Tax Credit Limitation (50% of Franchise Tax Due)

The 50 percent limitation is a statutory ceiling that restricts the total Research and Development tax credit applied to a single report to half of the franchise tax due before other credits. It ensures that innovative entities maintain a baseline tax contribution while allowing excess credits to be carried forward for up to twenty years.

This limitation acts as a critical fiscal anchor within the Texas Tax Code, balancing the state’s desire to incentivize high-level technological innovation with the necessity of maintaining a stable and predictable revenue stream from the franchise tax. While the Research and Development (R&D) credit offers a significant reduction in tax liability for entities engaged in qualified research, the legislature has historically maintained that no single incentive should entirely eliminate a taxpayer’s obligation to the state’s General Revenue Fund, except in very specific circumstances involving small or veteran-owned businesses. Consequently, the 50 percent cap, currently codified in Section 171.658 and transitioning to Section 171.9207 under the new Subchapter T regime in 2026, requires sophisticated tax modeling for corporations to manage their credit carryforwards effectively. By capping the immediate utility of the credit, the state effectively mandates a longer-term realization of the tax benefit, which aligns with the multi-year nature of significant R&D cycles in industries such as aerospace, biotechnology, and semiconductor manufacturing.

Legislative Evolution and the Statutory Basis of the Credit Cap

The Texas R&D tax credit has undergone several structural transformations since its modern inception, yet the 50 percent limitation has remained a consistent pillar of the state’s tax policy. To understand the current application of this limit, one must examine the transition from the legacy Subchapter M framework to the permanent Subchapter T framework established by Senate Bill 2206 during the 89th Legislative Session.

Legacy Framework: Subchapter M (Tax Code Section 171.658)

Under the Subchapter M regime, which applies to reports originally due on or after January 1, 2014, and remains active through December 31, 2025, the credit amount is generally five percent of the difference between the qualified research expenses (QREs) incurred during the period and 50 percent of the average QREs incurred during the preceding three tax periods. Section 171.658 explicitly defines the limitation, stating that the total credit claimed—inclusive of any carryforward—cannot exceed 50 percent of the franchise tax due for the report before any other applicable tax credits.

This “before other credits” provision is essential for determining the order of operations in tax filing. It establishes the R&D credit as a primary offset, preventing its potency from being diminished by secondary credits that may be limited to the tax due “after all other credits”. For taxpayers, this means the R&D credit effectively competes only against itself and its own carryforwards for space under the 50 percent ceiling.

Modern Framework: Subchapter T (Tax Code Section 171.9207)

With the signing of Senate Bill 2206, the legislature made the R&D credit permanent and substantially increased the credit rates to enhance Texas’s competitiveness against other states. Effective for reports due on or after January 1, 2026, the new Section 171.9207 replicates the language of the previous limitation, maintaining the 50 percent cap.

Statutory Feature	Subchapter M (Pre-2026)	Subchapter T (Post-2026)
Limitation Provision	Section 171.658	Section 171.9207
Cap Percentage	50% of Tax Due	50% of Tax Due
Calculation Base	Before other credits	Before other credits
Carryforward Inclusion	Yes (Subchapter O & M)	Yes (Subchapter M & T)
General Credit Rate	5.000%	8.722%
University Rate	6.250%	10.903%

The decision to maintain the 50 percent cap even while nearly doubling the credit rate reflects a strategic policy choice: the state is willing to grant deeper incentives for innovation, but only if those incentives are realized over a longer time horizon via carryforwards. This ensures that as the dollar value of credits generated by Texas businesses increases, the immediate impact on the state’s biennial budget remains constrained by the 50 percent of tax due ceiling.

Defining the Mathematical Base: “Tax Due Before Other Credits”

The most frequent area of ambiguity for tax professionals is the definition of the “tax due” figure upon which the 50 percent limit is calculated. In the Texas franchise tax system, tax is not assessed on net income but rather on a “taxable margin”.

The Margin Calculation Sequence

A taxable entity must first determine its margin using one of four methodologies, selecting the one that produces the lowest tax liability:

1. 70% of Total Revenue: A simplified method often used by service-heavy firms.
2. Revenue minus Cost of Goods Sold (COGS): Primarily utilized by manufacturing and retail entities.
3. Revenue minus Compensation: Used by firms with high payroll costs, with compensation per person capped at $450,000 for 2024-25 and $480,000 for 2026-27.
4. Revenue minus $1 Million: A standard deduction effective since 2014.

