Internal Revenue Code Section 41 defines the federal tax credit for increasing research activities by establishing rigorous criteria for qualified research and eligible expenditures. In the Texas tax landscape, this section serves as the statutory anchor for state-level franchise tax credits and sales tax exemptions designed to foster regional technological advancement.
The Internal Revenue Code (IRC) Section 41 represents one of the most significant fiscal interventions in the United States’ history, designed to stimulate private sector investment in scientific and technological innovation. Historically, the credit was enacted as a temporary measure under the Economic Recovery Tax Act of 1981 to counter a stagnation in domestic research spending. Over the ensuing decades, it evolved into a permanent fixture of the federal tax code, establishing a complex framework that distinguishes routine business development from “qualified research.” Within the jurisdiction of Texas, the adoption of IRC Section 41 is not merely a reference but a foundational integration into the Texas Tax Code. This integration traditionally occurred through Subchapter M of Chapter 171, which governs the franchise tax credit, and Section 151.3182, which provides for a sales and use tax exemption. The state’s reliance on federal definitions ensures a level of administrative consistency while allowing the Texas Comptroller of Public Accounts to overlay specific geographic and procedural requirements that serve the state’s economic development objectives. The recent enactment of Senate Bill 2206 has further modernized this relationship, moving Texas from a “static” conformity model—tethered to the 2011 version of the IRC—to a “dynamic” model that aligns more closely with contemporary federal standards.
The Federal Framework: Detailed Analysis of IRC Section 41
To understand the Texas R&D tax credit, one must first deconstruct the federal “engine” that powers it. IRC Section 41(a) provides a general rule for the determination of the credit, which is calculated as the sum of 20 percent of the excess of qualified research expenses (QREs) for the taxable year over a calculated base amount, and 20 percent of basic research payments. The credit is designed as an incremental incentive, rewarding taxpayers who increase their research intensity relative to a historical baseline.
The Statutory Gateway: The Four-Part Test
The determination of “qualified research” is governed by Section 41(d)(1), which mandates that an activity must satisfy all four parts of a rigorous test to be eligible for the credit. This test must be applied separately to each “business component,” which is defined as any product, process, computer software, technique, formula, or invention held for sale, lease, or license, or used by the taxpayer in its trade or business.
| Test Requirement | Statutory Description | Functional Standard for Eligibility |
|---|---|---|
| Permitted Purpose Test | The research must relate to a new or improved function, performance, reliability, or quality of a business component. | The activity must seek to improve the functional utility of the product or process, specifically excluding aesthetic or seasonal modifications. |
| Elimination of Uncertainty Test | The research must be intended to discover information that would eliminate uncertainty regarding capability, method, or design. | Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing the component, or the appropriate design. |
| Process of Experimentation Test | Substantially all (80% or more) of the activities must involve a process designed to evaluate one or more alternatives. | This requires a systematic evaluation of alternatives through modeling, simulation, or systematic trial and error, moving beyond simple brainstorming. |
| Technological in Nature Test | The process of experimentation must fundamentally rely on principles of physical, biological, or computer sciences or engineering. | The research must be grounded in the “hard sciences” rather than social sciences, humanities, management, or economic theory. |
The “substantially all” requirement within the process of experimentation test is particularly critical. Federal and state authorities interpret this to mean that at least 80 percent of the research activities for each business component, measured on a cost or other reasonable basis, must constitute a process of experimentation for a qualified purpose. If a project as a whole fails the four-part test, the “shrink-back” rule allows a taxpayer to apply the tests to increasingly smaller subsets of the project until a qualifying component is identified.
Classification of Qualified Research Expenses (QREs)
Eligible expenses under Section 41 are categorized into in-house research expenses and contract research expenses, each with specific requirements and limitations.
- Wages for Qualified Services: Under Section 41(b)(2), qualified wages include any amount paid or incurred to an employee for “qualified services.” This encompasses not only the actual performance of research but also the “direct supervision” or “direct support” of research activities. Direct supervision refers to first-line management, while direct support includes activities like a laboratory technician cleaning equipment or a machinist building a prototype specifically for research purposes. If “substantially all” (80% or more) of an employee’s services are qualified, 100% of their wages may be included.
