For companies with a burn rate that’s hot to the touch, there could be a little bit of relief from an unlikely source.

There’s a little-known credit in the federal tax code for research and development expenses that could save early-stage companies a boat load of money.

But most firms either overlook the credit entirely, or find it too mystifying to bother with, meaning that this powerful accounting tool isn’t getting the kind of play it should with the companies that need it most.

“Massachusetts companies form the heart of the nation’s innovation economy, so the federal R&D tax credit is extremely important to our state,” says state Sen. Karen Spilka (D-Second Middlesex and Norfolk), chairwoman of the state’s Economic Development & Emerging Technologies Committee. “Even in tough economic times, Massachusetts is better poised to come out of a recession because of its ability to innovate. This ability comes in part from the talent located here and in part from the culture in Massachusetts, which sets a high priority on solving problems to meet unmet needs.

{IMAGELEFT:http://www.massdevice.com/sites/default/wp-content/uploads/headshots/Spilka_Karen_100x100.jpg}”High-tech, cutting-edge industries, such as life sciences, information technology and precision manufacturing, will be the lynch pins of our economy moving forward,” Spilka notes. “These are the types of organizations that are and will continue to add jobs as other sectors shrink. I predict that Massachusetts will only see more companies that get their start in an R&D lab, so we’re wise to invest in this area.”

One of Spilka’s committee goals is promoting the credits to benefit both companies’ growth and the state’s economy.

“Both the federal and state R&D tax credits are essential to our economy — not only because they provide incentives to companies in the business of developing new products, but also because they encourage every company to innovate,” she says. “Most companies don’t know that the credit is available to any business that utilizes science and technology to improve or develop products, processes or software, and we’re actively working to make that information more widely available.”

Because medical device companies typically have an incredibly high R&D burn rate in their first five years, the tax credit is particularly applicable, according to Laura Cleminson, director of business development at Intrepid Advisors LLC, a firm that assists companies in reclaiming all available R&D credits.

Intrepid works with a lot of CPA firms and its clients and tax advisors to develop long-term strategies.

“If a company is not going to pursue the credit, its executives need to understand what they are giving up,” Cleminson explains. “We make sure they are OK with that. Companies tend to underestimate what the credit is and they don’t know all the areas to maximize the credit.”

What is the federal R&D tax credit?

First, what it’s not: Industry-specific. The government does not define how technically advanced a product needs to be to qualify for the credit. It could be a “low tech” consumer product, an entirely new offering or an improved version of an existing product.

{IMAGELEFT:http://www.massdevice.com/sites/default/wp-content/uploads/headshots/Cleminson_Laura_100x100.jpg}”The government does not specify the definition of product; it could be the next best ballpoint pen or a gear for outer space,” Cleminson explains. “Or it could be a new manufacturing process, a better and faster process that assures increased quality and that jobs don’t go overseas.”

Nigel Harvey, a physicist and the founder of the Empyrean Group Ltd. in Canada, is credited with helping to pioneer the concept of “shop floor” R&D. (The American division of the company became Intrepid Advisors).

“From a history standpoint, I built the business to help people understand what qualified and what didn’t,” Harvey recalls. “Back in mid-1980s, it dawned on me that only a third of people who are eligible would even consider asking for an R&D tax credit. Those in high tech know what it is, but someone in low tech thinks their company couldn’t possibly be doing R&D. Then there was the middle ground, asking for much less than what they were due. I saw a real opportunity for a consulting firm here: One little firm which understood a slice of the tax code, inside and out, and hired bright people who rapidly could understand, grasp, look at and see the cutting edge of their [clients’] technologies.”

Harvey’s insight soon bore out, as business opportunities arose both north of the border and in the United States. That’s because companies found working through the tax laws intimidating.

“When I first came to the U.S., before launching the business here, I flew to Washington and got to speak with the IRS lawyer who was drafting the next set of regulations for the credit,” he says. “I asked him two important questions: First, could R&D efforts on a new product or process be eligible for the credit, even if the efforts were only initiated because an order was received? And second, could R&D work be eligible even if it was carried out by ad hoc teams put together from technical staff who usually worked on production, rather than by members of a permanent R&D staff?

“His answer to both these questions was ‘yes.’ These answers meant that the way most small- and medium-sized companies did their product and process development work was eligible for the credit and there was a great opportunity for us to help these firms claim everything they should claim — and avoid claiming ineligible costs at the same time.”

The language of research and development

The answer to that first question, “What is R&D?” is simple: It’s the cost of an experiment, including worker’s time and the materials consumed in developing a product prior to production.

“It only supports the misery on the way to getting it to the production line,” Harvey notes.

But parsing what qualifies as an R&D expense and what doesn’t isn’t so simple. That’s where companies like Intrepid and Empyrean come in, acting almost as translators of the byzantine tax rules.

“In defining their R&D moments, some companies genuinely don’t remember problems with a job,” Harvey says. “The president remembers the problems like a dagger in the heart, because they cost money. Finally, the engineer recalling an incident, perhaps associated with an experimental insulation material, might say, ‘Oh, yeah, come to think of it, the customer’s roof did catch fire.’ You have to have a technical uncertainty solved by the process of experimentation.”

