Qualified Research Expenses (QREs)

Qualified Research Expenses represent the Texas-localized financial expenditures for labor, materials, and contracted expertise directly utilized in the systematic investigation and development of technological advancements. These expenses serve as the primary metric for determining the value of state tax incentives designed to foster a competitive environment for innovation and high-wage employment within the Texas economy.

The conceptual foundation of Qualified Research Expenses (QREs) in Texas is rooted in a deliberate alignment between state fiscal policy and federal tax standards, primarily Section 41 and Section 174 of the Internal Revenue Code (IRC). This alignment is not merely an administrative convenience but a strategic effort to reduce the compliance burden on taxpayers by allowing them to utilize existing federal data to substantiate state-level claims. Historically, the Texas tax code provided a choice for entities engaged in research: a sales and use tax exemption on depreciable property used directly in research or a franchise tax credit based on QREs. This dual-track system, governed by Subchapter M of Chapter 171 of the Texas Tax Code, was designed to accommodate different business models—providing immediate sales tax relief for capital-intensive R&D or long-term franchise tax relief for labor-intensive R&D. However, the landscape of Texas research incentives has undergone a radical transformation with the passage of Senate Bill 2206 (SB 2206) during the 89th Legislative Session in 2025. This legislation, effective January 1, 2026, repeals the elective sales tax exemption and the existing Subchapter M franchise tax credit, replacing them with a more robust, permanent, and simplified franchise tax credit under a new Subchapter T.

Theoretical and Statutory Evolution of the Texas Research Credit

The origin of the current Texas R&D credit framework can be traced back to House Bill 800 in 2013, which established the “either/or” elective system that became effective in 2014. Under this regime, the Comptroller of Public Accounts was tasked with interpreting federal IRC standards as they existed on December 31, 2011. This “static conformity” meant that any subsequent changes to federal regulations or judicial interpretations did not automatically apply to the Texas credit unless specifically adopted by the state legislature or the Comptroller through the rulemaking process. This lack of synchronicity often led to significant friction between taxpayers and state auditors, particularly regarding emerging technologies like cloud computing and advanced software development.

The adoption of 34 Texas Administrative Code (TAC) § 3.599 provided the regulatory meat to the statutory bones of Subchapter M, detailing exactly how a “taxable entity” or a “combined group” must calculate and establish their eligibility. A critical insight into the evolution of this guidance is the 2021 update to TAC 3.599, which introduced controversial restrictions on internal-use software and applied them retroactively to 2014. This regulatory shift created an atmosphere of uncertainty that legislative leaders sought to resolve with the 2025 overhaul.

By transitioning to Subchapter T, the state has moved toward “rolling conformity” for the specific purpose of defining QREs. The new law directly ties the definition of a Texas QRE to the amount reported on Line 48 of the federal Internal Revenue Service (IRS) Form 6765. This shift represents a second-order insight into Texas tax policy: the state has prioritized administrative efficiency and “federal audit flow-through” over maintaining its own independent definitions of research expenditures. Consequently, if the IRS accepts a taxpayer’s research expenses during a federal audit, the Texas Comptroller is now statutorily positioned to adopt those findings for the Texas portion of the research, provided the activities occurred within the state.

Comparison of Subchapter M and Subchapter T Frameworks

The following table highlights the structural differences between the legacy system and the modernized framework that takes effect in 2026.

Quantitative Components of Qualified Research Expenses

To understand the legal meaning of QREs, one must analyze the four distinct categories of expenditures permitted under both federal and Texas law. While the federal government provides the overarching definitions, Texas applies a “geographic nexus” requirement, mandating that the research be conducted specifically within the state to be included in the Texas computation.

In-House Research: Wages and Personnel Costs

Wages constitute the majority of most R&D tax credit claims. In the context of the Texas credit, “qualified services” include employees who are performing the research, as well as those providing direct supervision or direct support of the research activities. The Comptroller’s office has provided detailed guidance through Rule 3.599 to distinguish between direct and indirect labor.

