Texas manufacturers frequently underutilize the R&D tax credit because they think it is only for companies with formal R&D labs. In reality, many everyday manufacturing activities — developing new products, improving production processes, testing new materials, and designing tooling — may qualify for both the federal Section 41 R&D credit and the Texas franchise tax R&D credit.
The Two Credits Available to Texas Manufacturers
Federal R&D Tax Credit (Section 41)
The federal credit provides up to 20% of qualified research expenses above a base amount. Most manufacturers use the Alternative Simplified Credit method, which typically yields an effective credit of 6% to 8% of qualifying expenses. The credit is permanent and can be claimed annually.
Texas Franchise Tax R&D Credit
Texas offers a separate R&D credit against the state franchise tax based on qualified research expenses attributable to research conducted in Texas. Since Texas has no state income tax, the franchise tax is the primary state business tax — and the R&D credit directly reduces this liability.
Manufacturing Activities That Qualify
The four-part test for qualified research is broader than most manufacturers realize. Activities that involve developing or improving products, processes, or techniques through systematic experimentation may qualify:
Product Development
- Designing new products or components
- Developing prototypes and testing them
- Engineering drawings and specifications
- Material selection and testing
- Designing molds, dies, jigs, and fixtures
- First article testing and qualification
Process Improvement
- Developing new manufacturing processes
- Improving existing production methods to reduce waste, improve quality, or increase throughput
- Automating manual processes
- Developing new welding, machining, or assembly techniques
- Testing alternative production sequences
- Troubleshooting and solving production challenges through systematic experimentation
Tooling and Equipment Design
- Designing custom tooling for new products
- Developing fixtures and jigs that improve manufacturing precision
- Engineering equipment modifications to support new production requirements
- Integrating new equipment into existing production lines
Quality and Testing
- Developing new testing methods and quality control procedures
- Material characterization and testing
- Failure analysis and root cause investigation leading to process changes
- Environmental testing and compliance testing for new products
What Does Not Qualify
- Routine production runs
- Quality control testing without process improvement intent
- Maintenance and repair of existing equipment
- Market research and sales activities
- Cosmetic changes to products
- Copying existing designs without technical modification
- Activities after commercial production has begun (for that specific product/process)
Qualified Research Expenses for Manufacturers
- Employee wages: Salaries of engineers, designers, toolmakers, process technicians, and production workers performing or directly supporting qualifying activities
- Supplies: Materials consumed during R&D activities — prototype materials, test specimens, materials consumed in experimentation. This can be significant for manufacturers.
- Contract research: 65% of payments to outside engineers, design firms, or testing laboratories performing qualifying work on your behalf
How Much Is It Worth?
For a Texas manufacturer with $500,000 in annual qualifying expenses (engineer salaries, prototype materials, contract testing), the combined federal and state credits may be worth $30,000 to $50,000 per year. Larger manufacturers with more extensive R&D activities can see significantly larger credits.
The credit is especially valuable because it directly reduces tax liability dollar-for-dollar — it is not a deduction but a credit.
How to Identify Qualifying Activities in Your Shop
- Walk the floor: Talk to your engineers, designers, toolmakers, and experienced production staff. Ask about projects where they had to solve a technical problem, try multiple approaches, or develop something new.
- Review new product introductions: Every new product introduction likely involves qualifying design, prototyping, and testing activities.
- Look at process changes: Any time you changed how you make something — new welding technique, new machining sequence, new automation — there was likely experimentation involved.
- Check customer-driven development: When a customer brings you a new part or asks for a modification, the engineering and prototyping work to fulfill that request often qualifies.
- Review tooling development: Custom tooling design and testing is a frequently missed category of qualifying activity.
Documentation Requirements
- Project records: Engineering change orders, design documents, test reports, and prototype records
- Time records: How much time employees spent on qualifying vs. non-qualifying activities. Time studies or allocation methods are commonly used.
- Financial records: Payroll records, supply purchases, and contractor invoices tied to qualifying projects
- Technical narratives: Descriptions of the technical uncertainty, the experiments conducted, and the outcomes
Complementary Programs
- Manufacturing equipment sales tax exemption: Texas exempts manufacturing equipment from sales tax — make sure you are claiming this.
- Skills Development Fund: State-funded workforce training for manufacturers. Guide to the Skills Development Fund for manufacturers.
- TEF: For large expansion projects, the Texas Enterprise Fund may provide additional incentives. TEF for manufacturers guide.
- Section 179 and bonus depreciation: Accelerated depreciation on qualifying equipment purchases
- Freeport Exemption: Property tax exemption on inventory held 175 days or less before out-of-state shipment
Bottom Line
The R&D tax credit is not just for tech companies and pharmaceutical firms. Texas manufacturers who design products, improve processes, develop tooling, or test materials are likely performing qualifying activities. The combined federal and state credits can return thousands to tens of thousands of dollars annually. If you have engineers, designers, or toolmakers on staff, talk to a tax advisor experienced in manufacturing R&D credits.
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