CHEMICAL FINANCIAL CORP

Income Taxes

The current and deferred components of the provision for income taxes were as follows:



	Years Ended December 31,
(Dollars in thousands)	2017			2016			2015
Current income tax expense (benefit)
Federal	$	14,665		$	19,144		$	31,300
State	20			(423		)	—
Total current income tax expense	14,685			18,721			31,300
Deferred expense (benefit)
Federal	92,636			23,649			5,700
State	548			442			—
Total deferred income tax expense (benefit)	93,184			24,091			5,700
Change in valuation allowance	(1,089		)	(706		)	—
Income tax provision	$	106,780		$	42,106		$	37,000

A reconciliation of expected income tax expense at the federal statutory income tax rate and the amounts recorded in the Consolidated Financial Statements were as follows:



	Years Ended December 31,
	2017					2016					2015
(Dollars in thousands)	Amount			Rate		Amount			Rate		Amount			Rate
Tax at statutory rate	$	89,706		35.0	%	$	52,548		35.0	%	$	43,341		35.0	%
Changes resulting from:
Tax-exempt interest income	(9,001		)	(3.5	)	(5,320		)	(3.5	)	(3,943		)	(3.2	)
State taxes, net of federal benefit	369			0.1		13			—		—			—
Change in valuation allowance	(1,089		)	(0.4	)	(706		)	(0.5	)	—			—
Bank-owned life insurance adjustments	(1,696		)	(0.7	)	(832		)	(0.6	)	(124		)	(0.1	)
Director plan change in control	—			—		(508		)	(0.3	)	—			—
Income tax credits, net	(11,449		)	(4.4	)	(2,454		)	(1.6	)	(2,557		)	(2.1	)
Nondeductible transaction expenses	156			0.1		2,100			1.4		411			0.3
Tax benefits in excess of compensation costs on share-based payments⁽¹⁾	(5,886		)	(2.3	)	(2,240		)	(1.5	)	—			—
Impact of the Tax Cuts and Jobs Act⁽²⁾	46,660			18.2		—			—		—			—
Other, net	(990		)	(0.4	)	(495		)	(0.4	)	(128		)	—
Income tax expense	$	106,780		41.7	%	$	42,106		28.0	%	$	37,000		29.9	%


⁽¹⁾	The years ended December 31, 2017 and 2016 reflect the adoption of ASU 2016-09, as of January 1, 2016, which results in excess tax benefits recognized within "Income tax expense" rather than previously recognized directly into equity with "Additional paid-in-capital." Refer to Note 1, Summary of Significant Accounting Policies, for further details.


⁽²⁾	The year ended December 31, 2017 included the impact of the enactment of H.R.1 (the "Tax Cuts and Jobs Act"), which required a revaluation of net deferred tax assets and liabilities, see below for further details.

On December 22, 2017, H.R.1 (known as the "Tax Cuts and Jobs Act") was signed into law. Among other provisions, the Tax Cuts and Jobs Act, reduces the statutory corporate income tax rate from a maximum rate of 35% to flat tax rate of 21%, effective January 1, 2018. ASC Topic 740 requires the recognition of the effects of tax law changes be recorded in the period in which the law is enacted. Therefore, the Corporation's deferred tax assets and liabilities which were previously valued at a federal rate of 35%, were revalued to the current enacted federal tax rate of 21%. The impact of the Tax Cuts and Jobs Act resulted in a $46.7 million increase to income tax expense related to continuing operations as a result of the revaluation of the net deferred tax asset of $46.0 million and an acceleration of amortization expense on the low income housing tax credit investment portfolio of $0.7 million.

The SEC issued Staff Accounting Bulletin No. 118 to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available in reasonable detail to complete the accounting for certain income tax effects of the Tax Cuts and Jobs Act, thereby allowing a measurement period to reflect provisional adjustments as information becomes available. The measurement period includes the Tax Cuts and Jobs Acts' enactment date up until one year after. The Corporation does not have any provisional adjustments to its net deferred tax asset as a result of the tax reform at December 31, 2017 under Staff Accounting Bulletin No. 118, but the Corporation will have adjustments in 2018 to reflect the impact of the rate reduction on various deferred items that management reasonably estimated at December 31, 2017 and will true up with the filing of the 2017 tax return in 2018.

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The significant components of the deferred tax assets and liabilities at December 31, 2017 and 2016 were as follows:



	December 31,
(Dollars in thousands)	2017			2016
Deferred tax assets:
Allowance for loan losses	$	20,446		$	45,763
Acquisition-related fair value adjustments	27,607			54,704
Accrued stock-based compensation	4,082			18,891
Loss and tax credit carry forwards	57,969			76,446
Depreciation	2,954			11,270
Nonaccrual loan interest	6,155			9,465
Accrued expense	9,200			20,858
Other	9,127			15,751
Total deferred tax assets	137,540			253,148
Deferred tax liabilities:
Loan servicing rights	13,446			20,450
Core deposit intangible assets	6,022			11,844
Goodwill	4,076			6,373
Prepaid expenses	7,390			4,873
Other	7,735			2,762
Total deferred tax liabilities	38,669			46,302
Net deferred tax asset before valuation allowance	98,871			206,846
Valuation allowance	(1,150		)	(2,239		)
Net deferred tax asset	$	97,721		$	204,607

On August 31, 2016, the Corporation merged with Talmer and recorded $151.9 million in deferred tax assets, net of valuation allowance. In connection with the merger, Talmer incurred an ownership change within the meaning of Section 382 of the Internal Revenue Code ("IRC"). At August 31, 2016, Talmer had $102.8 million in gross federal net operating loss carry forwards, $88.7 million in gross realized built-in loss carry forwards, $1.0 million in federal tax credit carry forwards that expire from 2026 through 2035, and $14.9 million in federal alternative minimum tax credits with an indefinite life.