“Direct conduct” of research is generally defined as the actual physical or intellectual performance of the experimentation process. For instance, a chemist mixing compounds to observe a reaction or a software engineer writing a new proprietary encryption algorithm is engaging in the direct conduct of research. “Direct supervision” refers to the immediate, first-line management of those performing the research. A laboratory manager who oversees the daily progress of research scientists, but does not necessarily mix the chemicals themselves, qualifies under this definition. However, the Comptroller has made it clear that “direct supervision” does not extend to high-level executives or managers to whom the first-line managers report, even if those high-level individuals possess scientific expertise.

“Direct support” includes activities that are essential to the research process but do not constitute the research itself. This category is often scrutinized during audits. Examples provided in official state guidance include the services of a secretary typing laboratory results, a technician cleaning specialized research equipment, a clerk compiling data for analysis, or a machinist creating a prototype for testing. Conversely, general administrative functions—such as human resources, payroll processing, general accounting, or janitorial services for non-research areas—are strictly excluded.

The calculation of these wages for Texas purposes requires the use of IRS Form W-2 data. A significant second-order implication of state guidance is the “80% Rule.” If a taxable entity can demonstrate that an employee spent at least 80% of their working time in the performance of qualified services, then 100% of that employee’s wages may be treated as a QRE. If the time spent is below 80%, the entity must use a “reasonable method” to apportion the wages, typically multiplying the total W-2 wages by the ratio of time spent on qualified activities versus total work time.

In-House Research: Supplies and the Depreciable Property Conflict

Supplies represent any tangible personal property used in the conduct of qualified research, with the notable exception of land, improvements to land, and property of a character subject to an allowance for depreciation. The distinction between a “supply” and “depreciable property” has historically been the source of the most intense litigation and administrative disagreement between taxpayers and the Texas Comptroller.

In a landmark policy memorandum issued on March 24, 2025 (Accession Number 66350), the Comptroller clarified that property subject to depreciation under IRC Section 167 or 168 cannot qualify as a “supply” QRE, regardless of whether the taxpayer chooses to expense the item under IRC Section 174. Taxpayers often argued that if they deducted the cost of an item immediately under Section 174, the item was not “depreciable” in their books and should therefore count as a supply. The Comptroller’s guidance overrides this logic, asserting that the “character” of the property—meaning its useful life and general nature—determines its depreciability, not the specific accounting election made by the taxpayer.

This conflict was essentially the catalyst for the legislative overhaul in SB 2206. The new law provides that expenses for supplies properly reported as QREs for federal purposes cannot be excluded by the Comptroller solely on the basis that those supplies are taxable, nontaxable, or exempt from state sales and use tax. This creates a massive shift in favor of the taxpayer starting in 2026, as it effectively removes the Comptroller’s ability to “second-guess” the federal classification of supplies unless the IRS has already done so.

Contract Research Expenses and the Funded Research Doctrine

Contract research involves payments made to third parties—other than employees—for the performance of qualified research on behalf of the taxable entity. Under Texas law, these expenses are generally limited to 65% of the total payment. However, this percentage increases to 75% for payments made to qualified research consortia and certain small businesses or universities.

State revenue office guidance, as codified in Rule 3.599(b)(5), explicitly excludes “funded research” from being a QRE. For research to be non-funded (and thus qualified), the taxpayer must meet two stringent criteria in their contract:

1. Financial Risk: The taxable entity must be required to bear the expense of the research even if it is unsuccessful. If payment is contingent upon the success of the research, the entity has not incurred a “qualified research expense” because the risk was transferred to the contractor.

2. Substantial Rights: The taxable entity must retain substantial rights to the results of the research. “Substantial rights” mean more than just the incidental benefit of increased experience; it requires the entity to own or have a non-exclusive right to use the research without paying for it later.