Once the margin is calculated and apportioned to Texas via the single-receipts factor, the applicable tax rate (0.75% for most businesses or 0.375% for retail/wholesale) is applied to reach the “Tax Due”. It is this figure—the tax after apportionment and rate application but before any credits—that serves as the denominator for the 50 percent limitation.

Administrative Reporting on Form 05-160

The Comptroller of Public Accounts provides a clear administrative pathway for this calculation on Form 05-160, the “Texas Franchise Tax Credits Summary Schedule”. Part A of the form is dedicated to the “Credit Limit,” where Item 1 requires the taxpayer to enter the tax due before credits from the main franchise tax report (Form 05-158-B). Item 2 then directs the taxpayer to multiply that amount by 0.50. This resulting value is the maximum “Research credit claimed” that can be entered in Part C, Item 19 of the form.

If a taxpayer possesses credits (current year plus carryforwards) exceeding this limit, the administrative instructions mandate that only the amount up to the limit be claimed, with the remainder tracked as an unused carryforward for future reports.

State Revenue Office Guidance: Policy Memoranda and Rules

The Texas Comptroller’s Tax Policy Division has issued specific guidance clarifying how the 50 percent limitation interacts with other statutory requirements, most notably the statute of limitations and the order of credit application.

Order of Application (Policy Memorandum 202501001M)

A significant concern for entities with multiple incentives is which credits must be “consumed” first. Policy Memorandum 202501001M provides the definitive hierarchy. Because Section 171.658 specifies that the R&D credit limit is 50 percent of the tax due before other credits, the R&D credit must be calculated and applied as if it were the primary offset.

Order	Credit Category	Limitation Basis
1st	R&D Credits (Subchapters O, M, and T)	50% of tax due before other credits
2nd	Clean Energy Project Credit	Tax due after all other credits
3rd	Historic Structure Credit	Tax due after all other credits
4th	Housing Development Credit	Tax due after all other credits

The Comptroller’s rationale is that by applying the R&D credit first, taxpayers can maximize their total credit utilization. Since secondary credits like the Historic Structure Credit are limited to the tax due after other credits, they can be used to wipe out the remaining 50 percent of liability that the R&D credit was legally prohibited from touching. Within the R&D bucket itself, the law requires that carryforwards be applied in chronological order: first Subchapter O, then Subchapter M, and finally current-year Subchapter T credits.

Statute of Limitations and Credit Creation (Policy Memorandum 202301007M)

Another vital piece of guidance relates to the “creation” of credits. In Policy Memorandum 202301007M, the Comptroller addresses whether a taxpayer can create an R&D credit by filing an amended report for a year that is outside the four-year statute of limitations for refund claims.

The Comptroller’s position is clear: a taxpayer cannot create a credit in a closed year to generate a carryforward for an open year. Section 171.661 requires the credit to be applied for on or with the report for the period for which it is claimed. If that period is closed, the taxpayer is barred from establishing the credit, and consequently, there is no “unused credit” available to carry forward into the 20-year window. This highlights the importance of claiming the R&D credit and calculating its 50 percent limitation accurately on the original, timely filed report, even if no tax is currently due.

The Refundability Exception: A Strategic Pivot for 2026

The most profound change in the meaning of the 50 percent limitation occurs in the context of the new refundability provisions for small and veteran-owned businesses.

Disapplication of the Cap for No-Tax-Due Entities

Under the legacy Subchapter M, the 50 percent cap was absolute; if a firm owed no tax (due to being below the revenue threshold), the credit could only be established and carried forward, providing no immediate liquidity. However, the new Section 171.9205(b) explicitly states that for entities not required to pay franchise tax, the 50 percent limitation prescribed by Section 171.9207 does not apply.

This exception is designed to offset the repeal of the sales and use tax exemption for R&D equipment. Under the old system, a startup with no revenue could still save money by not paying sales tax on laboratory equipment. Without the sales tax exemption, these pre-revenue firms would have had no immediate incentive until SB 2206 introduced refundability.

