3.599(g) explicitly states that the burden of establishing the credit, including the amount and the qualification of expenses, rests entirely on the taxable entity. This means that the absence of detailed records is often fatal to a credit claim. The Comptroller requires contemporaneous documentation—records created at the time the research was performed—to support the inclusion of any IHRE.

The guidance on "direct support" within this rule is particularly strict. The Comptroller has consistently ruled that activities such as marketing research, efficiency surveys, and routine quality control do not meet the definition of qualified research. Consequently, any wages or supplies associated with these activities must be excluded from IHRE. Furthermore, the Comptroller has issued specific guidance regarding the "Texas Nexus" for remote employees. If an employee is performing research for a Texas company but is physically located outside of the state, their wages cannot be included in the Texas IHRE calculation, as the research was not "conducted in Texas".

A critical area of guidance concerns the timing of credit claims. In STAR memorandum 202301007M, the Comptroller clarified that a taxpayer is barred from creating a credit in a tax year that is closed by the statute of limitations. This has profound implications for credit carryforwards. Because the Texas R&D credit allows for a 20-year carryforward period, a business might attempt to "reach back" to a closed year to establish a credit to be used in an open year. The Comptroller’s position is that while they may verify the QREs in a closed year to validate the amount of a carryforward appearing in an open year, they will not allow the creation of a new credit for an out-of-statute period.

Historically, Texas allowed a person engaged in qualified research to claim either a sales and use tax exemption on depreciable property or a franchise tax credit based on QREs. Revenue office guidance (specifically Rule 3.599 and the instructions for Form 01-931) required a yearly election. A business could not claim both the sales tax exemption and the franchise tax credit for the same period.

The passage of Senate Bill 2206 (Subchapter T) dramatically alters this landscape by repealing the sales tax exemption effective January 1, 2026. Under the new law, businesses must pay sales tax on R&D equipment, but the law explicitly allows those sales tax costs to be included in the QRE calculation for the enhanced franchise tax credit. This shift reflects a policy decision to simplify the incentive structure by consolidating it into a single, more robust franchise tax credit while increasing the credit rate to offset the loss of the sales tax exemption.

Calculation Methodology and the Incremental Credit Structure

The Texas R&D credit is not a flat percentage of all research spending; rather, it is an "incremental" credit intended to reward businesses for increasing their investment in innovation over time. This is accomplished by subtracting a "base amount" from the current year's QREs.

For established entities that have QRE history, the credit is typically 5 percent (under Subchapter M) of the amount by which current-year Texas QREs exceed 50 percent of the average Texas QREs from the three preceding tax periods.

$$Credit = 0.05 \times$$

This formula ensures that the taxpayer only receives a credit for research spending that is higher than their historical baseline. If a company's research spending is declining, they may not be eligible for a credit even if they have substantial IHRE.

Recognizing that startups and new research entities do not have three years of historical data to calculate a base period, the law provides a "no prior periods" provision. In these instances, the credit is calculated at a reduced rate of 2.5 percent of the total current-year Texas QREs. This provides an immediate benefit to new innovative firms without penalizing them for their lack of history.

Texas places a high value on public-private collaboration. If a taxable entity contracts with a Texas public or private institution of higher education for research, the credit rate is enhanced. Under the current Subchapter M, the rate increases to 6.25 percent (or 3.125 percent for startups). Under the new Subchapter T, these rates jump to 10.903 percent and 5.451 percent, respectively. To qualify for this enhancement, the research must be performed under a formal contract, and the institution must be located in Texas.

Example Scenario: Texas Biotech Innovation Corp

To practically apply the definitions of IHRE and the Comptroller’s guidance, consider the case of "Texas Biotech Innovation Corp" (TBIC), a medical device company located in San Antonio. In 2024, TBIC is developing a new non-invasive blood glucose monitor.

TBIC reviews its internal expenditures to identify potential In-house Research Expenses for its Texas franchise tax report.