If a taxable entity performs research for another person but does not retain these rights, the research is considered “funded” by the other person, and the entity performing the work cannot claim the credit. This “all-or-nothing” approach to funded research requires meticulous contract drafting to ensure that the Texas nexus is preserved and the credit eligibility is not inadvertently transferred to a vendor or customer.

Computer Rental and Leasing in the Cloud Era

The final category of QREs involves amounts paid or incurred to another person for the right to use computers in the conduct of qualified research. In the modern digital economy, this most frequently applies to cloud computing resources like AWS, Azure, or Google Cloud that are used specifically for R&D workloads. Routine data processing or administrative use of cloud software does not qualify. The Comptroller’s guidance emphasizes that the computer use must be “direct.” For example, if a developer uses a cloud environment to host a test sandbox for a new product, that expense is a QRE. If the same environment is used to host a company’s internal email system, it is not.

Calculation Methodologies and Incremental Benefit

The Texas R&D credit is designed as an “incremental” incentive, rewarding businesses that increase their innovation spending year-over-year. The calculation methodology varies depending on the taxpayer’s history and their collaboration with Texas academic institutions.

The Standard Calculation (Incremental Method)

For businesses that have conducted research in Texas for the three tax periods preceding the current report, the credit equals 8.722% of the difference between the current year’s QREs and a “base amount”. The base amount is defined as 50% of the average QREs incurred during the three tax periods immediately preceding the report period.

This formula creates a high hurdle for established companies, as they must significantly grow their R&D spend to see a meaningful credit. However, the legislation ensures that the determination of what was a QRE in a previous period remains consistent, even if the statute of limitations for those previous years has expired.

Startup and New Entrant Calculations

Recognizing that startups and companies entering the Texas market may lack a three-year baseline, the law provides a “reduced rate” calculation that does not utilize a base amount. If an entity has no QREs in one or more of the three prior years, the credit is simply a flat percentage of the current year’s QREs.

• Standard Rate for New Entrants: 4.361% of current year Texas QREs.
• University Contract Rate for New Entrants: 5.451% of current year Texas QREs.

This provision is automatic and does not require an election, making the Texas credit one of the most accessible in the nation for the venture-backed startup community.

Higher Education Contract Enhancement

Texas provides a distinct financial incentive for businesses to collaborate with state universities. If a taxable entity contracts with a public or private institution of higher education for the performance of qualified research, the standard credit rate is increased from 8.722% to 10.903%.

The definition of a “public or private institution of higher education” is strictly limited to accredited Texas institutions as defined by Section 61.003 of the Texas Education Code. This includes:

• General academic teaching institutions (e.g., UT Austin, Texas A&M).
• Public technical institutes (e.g., Texas State Technical College).
• Accredited private or independent colleges and universities.

A third-order insight here is that research performed with out-of-state universities, such as MIT or Stanford, only qualifies at the standard 8.722% rate, and only for the portion of the work actually conducted in Texas. This creates a powerful economic “moat” around Texas universities, encouraging local industry to reinvest in the state’s academic talent pool.

Administrative Procedures and Registration Requirements

Claiming the Texas R&D credit involves a multi-step administrative process that begins with the Comptroller’s office and continues through the annual franchise tax reporting cycle.

Registration and the RD Number

Before claiming the (now-repealed) sales tax exemption, taxpayers were required to register with the Comptroller to obtain a Texas Qualified Research Registration Number. This registration number, which begins with the prefix “RD,” remains relevant for entities transitioning from the old system to the new franchise-only system. For those claiming the sales tax exemption prior to 2026, the registration must be renewed annually by filing an Annual Information Report (AIR) on or before March 31. Failure to file the AIR can result in the cancellation of the registration and the potential assessment of back taxes, penalties, and interest on all “tax-free” purchases made during the cancelled period.

