When we mention the R&D tax credit, you might think of the federal program that incentivizes US businesses to improve or develop new products and processes. However, many states also offer this incentive — and Texas approaches it a little differently than others.
Texas offers R&D incentives in two different ways: Franchise tax credits and sales tax exemptions.
Luckily, this approach still offers businesses plenty of opportunities to get some money spent on their R&D efforts back come tax time.
Related: 2022 Changes to R&D Amortization
What Are R&D Tax Credits?
The federal government established the research and development tax credit in 1981 as a way to help businesses reduce their income tax liability. This program provides billions to US companies to foster innovation — almost any business that works toward developing or improving its products, processes, or technologies can qualify.
Many states, including Texas, have since implemented their own R&D tax credit programs, allowing qualifying businesses to claim the credit at both the federal and state level.
Unfortunately, businesses in many industries and of various sizes don’t realize that their operations can qualify for this dollar-for-dollar credit. That’s why we recommend working with an R&D tax expert to help you reduce your tax burden, document the claim in case of an audit, and ensure you get the biggest incentive for your research and development processes.
Do you want to skip the paperwork this tax season and file your R&D tax credit claim the easy way? It’s as simple as working with TaxRobot — the most efficient AI-powered R&D tax software!
Texas R&D Tax Credits: Franchise Tax Credit vs. Sales and Use Tax Exemption
If your company invests in R&D in Texas, it likely qualifies for the state’s R&D tax credit. Since 2014, local businesses of all sizes can receive this credit in one of two ways:
- The franchise tax credit
- The sales and use tax exemption
Taxpayers can only choose one of these methods each tax year — so how do you know which R&D credit your Texas business qualifies for so that you can apply?
The Texas Franchise Tax Credit
Texas’s franchise tax credit refunds some of the money you spend on qualified research expenses (more on that later).
If you opt for this credit, the amount calculated gets applied to your taxes the following year. For example, your R&D tax credits based on 2023 expenses will go toward your 2024 filing.
The Texas franchise tax credit amount equals five percent of the difference between two things:
- The amount of qualified research expenses incurred during the period of filing in Texas; and
- 50% of the average qualified research expenses your business incurred in Texas over the previous three tax periods preceding the period that the report is based on.
You can claim this credit by filing the following forms on Texas’s Comptroller website:
- Long Form Franchise Tax Report
- Credits Summary Schedule
- R&D Activities Credits Schedule
The Texas Sales and Use Tax Exemption Credit
On the other hand, if your business chooses to take the tax exemption credit instead of the franchise credit, you can save on the storage, use, or sale of depreciable property used in your qualified research.
This credit exempts that property from sales and use tax for anyone who uses, sells, rents, or stores the property and that person:
- Registers with the Texas Comptroller’s office
- Engages in qualified research
- Will not claim the franchise tax credit while using property that is exempt from taxes under the sales and use tax exemption
Texas businesses can claim this credit by submitting their exemption certificate when purchasing an item used directly in qualified research.
What Are Qualified Research Expenses in Texas?
Luckily, Texas follows the IRS definition of what qualifies for the federal R&D tax credit.
First, the research must follow all three of the following guidelines:
- The research must aim to discover information that’s technological.
- The research team must undertake the research with the intent to improve or develop a business component.
- All research must consist of an experimentation process that relates to new or improved functions, performance, quality, or reliability.
Furthermore, the IRS recognizes three categories of qualified expenses:
- Employee Wages
Your employee wages play a significant role in determining how much you can claim in R&D credits; it’s typically the largest expenditure.
There are three types of employees whose wages contribute toward your R&D expenses:
- Employees engaged in qualified research: Any employee conducting experiments, creating new plans, developing software, or using science and engineering to solve a problem falls under this category.
- Employees supporting qualified research: Employees who support those who conduct or supervise research count toward employee wages — however, this doesn’t include anyone performing administrative tasks.
- Employees supervising qualified research: Any employee supervising qualified research activities (first-line managers, supervisors, etc.) can qualify for your tax credit — excluding managers that those supervisors report to, regardless of if they are part of the research team.
Related: Best Tax Deductions for Sole Proprietorships
- Supplies Used
Businesses can also claim expenses relating to non-depreciable property they use in their qualified research processes. To do so, employees must use those supplies to perform research.
This section should only make up a small part of your expenditures — land and land improvements, depreciable property, and intangible supplies and expenses (rentals, travel, licensing, etc.) do not qualify.
- Contracted Research
You can gain credit for 65-75% of qualified expenses performed by a contracted party, depending on whether or not they are a qualified research consortium.
Contracted research must follow the same guidelines as employees performing in-house activities.
This expense only qualifies for the Texas R&D credit if:
- You enter the contract before starting research.
- Your business retains the rights to the research results.
- Your company pays for the research expenses, even if unsuccessful.
For example, paying for research on the contingency that it’s successful does not qualify for the credit — the purpose of the incentive is to reward your business for taking risks when developing new products or processes.
Texas R&D Credits at a Glance: Important Highlights
That’s a lot of information! Let’s summarize the important pieces of the Texas R&D tax credit regulations:
- You cannot file for both the franchise tax credit and the sales tax exemption. However, you can change your election each time you file.
- Texas uses the same guidelines as the IRS for determining which activities are qualified research expenses. The only difference is your research must take place in the state.
- Your business can carry forward unused credits for a maximum of 20 years.
- If you take the franchise tax credit, your credit (including any that you carry forward) cannot exceed 50% of your business’s franchise taxes due that period.
- Even if your business doesn’t have qualified expenditures in previous years, it can still claim 2.5% against the current year’s expenses.
How Much Can Your Business Claim in Texas Tax Credits?
We discussed how much you can claim using the franchise tax credit above, but what if your business doesn’t quite align with using that formula?
For example, if your business doesn’t have qualified expenses in one, two, or three tax periods on which the report is based, it can claim 2.5% in credits for the research expenses incurred during that time.
Or if your business doesn’t have expenses in any of the first three tax periods after the report, it can claim 3.125% in R&D credits.
Finally, if you perform qualified research with higher education institutions, you can claim 6.25% of the difference instead of the 5% we mentioned in the franchise tax section.
How to Prepare to File For the Texas R&D Tax Credit
Texas’s R&D tax credit program helps businesses recover large amounts of their spending on qualified research, but claiming it can be complicated. You must provide evidence of your research activities.
First, you must document expenses in the form of invoices and receipts as soon as they occur — bigger claims mean more documents.
You also need to provide proof that you performed the work during the year you claimed — you must date all qualified expense documents.
Finally, you’ll have to show the technical challenges your research aimed to improve — these challenges must align with one of the IRS categories that qualify as R&D work.
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