Defining the Refundable Population

The entities exempt from the 50 percent limitation include:

• Businesses below the No-Tax-Due Threshold: For 2026-2027, this threshold is projected at $2,650,000 in total revenue.
• New Veteran-Owned Businesses: Qualifying entities during their initial five-year exemption period.

For these taxpayers, the R&D credit acts as a cash refund rather than a liability offset. Because there is no “tax due” to take 50 percent of, the legislature recognized that the cap would effectively render the credit useless for the very startups it sought to nurture. By removing the cap for this cohort, Texas ensures that its innovation ecosystem remains robust even for firms in the “valley of death” between research and commercialization.

Technical Nuances of “Qualified Research Expenses” (QREs)

The denominator of the limitation is the tax due, but the numerator—the credit itself—is driven by the definition of QREs. The transition to Subchapter T brings a significant shift in how these expenses are identified, moving from a static reference to the 2011 Internal Revenue Code (IRC) to a “rolling conformity” with current federal line 48 of Form 6765.

Alignment with Federal Line 48

Effective 2026, the Texas QRE is defined as the portion of the amount reported on Line 48 of federal Form 6765 that is attributable to research conducted in Texas. This alignment is intended to reduce administrative burdens and factual disputes during audits. However, the Comptroller has issued specific warnings regarding the interplay between IRC Section 41 (the credit) and Section 174 (amortization of research costs).

In a 2025 policy memorandum, the Comptroller clarified that for an expense to be a QRE (and thus part of the credit that is subject to the 50 percent cap), it must not be “property of a character subject to the allowance for depreciation”. Even if an expense is deductible or amortizable under Section 174, it cannot be treated as a “supply” QRE if it is depreciable under Section 167. This distinction is critical because including ineligible depreciable property in the credit calculation would artificially inflate the credit, potentially leading to an over-application against the 50 percent limit that would be overturned on audit.

Funded Research and Substantial Rights

Guidance under Rule 3.599(b)(5) further refines what research may be included in the credit calculation. A key limitation involves “funded research,” which is excluded from the credit base. Research is considered funded—and thus ineligible—if the entity performing the research retains no substantial rights to the results or if the payments are not contingent on the success of the research.

For entities involved in complex government contracting or third-party R&D, the 50 percent limitation often becomes a secondary concern compared to the primary hurdle of proving “substantial rights”. If the Comptroller determines the research was funded, the credit may be reduced to zero, making the 50 percent cap moot.

Practical Example: Multi-Year Credit Management

To illustrate the application of the 50 percent limitation and the carryforward mechanism, consider “AeroTex Dynamics,” a hypothetical aerospace firm conducting advanced propulsion research in Fort Worth.

Scenario A: Profitable Operation (2026 Report)

AeroTex Dynamics has a successful year with high revenue and significant R&D spending, including a contract with the University of Texas at Arlington.

1. Calculate Potential Credit (Subchapter T):
   • Texas QREs: $10,000,000
   • Base Amount (50% of 3-year Avg): $4,000,000
   • Incremental QREs: $6,000,000
   • University Contract Portion: $1,000,000
   • Standard Portion: $5,000,000
   • Credit Calculation:
   • Standard: $5,000,000 x 8.722% = $436,100.
   • University: $1,000,000 x 10.903% = $109,030.
   • Total Earned Credit: $545,130
2. Calculate Tax Due Base:
   • Apportioned Taxable Margin: $80,000,000
   • Tax Rate (Non-retail): 0.75%
   • Tax Due Before Credits: $600,000.
3. Apply 50% Limitation:
   • Statutory Cap: $600,000 x 50% = $300,000.
   • Credit Claimed on 2026 Report: $300,000
   • Unused Credit for Carryforward: $545,130 – $300,000 = $245,130.

In this scenario, AeroTex pays $300,000 in franchise tax. The remaining $245,130 of the credit is moved to a carryforward schedule, available for use on the 2027 report.

Scenario B: Low-Revenue Startup Transition (2026 Report)

Assume a different entity, “NanoVets LLC,” a new veteran-owned business with high R&D but revenue below the $2.65M threshold.