Filing Forms for 2026 Reports

The Comptroller has developed a new suite of forms to manage the Subchapter T credit. For reports due in 2026, the primary schedules include:

One significant change under SB 2206 is the mandate for “Combined Reporting.” If a company is part of a combined group, the group must claim the credit on a single combined report. An upper-tier entity can claim the credit for expenses incurred by a lower-tier entity to the extent of its ownership interest, ensuring the benefit flows through complex corporate structures.

Refundability for Low-Revenue and Veteran-Owned Businesses

Under the legacy rules, the R&D credit was strictly non-refundable and could only be used to offset 50% of the franchise tax liability. Any unused credit was carried forward for up to 20 years. While the 20-year carryforward remains, the new Subchapter T introduces a groundbreaking “refundability” provision.

A taxable entity that incurs QREs during a period for which it owes no franchise tax—such as a startup below the $2.65 million no-tax-due threshold or a new veteran-owned business—may apply for a cash refund of the credit. To receive this refund, the entity must submit the Comptroller’s specific refund application form on or before the date their franchise tax report would have been due. This provides critical non-dilutive capital to early-stage ventures that are not yet profitable but are contributing to the state’s innovation economy.

Detailed Audit Protocols and Documentation Standards

The Texas Comptroller’s office has an aggressive audit program for R&D credits, driven by the substantial revenue impact of these claims. Taxpayers must be prepared to defend every dollar of their QREs with contemporaneous records.

The Audit Lifecycle

A Texas R&D audit typically begins with a “Notice of Audit” and a request for a completed “Audit Questionnaire”. This questionnaire helps the auditor understand the business operations and identify the location of research projects. The auditor then conducts an “Entrance Conference” to design a cost-efficient audit plan.

A critical procedural insight is the “45-Day Rule”: once an auditor makes initial contact, if an appointment is not set within 45 days, a written follow-up is required every 45 days thereafter. This prevents audits from languishing and ensures a timely resolution. During the “Examination of Records,” the auditor will request documents including, but not limited to:

• General ledgers and charts of accounts.
• Depreciation schedules and capital asset invoices (to verify the “depreciable property” exclusion for supplies).
• W-2 forms and time-tracking data.
• Project narratives and technical design documents.

If the auditor finds errors, the taxpayer is given time to dispute the adjustments. If disagreements persist after the “Exit Conference,” the taxpayer can request a “Reconciliation Conference” with an audit manager or an “Independent Audit Review (IAR) Conference” with a third-party reviewer to attempt to resolve the issues without litigation.

Statistical Sampling and Federal Conformity

For large claimants, Texas law allows the use of statistical sampling as permitted by Texas Tax Code Section 111.0042. Specifically for R&D, the state follows IRS Revenue Procedure 2011-42, which provides the gold standard for sampling methodologies.

Under SB 2206, there is a “mandatory acceptance” provision: if the IRS (or the Comptroller) has audited a federal return and accepted the adjusted Accounting Standards Codification (ASC) 730 financial statement R&D costs as sufficient evidence of QREs, the Texas portion of those costs must be accepted as sufficient for the Texas credit. This prevents auditors from using overly aggressive or non-standard documentation requirements to deny credits that have already passed federal scrutiny.

Record Retention Best Practices

While the standard statute of limitations is four years, the 20-year carryforward period for R&D credits creates a unique documentation challenge. Taxpayers must retain records not only for the current year but for the years in which the credit was created. If an entity claims a carryforward from a “closed” tax year, the Comptroller has the authority to verify the QREs in that closed year specifically to validate the carryforward amount in the current “open” year. Consequently, a best practice for Texas researchers is to retain all R&D-related documentation for 20 years plus the standard statute period, or at least until the carryforward is fully utilized.

Interaction with Federal Bonus Depreciation

A final, complex layer of state guidance relates to how the Texas franchise tax interacts with federal bonus depreciation rules. In December 2025, Acting Texas Comptroller Kelly Hancock announced an update to the agency’s interpretation of depreciation rules. Effective with the 2026 report, Texas will align its rules with the federal “One Big Beautiful Bill Act of 2025,” allowing businesses to take advantage of bonus depreciation for assets acquired after January 19, 2025.