The valuation allowance against the Corporation’s deferred tax assets at December 31, 2017 totaled $1.2 million and included $0.6 million due to IRC Section 382 limitations on the utilization of pre-ownership change loss and tax credit carry forwards associated with Talmer’s previously acquired entities and $0.6 million due to management’s estimate of capital loss carry forwards more likely than not to expire unutilized. Actual outcomes could vary from the Corporation's current estimates, resulting in future increases or decreases in the valuation allowance and corresponding future tax expense or benefit.

Due to the substantial equity value of Talmer at the time of the ownership change, the entity was deemed to be in a net unrealized built-in gain position which allows for the utilization of certain carry forward attributes. Therefore, no additional valuation allowance was established against Talmer's net deferred tax assets.

The following table is a summary of the loss attributes, Section 382 limitations, and tax expiration periods as of December 31, 2017.



	From the Acquisition of:
						Talmer's Prior Ownership Changes
(Dollars in thousands)	Talmer		Monarch			First Place Holdings/First Place Bank			Talmer West Bank			First of Huron Corp./Signature Bank		From 2009 Ownership change			Not Limited by Section 382			Total
Tax Loss and Credit Carryforwards as of 12/31/17:
Years Expiring (except AMT Credits)	2032-2034		2026-2034			2027-2031			2028-2032			2029-2032		2027-2029			2036
Annual Section 382 limitation-base⁽¹⁾	$	34,668	$	673		$	6,650		$	3,028		$	365	$	145		$	—		$ N/A
Gross Federal Net Operating Losses	—		15,047			—			47,284			649		1,740			—			64,720
Gross Capital Losses	—		—			—			—			—		—			—			—
Realized Built-in Losses	—		—			68,356			8,936			—		—			—			77,292
Business Tax Credits	170		1,651			781			—			—		—			912			3,514
Less amounts not recorded due to Sec 382 Limitation	—		(1,738		)	(65		)	(3,218		)	—		(145		)	—			(5,166	)
Alternative Minimum Tax Credits - no expiration	12,473		106			2,115			—			303		—			10,832			25,829
Valuation Allowance	—		—			—			(585		)	—		—			(565		)	(1,150	)


⁽¹⁾	In respect to the Monarch and Talmer acquisitions, in addition to the statutory "base" Section 382 limitation, recognized built in gain increases the Section 382 limitation during the five year period beginning on the acquisition date. The Corporation estimates that the recognized built in gain will total $2.8 million and $253.2 million for the Monarch and Talmer acquisitions, respectively.

Management concluded that no valuation allowance was necessary on the remainder of the Corporation's net deferred tax assets at December 31, 2017 and 2016. This determination was based on the Corporation's history of pre-tax and taxable income over the prior three years, as well as management's expectations for sustainable profitability in the future. Management monitors deferred tax assets quarterly for changes affecting the ability to realize and the valuation allowance could be adjusted in future periods.

At December 31, 2017, the Corporation had approximately $36.0 million of bad debt reserve in equity for which no provision for federal income taxes was recorded. This amount represents Talmer's qualifying thrift bad debt reserve at December 31, 1987 through its acquisition of First Place Bank, which is only required to be recaptured into taxable income if certain events occur. At December 31, 2017, the potential tax on the above amount was approximately $7.5 million. The Corporation does not intend to take any action that would result in a recapture of any portion of its bad debt reserve.

The Corporation's federal tax return for the years ended December 31, 2014 to present are open to potential examination. Talmer amended its four federal tax returns for the years 2011, 2012, 2013 and 2014 to reflect the impact of changes to First Place Bank due to an IRS settlement in January of 2016. These four amendments were selected for audit which concluded with no changes and all expected refunds were received in 2017.The Corporation's most significant states of operation, Michigan and Ohio, do not impose income-based taxes on financial institutions. The Corporation and/or its subsidiaries are subject to immaterial amounts of income tax in various other states, with varying years open to potential examination. The Corporation received notice in February 2018 that Talmer Bancorp's Ohio Financial Institutions tax has been selected for audit for the years ended December 31, 2013, 2014 and 2015.

The Corporation had no unrecognized tax benefits at December 31, 2017 or 2016 and does not expect to record unrecognized tax benefits of any significance during the next twelve months. The Corporation recognizes interest and/or penalties related to income tax matters in income tax expense, when applicable. There were no liabilities accrued for interest and/or penalties at December 31, 2017 or 2016.