1. Engineering Wages: TBIC employs 10 hardware engineers who spend 100% of their time on the project. Their total wages are $1,200,000. Under the 80% rule, 100% of these wages are included.
2. Lab Support: Two lab assistants spend 50% of their time cleaning the specialized cleanroom and preparing samples. Their wages are $100,000. Since they do not meet the 80% rule, TBIC includes $50,000 as direct support IHRE.
3. Supplies: TBIC spent $200,000 on silicon wafers and specialized chemical sensors that are consumed during the testing of prototype batches. These are qualified supplies.
4. Capital Equipment: TBIC purchased a $500,000 laser etching machine for the R&D lab. Because this is a depreciable asset, its cost is excluded from IHRE.
5. Administrative Overhead: TBIC's HR and accounting departments spent significant time on R&D-related tasks. However, following Rule 3.599, these wages are excluded as indirect administrative costs.
6. Cloud Computing: TBIC paid $40,000 to a cloud provider for data storage and processing of its clinical trial results. These are included as computer usage fees.

Total 2024 Texas QRE (IHRE only): $1,490,000.

TBIC has been conducting research in Texas for several years. Its QREs for the three preceding tax periods were:

• 2023: $1,200,000
• 2022: $1,000,000
• 2021: $1,100,000

Step 1: Calculate the Average QRE for preceding periods.

$$\text{Average} = \frac{1,200,000 + 1,000,000 + 1,100,000}{3} = 1,100,000$$

Step 2: Determine 50% of the Average.

$$1,100,000 \times 0.50 = 550,000 \text{ (Base Amount)}$$

Step 3: Calculate the Difference.

$$1,490,000 - 550,000 = 940,000 \text{ (Excess QRE)}$$

Step 4: Apply the Credit Rate (5% under Subchapter M).

$$940,000 \times 0.05 = 47,000$$

Result: TBIC has established a current-year franchise tax credit of $47,000. If TBIC’s total franchise tax due was $100,000, it could use this entire credit (as it is less than 50% of the tax due) to reduce its liability to $53,000.

Strategic Considerations and Final Thoughts

The repeal of Subchapter M and its replacement with Subchapter T in 2026 marks the most significant change to the Texas R&D landscape in a decade. For businesses heavily reliant on IHRE, these changes are overwhelmingly positive but require a shift in documentation strategy.

One of the most streamlined aspects of the new law is its direct link to federal reporting. The definition of QRE will now be tied directly to Line 48 of IRS Form 6765 (attributable to Texas-based research). This "rolling conformity" ensures that as federal law changes—such as the recent requirement under the Tax Cuts and Jobs Act to capitalize and amortize R&D expenses—the Texas definition will follow suit. This reduces the administrative burden of maintaining two entirely separate sets of R&D books for state and federal purposes.

Perhaps the most impactful change for the innovation ecosystem is the introduction of refundability. Currently, the R&D credit is non-refundable, meaning it can only be used to offset tax owed. For early-stage companies with high IHRE but no revenue, the credit simply accumulates as a carryforward. Starting in 2026, entities that are not required to pay franchise tax (due to being under the revenue threshold or being a new veteran-owned business) can receive their R&D credit as a cash refund. This transforms the credit from a tax reduction tool into a direct funding mechanism for Texas startups.

Despite the move toward federal alignment, Texas auditors will remain diligent. The Comptroller has historically required detailed "nexus" documentation to prove that the research actually occurred in Texas. Businesses should ensure that their time-tracking systems identify the physical location of the employee at the time the work was performed. Furthermore, the Comptroller has recently authorized the use of statistical sampling for determining QREs, provided it follows IRS Revenue Procedure 2011-42. This is a critical development for large corporations with thousands of R&D employees, as it allows for a more efficient audit process.

In conclusion, In-house Research Expenses are the vital center of the Texas R&D tax credit. By carefully adhering to the Comptroller’s guidance on qualified services, avoiding the pitfalls of depreciable property in supply costs, and maintaining contemporaneous records, Texas businesses can significantly lower their tax burden and fuel further innovation. The transition to a permanent, enhanced, and potentially refundable credit in 2026 reinforces Texas's position as a premier destination for high-technology investment.