This is relevant for QREs because it reinforces the state’s commitment to “current IRC” rules rather than the outdated 2007 IRC rules previously used for franchise tax depreciation. For R&D purposes, this means that while capital assets themselves may not be “supply” QREs, the underlying accounting treatment for those assets on the franchise tax report is now fully synchronized with federal books, further reducing the “red tape” associated with innovation in Texas.

Illustrative Practical Example: “NexGen Bio-Materials LLC”

To synthesize these complex rules, consider the fictional entity “NexGen Bio-Materials LLC,” a Houston-based company developing biodegradable surgical mesh.

Year 1: Baseline Establishment (2023-2025)

NexGen has been active in Texas for three years, with the following annual QREs:

• 2023: $1,200,000
• 2024: $1,500,000
• 2025: $1,800,000
• Three-Year Average: $1,500,000
• Base Amount (50%): $750,000

Year 2: Current Period Research (2026)

In 2026, NexGen incurs the following costs:

1. Texas Wages: $1,500,000 for its team of lab scientists.
2. Supplies: $400,000 in specialized biodegradable polymers and chemicals consumed during testing.
3. Contract Research (Standard): $200,000 to an independent lab for clinical testing (NexGen owns the data).
4. University Collaboration: $300,000 paid to Rice University for specialized molecular modeling.
5. Cloud Computing: $100,000 in Azure costs for virtual stress tests.

Step-by-Step Credit Calculation

First, NexGen must calculate its Total Texas QREs for 2026:

• Wages: $1,500,000
• Supplies: $400,000
• Contract Research (Standard): $130,000 ($200,000 x 65%)
• Contract Research (University): $195,000 ($300,000 x 65%)
• Cloud Computing: $100,000
• Total 2026 QREs: $2,325,000

Because NexGen contracted with a Texas university, it is eligible for the enhanced 10.903% rate.

• Excess QREs: $2,325,000 (Current) – $750,000 (Base) = $1,575,000
• Credit Calculation: $1,575,000 x 0.10903 = $171,722.25

Filing and Utilization

NexGen’s total franchise tax liability for 2026 is $200,000.

• 50% Liability Cap: $200,000 x 0.50 = $100,000.
• Credit Claimed on 2026 Report: $100,000.
• Credit Carryforward: $171,722.25 – $100,000 = $71,722.25.

NexGen will report this carryforward on Schedule 05-181 of its 2027 report. If NexGen had been a veteran-owned business with zero tax due, it could have requested the entire $171,722.25 as a cash refund.

Final Thoughts

The overhaul of the Texas R&D tax credit system starting in 2026 represents a strategic realignment of the state’s economic incentives. By eliminating the cumbersome “either/or” elective system and moving toward rolling conformity with federal IRC Line 48 definitions, Texas has removed significant administrative hurdles for taxpayers. The substantial increase in the credit rate—from a standard 5% to over 8.7%—is a clear signal that the state is willing to compete with other tech-heavy states like California and Massachusetts.

However, the repeal of the sales tax exemption necessitates a careful reevaluation of procurement strategies for research-heavy industries. Since depreciable equipment can no longer be “exempt” at the point of sale, and since state guidance prohibits depreciable property from being counted as a “supply” QRE, capital-intensive research projects may face higher upfront costs. The higher franchise tax credit rate is intended to offset this over time, but businesses must manage the cash-flow timing difference.

Finally, the new refundability provision for low-revenue and veteran-owned businesses is perhaps the most transformative aspect of the new law. It democratizes the R&D incentive, ensuring that the state’s smallest and most innovative companies can access capital exactly when they need it most: during the pre-revenue experimentation phase. As the Texas Comptroller’s office continues to roll out new forms and administrative guidance throughout 2025 and 2026, businesses should ensure their recordkeeping is fully aligned with federal standards to take full advantage of this enhanced innovation framework.