- Supplies Used in Research: Section 41(b)(2)(C) defines supplies as any tangible property other than land or improvements to land and property of a character subject to the allowance for depreciation. This exclusion of depreciable property is a frequent point of contention in state audits, particularly when taxpayers attempt to include the cost of pilot models or prototypes that may have a useful life beyond the research phase.
- Computer Rental and Lease Costs: Taxpayers may include amounts paid for the right to use computers in the conduct of qualified research. In the contemporary digital economy, this often extends to cloud computing services and server space dedicated to running simulations or developing software.
- Contract Research Expenses: Generally, 65 percent of payments made to third parties for research conducted on the taxpayer’s behalf are includable. However, for payments to “qualified research consortia”—typically non-profit organizations or universities—the inclusion rate increases to 75 percent. To qualify, the taxpayer must bear the economic risk of the research and retain “substantial rights” to the results.
Statutory Exclusions and Prohibited Activities
Section 41(d)(4) provides an exhaustive list of activities that do not constitute qualified research, regardless of whether they meet the four-part test. These exclusions are strictly enforced by the Texas Comptroller to ensure that credits are only awarded for true innovation.
| Exclusion Category | Description of Prohibited Activity | Regulatory Impact |
|---|---|---|
| Post-Commercial Production | Research conducted after the beginning of commercial production of the business component. | Excludes pre-production planning, tooling up, and debugging production equipment. |
| Adaptation of Components | Research related to the adaptation of an existing component to a specific customer’s requirement. | Excludes custom modifications that do not involve fundamental technological advancements. |
| Duplication of Components | Research related to reproducing an existing component from plans, blueprints, or physical examination. | Prohibits credits for “reverse engineering” activities. |
| Foreign Research | Any research conducted outside the United States, Puerto Rico, or U.S. possessions. | Limits the fiscal benefit to domestic economic activity. |
| Funded Research | Research to the extent it is funded by any grant, contract, or other person or entity. | Prevents “double-dipping” by the researcher if the funding party retains the rights. |
The Texas Context: Subchapter M and Historical Continuity
The Texas Research and Development Tax Credit was established in its modern form by the 83rd Legislature in 2013 via House Bill 800. This legislation introduced Subchapter M to Chapter 171 of the Texas Tax Code, providing a framework for taxpayers to claim either a franchise tax credit or a sales tax exemption. For over a decade, the hallmark of the Texas program was its “static” conformity to the Internal Revenue Code. Specifically, Section 171.651(3) defined “qualified research” by reference to IRC Section 41 as it was in effect on December 31, 2011.
The Dual Election Strategy
Under Subchapter M, taxpayers engaged in qualified research were required to choose between two mutually exclusive incentives for each period.
- The Franchise Tax Credit: This was calculated as 5 percent of the difference between the QREs incurred in Texas during the current period and 50 percent of the average annual QREs incurred in Texas during the three preceding tax periods. If a taxpayer partnered with a Texas institution of higher education, the rate increased to 6.25 percent.
- The Sales and Use Tax Exemption: Taxpayers could opt for an exemption from sales and use tax on the purchase, lease, or rental of depreciable tangible personal property directly used in qualified research. This exemption required the taxpayer to register with the Comptroller and obtain a “Texas Qualified Research Registration Number”.
This elective structure created significant strategic considerations. Start-ups and capital-intensive firms often preferred the sales tax exemption to reduce the high upfront costs of laboratory equipment and high-performance computing hardware. In contrast, profitable established entities generally favored the franchise tax credit to reduce their annual tax liability on the margin.
The Impact of Static 2011 Conformity
The decision to freeze the Texas Tax Code’s reference to the 2011 version of the IRC created a divergence between state and federal standards as the IRS issued new regulations. The most notable example involves the treatment of Internal Use Software (IUS). While federal regulations in 2016 significantly modernized and relaxed the “High Threshold of Innovation” test for IUS, the Texas Comptroller continued to enforce the far more restrictive 2011 standards. This led to numerous audits where software development activities qualified for the federal credit but were denied for the Texas credit.
Local State Revenue Office Guidance: The Role of the Comptroller
The Texas Comptroller of Public Accounts exercises broad authority over the administration of the R&D credit, primarily through Administrative Rule 3.599 (Franchise Tax) and Rule 3.340 (Sales Tax). The Comptroller’s office also publishes redacted letter rulings and hearing decisions via the State Tax Automated Research (STAR) system, which provides essential guidance on how the law is applied in practice.