1. Calculate Potential Credit:
   • Texas QREs: $500,000
   • No Prior QRE History Rate: 4.361%.
   • Total Earned Credit: $21,805
2. Apply Limitation Exception:
   • Tax Due: $0 (Below threshold).
   • Limitation Status: Section 171.9205(b) disallows the 50% cap.
   • Result: NanoVets LLC applies for and receives a cash refund of $21,805 from the Comptroller.

Combined Group Complexity and Member Attrition

For large multinational corporations operating in Texas, the 50 percent limitation is applied at the combined group level. This brings unique challenges when the composition of the group changes over time.

Group-Level Caps

The “taxable entity” for purposes of the credit is the combined group as defined by Section 171.1014. Therefore, the 50 percent cap is calculated against the group’s total apportioned tax liability. This allows a member with high tax liability but no R&D to “shield” the credits generated by a research-intensive affiliate within the same group.

Attribution of Carryforwards (Rule 3.599(i))

When a member leaves a combined group, the treatment of any carryforward that was generated while it was a member but restricted by the 50 percent cap becomes a matter of complex attribution. Under Rule 3.599(i)(3), the carryforward is generally attributed to the members based on their relative QRE contributions in the year the credit was established.

If a member of a group that has $1,000,000 in carryforwards leaves to become a standalone entity, and that member was responsible for 20% of the group’s QREs during the years the credits were earned, it may be entitled to take $200,000 of that carryforward with it. This entity would then be subject to its own 50 percent limitation as a standalone filer in future years.

Comparison of Limitation Dynamics: Combined vs. Separate Filer

The following table summarizes how the 50 percent limitation impacts different entity types under the post-2026 Subchapter T rules:

Entity Type	Base for 50% Limit	Refundable?	Carryforward Limit
Large Combined Group	Aggregate Group Tax	No	20 Consecutive Reports
Mid-Market Corp	Entity-Level Tax	No	20 Consecutive Reports
Startup (< $2.65M Rev)	N/A (Exempt)	Yes	N/A (Fully Refunded)
New Veteran-Owned Biz	N/A (Exempt)	Yes	N/A (Fully Refunded)

Audit Verification and the 50 Percent “Look-Back”

The Comptroller’s Audit Division frequently reviews R&D claims, and the 50 percent limitation is a common point of adjustment. If an auditor reduces the “Tax Due Before Credits” through other adjustments (such as changing the COGS or Compensation deduction), the 50 percent credit limit automatically contracts as well.

For example, if a firm originally reported $1,000,000 in tax due and claimed a $500,000 R&D credit, but an audit reduces the tax due to $800,000, the allowable R&D credit is reduced to $400,000. The $100,000 difference becomes an additional tax liability, subject to penalties (5% to 10%) and interest. However, that “lost” $100,000 is not permanently forfeited; it simply reverts to a carryforward status, provided the 20-year window has not expired.

Strategic Implications of the 20-Year Carryforward

The interaction between the 50 percent cap and the 20-year carryforward creates a “long-tail” incentive structure. This is particularly relevant for capital-intensive industries where profitability may be deferred for a decade while research continues.

Because the 50 percent limit prevents immediate monetization, the “Effective Tax Rate” of an innovative company in Texas is essentially stabilized at 50% of the statutory rate for the duration of its carryforward period. For a firm with a 0.75% tax rate, the effective rate becomes 0.375% once the R&D credit is applied. This provides a highly predictable tax environment that supports long-term capital budgeting and encourages sustained reinvestment in Texas-based research facilities.

Final Thoughts

The 50 percent limitation is the defining boundary of the Texas R&D tax credit, representing the state’s commitment to a balanced fiscal policy that rewards innovation without compromising the foundational revenue of the franchise tax. While the 2026 overhaul through Senate Bill 2206 provides massive gains for taxpayers in the form of higher rates and permanency, the retention of the 50 percent cap—coupled with the strategic exception for no-tax-due entities—ensures that the incentive remains scalable for the state’s budget.

For tax professionals, navigating this limitation requires a holistic understanding of the “before other credits” sequence, a rigorous adherence to the statute of limitations for credit creation, and a meticulous tracking of 20-year carryforward schedules across evolving combined group memberships. As Texas continues to position itself as a global leader in technological advancement, the 50 percent limitation will remain the primary mechanism for distributing the fiscal impact of that growth over the decades to come.