Harvey defines three examples of bona fide research and development projects: In the classic example, management knows they have a product or process that needs to be developed and assigns staff and funds to the project.

The second occurs when an order comes in for product that’s not viable. The company sets out to solve the problems and, in the meantime, quotes a suitably long delivery time.

“The third kind is ‘blind panic’ R&D,” Harvey explains. “In this scenario, the technical staff is quite sure they know how to make it so they accept the order and quote a normal delivery time. But once they begin, they discover they don’t. All hell breaks loose as they go into R&D mode. This is R&D under the worst possible circumstances.”

The struggle to solve such problems is really the heart of research and development, he notes.

“I would ask them, ‘If you are struggling to improve products all the time, then aren’t you often involved in R&D?'” he says.

What expenses qualify for the federal R&D tax credit?

The federal R&D tax credit is triggered by how much money is spent on qualified research expenses by any company in any market, Cleminson says.

“A company may invest more in research and development, be much more innovative than another company, and receive a more significant credit. A company needs to track their research and development expenses, how the money is being spent, and truly understand what qualifies for the credit.”

That’s as important as understanding what does not qualify, Cleminson adds. A company cannot claim salary expense for a researcher overseas, for example. Outside lab testing qualifies, but travel, meals and hotel expenses incurred by a contractor do not.

Expenses that do qualify include the salaries or wages of employees involved in R&D projects. Workers fall into three different groups; companies must qualify time and effort for each. The first group is the actual R&D team — the researchers, engineers and the inventor(s) of the product or process under development. The other two groups support and/or supervise the the R&D team.

Cleminson says the latter two groups are frequently overlooked.

“People forget or don’t know that personnel who support R&D and supervise the R&D project qualify,” she explains. “An example of a support person is someone who assembled the prototype or an individual who is tasked with testing a prototype to see if it meets all specifications.

“Consider also the support of a project manager or even administrators who produce and track meeting minutes, test results, etc.; they all support the development process. Companies that underestimate the credit tend to identify primarily engineers’ wages or, at the other end of the spectrum, they identify everything they do as R&D, which leads to overestimating the credit.”

The second qualified expense is subcontractors’ charges for work done in support of development projects. Here Cleminson offers up a caveat. A contractor’s usual invoice may include time, travel, meals, hotel and the prototype parts it makes. Only two of those are qualified expenses — time and prototype parts. She suggests structuring the contractor’s invoice so companies can easily identify the eligible expenses.

“When the invoice comes in, it’s entered into the accounting system, sectioned out, so the company will know what line items can be used and what can’t,” Cleminson says. “For companies just getting started, this is such a great time to set things up right.”

The third category of qualified expenses tis consumables, including scrap produced from test runs, prototypes, jigs and fixtures developed that were not used in final production runs — anything used prior to the product’s commercialization. Materials scrapped in commercial production do not qualify.

“Scrap produced due to quality issues doesn’t qualify. The government draws the line at anything after the ‘FAS’ – first article inspection,” Cleminson warns.

And companies that haven’t claimed a tax credit can go back up to three years, filing amended tax returns for those years.

“One thing to keep in mind — if a product has been in development for seven years, the company cannot go back and claim credit for the first four years, as the statute of limitations has been exceeded,” she says. “If a company is claiming the benefit in the current year, it makes sense to look and see if it would be beneficial to amend the last three returns, especially if large expenditures were incurred in those other years.”

Be prepared with documentation

“Recently, the government increased the level of review for contemporaneous documentation,” Cleminson says. “Twenty years ago, the government emphasized that a company claiming the R&D tax credit was indeed performing qualified R&D, as the IRS defined it. Now what we are seeing is an increased level of scrutiny for how the hours and percentage allocated to each person maps to each identified project.”

That means it’s vital to save the client lab notebooks, Gantt charts, project notes, time tickets and anything that helps piece that puzzle together and answer, “How much time was identified for wages claimed?” That includes dated notes of experiments, tests and drawings, invoices for materials, meeting minutes, letters, memos and emails, timesheets and any other dated material that refers to events, designs, results and difficulties encountered during the project.

The credit compensates companies for increasing R&D activities and the federal credit carries forward for 20 years. In fact, Cleminson says, if a company is structured as a C corporation and engaged in qualified R&D, any unused credits can be listed as an asset on their balance sheet.

“If their end game is to be sold, that’s an attractive thing to have on the books,” she notes. “Some companies could care less about that, but it needs to be a conscious decision not to take advantage of the R&D tax credit. They must understand the potential of not going for the credit — it must be an educated decision not to pursue that credit.”

Unlike one client that got away from Empyrean, Harvey adds.

“He was very autocratic, a bit eccentric, but doing a lot of R&D and not claiming anything for it. He was very courteous and welcoming to us,” he recalls. “We were helping him identify projects to claim for the R&D tax credit when he stopped us and said, ‘I’m not going to do this. No way am I going to take the American public’s money just because my staff was too stupid to get the experiments right the first time.'”