Substantiation and the Burden of Proof
A recurring theme in Comptroller guidance is the high burden of proof placed on the taxpayer. Historically, the Comptroller has required “clear and convincing evidence” to substantiate that expenses claimed are eligible for the credit. This is a higher standard than the “preponderance of the evidence” typically used in federal tax disputes. Taxpayers must produce records that link specific employee hours and supply costs to discrete business components and technical uncertainties. While SB 2206 has introduced language requiring “sufficient” rather than strictly “contemporaneous” records, the practical necessity for robust documentation remains unchanged.
The “Funded Research” Nuance in Texas
The Comptroller provides specific guidance on when research is considered “funded” by a third party, which would disqualify the performer from claiming the credit. Under Rule 3.599, research is funded if the performing entity “retains no substantial rights” to the results or if the payments are not contingent on the success of the research.
| Funding Condition | Comptroller Interpretation | Inclusion Status |
|---|---|---|
| No Substantial Rights | The researcher must pay to use the results or gains only “incidental benefits” like experience. | Disqualified. |
| Non-Contingent Payment | The researcher is paid regardless of whether the research objective is achieved. | Disqualified. |
| Contingent Payment w/ Rights | The researcher is only paid if successful and keeps the right to use the technology. | Eligible for Credit. |
If research is partially funded, the Comptroller allows a “carve-out” where the researcher may claim expenses that exceed the amount of funding received, provided they retain substantial rights. For example, if a company spends $120,000 on a project but is paid $100,000 in a non-contingent contract, only the $20,000 excess might qualify as a QRE.
Intra-Group Transactions and Combined Reporting
Texas franchise tax utilizes “combined reporting,” where an affiliated group of entities engaged in a unitary business is treated as a single taxpayer. This has significant implications for the R&D credit. In a 2025 memorandum (STAR 202503004M), the Comptroller clarified that for franchise tax purposes, the combined group is the taxable entity, and research performed by one member for another is generally disregarded as an intra-group transaction. However, this concept does not apply to the sales tax exemption, as the sales tax does not recognize combined reporting; therefore, a member of a group must meet the “qualified research” criteria on its own merits to claim a sales tax exemption on equipment.
Internal Use Software: The Texas Interpretation Controversy
Internal Use Software (IUS) has been one of the most litigated and debated aspects of the Texas R&D credit. The Comptroller defines IUS as any computer software developed by or for the benefit of the taxable entity primarily for its own internal use.
The High Threshold of Innovation Test
Under the 2011 standards adopted by Texas, software intended for internal use only qualifies for the R&D credit if it meets a “High Threshold of Innovation” test, which is significantly more difficult than the standard four-part test. This test consists of three prongs:
- Innovativeness: The software must be intended to result in an improvement that is substantial and economically significant.
- Significant Economic Risk: The taxpayer must commit substantial resources to the development, and there must be substantial uncertainty—because of technical risk—that those resources will be recovered in a reasonable time.
- Commercial Availability: The software cannot be purchased, leased, or licensed in the commercial market and used for its intended purpose without modifications that would satisfy the first two prongs of the test.
The “Separately Stated Consideration” Safe Harbor
The Comptroller’s guidance provides a presumption that software is IUS unless it is developed to be commercially sold, leased, or licensed to unrelated third parties for “separately stated consideration”. This means that if the software is “bundled” into a service without a distinct price, the Comptroller will likely categorize it as IUS, subjecting it to the higher innovation threshold. For example, a bank developing a new online portal for its customers may find the development costs disqualified because the portal is used to provide a “non-computer service” (banking), even if the portal itself is highly innovative.
The Modernization: SB 2206 and the Transition to Subchapter T
In June 2025, the Texas legislature passed Senate Bill 2206, representing the most comprehensive overhaul of the R&D tax incentive in the state’s history. The bill seeks to address the administrative inefficiencies of the previous regime and make Texas more competitive with other states.
