Texas does not have a state income tax, which means the federal Research and Development (R&D) Tax Credit is the primary R&D incentive available to Texas businesses. However, Texas also offers a franchise tax R&D credit that many business owners overlook entirely. Together, these two programs can substantially reduce the cost of innovation for qualifying companies.
The Federal R&D Tax Credit (IRC Section 41)
The federal R&D tax credit rewards businesses that invest in developing new or improved products, processes, software, formulas, or techniques. It applies across virtually every industry, not just technology or life sciences. Manufacturing companies that improve production processes, construction firms that develop new building methods, food companies that create new formulations, and software companies that write new code can all qualify.
The Four-Part Test
To qualify, an activity must meet all four parts of the IRS test:
- Permitted purpose: The activity must relate to developing or improving the function, performance, reliability, or quality of a business component (product, process, software, or technique).
- Technological in nature: The work must rely on principles of engineering, physical science, biological science, or computer science.
- Elimination of uncertainty: The business must face uncertainty about the capability, method, or design of the development at the outset.
- Process of experimentation: The business must evaluate alternatives through modeling, simulation, systematic trial and error, or other methods.
How Much Is the Credit Worth?
The regular credit is approximately 20% of qualifying research expenses above a base amount. Most small and mid-size businesses use the Alternative Simplified Credit (ASC), which is 14% of qualifying expenses above 50% of the average qualifying expenses for the preceding three years. For startups with less than five years of revenue and under $5 million in gross receipts, the credit can also offset payroll taxes up to $500,000 per year.
The Texas Franchise Tax R&D Credit
While Texas has no income tax, it does impose a franchise tax on most businesses operating in the state. Texas offers a franchise tax credit for qualifying research expenses that follows the same definitions and four-part test as the federal credit. The Texas credit is calculated based on the increase in qualified research expenses over a base amount, similar to the federal approach.
Many Texas business owners miss this credit because they assume that without a state income tax, there are no state-level R&D incentives. In fact, the franchise tax credit can reduce or eliminate franchise tax liability for companies actively investing in research and development.
Qualifying Expenses
Both the federal and Texas credits cover the same types of expenses:
- Wages: Salaries and wages paid to employees who directly perform, supervise, or support qualified research activities.
- Supplies: Materials used or consumed in the research process (excluding capital items or general administrative supplies).
- Contract research: 65% of amounts paid to third-party contractors for qualified research performed on your behalf.
Industries That Commonly Qualify in Texas
The R&D credit is far broader than most business owners realize. In Texas, common qualifying industries include:
- Software development and SaaS companies
- Oil and gas extraction and refining technology
- Manufacturing and process improvement
- Aerospace and defense contractors
- Agriculture and food science
- Architecture and engineering firms
- Pharmaceutical and medical device companies
- Construction companies developing new methods or materials
- Chemical and materials companies
Common Mistakes to Avoid
Not claiming the credit at all. The most common mistake is assuming your business does not qualify. If any part of your business involves developing or improving products, processes, or software, it is worth evaluating.
Poor documentation. The IRS expects contemporaneous documentation: project descriptions, time records, expense allocations, and evidence of the technical uncertainty addressed. Claiming the credit without supporting records increases audit risk.
Forgetting the Texas franchise tax credit. Even businesses that claim the federal credit often miss the state-level franchise tax credit, leaving money on the table.
Overlooking the payroll tax offset for startups. Startups with under $5 million in gross receipts can apply up to $500,000 of the federal credit against payroll taxes, which is valuable for pre-revenue or low-revenue companies.
How to Claim the Credits
The federal credit is claimed on IRS Form 6765, filed with your annual tax return. The Texas franchise tax credit is claimed on the Texas franchise tax return. Both credits can be carried forward to future tax years if they exceed current-year liability. Most businesses work with a CPA or R&D credit specialist to conduct a study that identifies qualifying activities and expenses, calculates the credit, and prepares the supporting documentation.
Other Texas Incentives That Stack With R&D Credits
The R&D credit is just one piece of the Texas incentive landscape. Companies investing in research often also qualify for the Texas manufacturing sales tax exemption, the Skills Development Fund for training R&D staff, and federal programs like SBIR/STTR grants for technology-focused research.
Find All Programs You Qualify For
R&D credits are valuable, but they are rarely the only program available to research-active Texas businesses. Our screening report checks your business against 150+ verified programs, including grants, tax credits, loans, and incentives, and identifies which ones may fit your situation. Start your free screening →