Shift to Dynamic Conformity
The most critical change under SB 2206 is the adoption of “rolling” or “dynamic” conformity with the Internal Revenue Code. For franchise tax reports due on or after January 1, 2026, the definition of QREs will no longer be tied to the 2011 IRC. Instead, the Texas credit will follow the federal law in effect for the tax year for which the report is filed. This change effectively aligns Texas’s definitions with the contemporary standards used by the IRS, including modern regulations for Internal Use Software and software development.
Increased Credit Rates and Permanent Status
SB 2206 removes the expiration date of the R&D credit, which was previously set to sunset on December 31, 2026, making the incentive permanent. To compensate for the repeal of the sales tax exemption, the statutory credit rates have been increased significantly.
| Credit Type | Subchapter M Rate (Pre-2026) | Subchapter T Rate (2026+) |
|---|---|---|
| Standard R&D Credit | 5.000% of excess QREs | 8.722% of excess QREs |
| University Partnership Credit | 6.250% of excess QREs | 10.903% of excess QREs |
| New Entity Base Rate | 5.000% of current QREs | 4.361% of current QREs |
| New Entity w/ University | 6.250% of current QREs | 5.451% of current QREs |
The “excess” is defined as the current-year Texas QREs minus a base amount equal to 50 percent of the average Texas QREs from the preceding three periods. For companies with no prior research history in Texas, the “base rate” allows them to claim a percentage of their total current-year expenses, providing an immediate incentive for new businesses to relocate their R&D operations to the state.
Refundability: A Paradigm Shift for Startups
Perhaps the most impactful provision of SB 2206 is the introduction of refundability for certain entities. Historically, if a taxpayer owed no franchise tax, their R&D credit could only be carried forward for up to 20 years. Under the new Subchapter T, the credit is refundable for entities that owe no franchise tax, including those below the “no tax due” threshold (currently $2.47 million) and new veteran-owned businesses. This allows pre-revenue startups in sectors like biotechnology and software development to receive a cash payment from the state, significantly improving their liquidity and runway for innovation.
The Repeal of the Sales and Use Tax Exemption
As of January 1, 2026, the sales and use tax exemption for depreciable property used in R&D (Section 151.3182) will be repealed. This marks the end of the “elective” period where taxpayers had to choose between the exemption and the franchise credit.
Transition and Planning Considerations
The repeal of the sales tax exemption creates a “timing” issue for capital-intensive firms. While the increased franchise tax credit (8.722%) is intended to provide a greater total benefit over time, the loss of the sales tax exemption means companies must pay tax at the time of purchase for expensive research equipment. Taxpayers are encouraged to model their scenarios for 2025 and 2026 to optimize the timing of large equipment acquisitions before the exemption sunset.
Interaction with IRC Section 174
The interplay between the Section 41 credit and the Section 174 amortization rules is also a key concern for the Comptroller. In a 2025 policy memorandum, the Comptroller clarified that even though Section 174 allows for the expensing or amortization of certain research costs, it does not override the definition of “supplies” in Section 41. Specifically, if an expense is for property “of a character subject to the allowance for depreciation” under IRC Section 167, it cannot be claimed as a supply QRE for the Texas R&D credit, even if it was properly expensed under Section 174. This distinction ensures that large-scale capital assets are excluded from the wage-and-supply-based credit, preventing a “double benefit” once the assets are put into service.
Administrative Compliance and Audit Defense
To successfully claim and defend the Texas R&D credit, taxpayers must navigate a specific set of administrative hurdles established by the Comptroller’s office.
Registration Requirements
Any person claiming an R&D incentive must register with the Comptroller’s office and provide detailed information about their prior-year research activities.
- Registration Data: Taxpayers must report the total amount of Texas QREs, the number of full-time and part-time employees engaged in research, and total payroll expenses for those employees.
- Annual Information Report (AIR): Failure to file the mandatory AIR can result in the cancellation of the registration number, which in turn leads to the denial of the sales tax exemption or franchise credit for that period.
- Statute of Limitations: The Comptroller has ruled that a credit must be established in the year the expenses were incurred. Amending an out-of-statute report to “create” a credit for carryforward purposes is generally barred by the statute of limitations.
Statistical Sampling and Federal Audit Flow-Through
Under the new SB 2206 framework, Texas will officially permit the use of statistical sampling procedures, as allowed by IRS Revenue Procedure 2011-42, to determine QRE amounts. Furthermore, if the IRS accepts a taxpayer’s R&D costs reported on financial statements (ASC 730) as sufficient evidence for the federal credit, the Texas portion of those costs will also be deemed sufficient for the state credit. This represents a significant easing of the traditional “clear and convincing” burden of proof for large taxpayers who are already subject to intense federal scrutiny.
Detailed Example: Applied R&D Credit Calculation
To visualize the application of these rules, consider “Galveston Genomics Inc.,” a fictional mid-sized biotechnology firm based in Houston, Texas.
Case Profile
In the 2026 tax year, Galveston Genomics Inc. conducts advanced genetic sequencing research to develop a new diagnostic tool for oncology. Their expenses are as follows:
- Total Texas QREs (2026): $4,000,000 (comprising $3M in wages and $1M in supplies).
- Prior 3-Year QRE History:
- 2025: $3,500,000
- 2024: $3,000,000
- 2023: $2,500,000
- Average Prior 3 Years: $3,000,000.
- Base Amount (50% of Average): $1,500,000.
- University Component: $500,000 of the $4M was incurred through a research contract with the University of Texas M.D. Anderson Cancer Center.
Step 1: Calculate the Standard Credit Segment
The firm first identifies the portion of its “excess” QREs that does not involve a university partnership.
- Total Excess QREs: $4,000,000 – $1,500,000 = $2,500,000.
- Standard Credit (8.722%): Galveston Genomics applies the new 8.722% rate to the portion of the excess that represents standard R&D.
- University Segment (10.903%): The $500,000 university contract is calculated at the higher rate.
| Calculation Layer | Formula Basis | Resulting Credit |
|---|---|---|
| Standard Excess | $2,000,000 (portion) x 8.722% | $174,440 |
| University Excess | $500,000 (portion) x 10.903% | $54,515 |
| Total 2026 Credit | $174,440 + $54,515 | $228,955 |
Step 2: Application of Credit
If Galveston Genomics Inc. has a 2026 Texas franchise tax liability of $500,000:
- Liability Limit: The credit is capped at 50% of the tax due before credits.
- Max Credit for 2026: $250,000.
- Amount Applied: The full $228,955 is applied, reducing the tax bill to $271,045.
If Galveston Genomics Inc. was a startup with $0 tax liability:
- Refundable Option: Under Subchapter T, the firm can elect to receive the $228,955 as a cash refund rather than carrying it forward for 20 years.
Final Thoughts: Strategic Outlook for Texas Innovation
The transformation of the Texas R&D tax credit from the Subchapter M era to the Subchapter T era marks a pivotal shift in the state’s economic strategy. By moving to dynamic federal conformity, the state has acknowledged that the 2011 “static” model was no longer sustainable in an era of rapid technological change and evolving federal regulations. The integration of IRC Section 41 into the Texas Tax Code now provides a more predictable and generous incentive for businesses, particularly those in the software and life sciences sectors that were previously disadvantaged by restrictive state-level interpretations of Internal Use Software.
While the repeal of the sales tax exemption represents a loss of an immediate “point-of-sale” benefit, the significant increase in the franchise tax credit rate and the introduction of refundability for small businesses and veterans ensure that Texas remains one of the most attractive jurisdictions for R&D investment. Taxpayers must remain vigilant, however, in their documentation practices. The alignment with federal standards means that a failure at the federal level—such as a reclassification of wages during an IRS audit—will now have a direct and immediate impact on the state credit. For professional peers in the tax and finance domain, the 2026 transition requires a comprehensive review of current R&D tracking systems to ensure they can produce the granular business-component-level data required by IRS Form 6765, which has now become the definitive source for the Texas R&D credit. In this new landscape, the synergy between federal technical standards and state fiscal incentives provides a robust foundation for the next decade of Texas-led innovation.
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What is the R&D Tax Credit?
The Research & Experimentation Tax Credit (or R&D Tax Credit), is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States. The credits are a tax incentive for performing qualified research in the United States, resulting in a credit to a tax return. For the first three years of R&D claims, 6% of the total qualified research expenses (QRE) form the gross credit. In the 4th year of claims and beyond, a base amount is calculated, and an adjusted expense line is multiplied times 14%. Click here to learn more.
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