Income Taxes
The provision (benefit) for income taxes is based upon the results of operations, adjusted for the effect of certain tax-exempt income and nondeductible expenses. Certain items of income and expense are reported in different periods for financial reporting and tax return purposes resulting in temporary differences. The tax effects of these temporary differences are recognized currently in the deferred income tax provision or benefit on the Company’s consolidated statements of income. As of December 31, 2016, the Company had a net deferred tax asset of $157.8 million, which is net of a valuation allowance of $780 thousand.
The following table presents the statutory tax rate reconciled to the Company’s effective tax rate from continuing operations for the periods stated:
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| | | | | | | | | | | |
| December 31, 2016 | | December 31, 2015 |
| Tax | Rate | | Tax | Rate |
Income tax benefit at statutory rate | $ | (1,493 | ) | (35.00 | )% | | $ | (587 | ) | (35.00 | )% |
State tax expense, net of federal benefit | (120 | ) | (2.85 | )% | | 95 |
| 5.66 | % |
Other nondeductible expenses | 14 |
| 0.33 | % | | — |
| — | % |
Nondeductible Merger-related expenses | 1,310 |
| 31.09 | % | | — |
| — | % |
Tax-exempt income | (681 | ) | (16.16 | )% | | (470 | ) | (28.01 | )% |
Reduction in state statutory tax rate | 1,170 |
| 27.76 | % | | 2,653 |
| 158.10 | % |
Change in state tax apportionment | 372 |
| 8.83 | % |
| — |
| — |
|
Valuation allowance release | (59,950 | ) | n/m |
| | (95,111 | ) | n/m |
|
Loss of deferred tax assets due to Section 382 limitation | — |
| — |
| | 756 |
| 45.05 | % |
Prior year's tax return adjustments | (99 | ) | (2.35 | )% |
| — |
| — | % |
Adjustments to deferred items | (193 | ) | (4.58 | )% |
| — |
| — | % |
Other | (58 | ) | (1.38 | )% | | 249 |
| 14.84 | % |
Income tax benefit reported | $ | (59,728 | ) | n/m |
| | $ | (92,415 | ) | n/m |
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n/m - Rate not meaningful |
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The reduction in the statutory state tax rate resulted in a reduction in the Company’s deferred tax asset related to net operating losses in a state in which the Company does business. This change was enacted during 2016 and is effective beginning in 2017.
Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities. These differences will result in deductible or taxable amounts in a future year(s) when the reported amounts of assets or liabilities are recovered or settled. Deferred assets and liabilities are stated at tax rates expected to be in effect in the year(s) the differences reverse. A valuation allowance is recorded against that portion of the deferred tax assets when it is not more likely than not that all or a portion of the asset will be realized.
The following table presents the components of the net deferred tax asset as of the dates stated:
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| | | | | | |
| December 31, 2016 | December 31, 2015 |
Deferred tax assets: | | |
Allowance for loan losses | $ | 31,854 |
| $ | 38,137 |
|
Federal net operating loss carryforward | 114,965 |
| 103,578 |
|
State net operating loss carryforward | 3,841 |
| 4,431 |
|
Start-up costs | 1,377 |
| — |
|
AMT carryforward | 502 |
| 502 |
|
Impairment of other real estate owned | 5,247 |
| 10,812 |
|
Compensation related | 3,428 |
| 2,546 |
|
SERP related | 705 |
| — |
|
Interest on nonaccrual loans | 5,617 |
| 6,024 |
|
Basis in acquired loans | 3,654 |
| — |
|
Other acquisition accounting adjustments | 316 |
| — |
|
Other tax assets | 1,351 |
| 1,392 |
|
Gross deferred tax assets before valuation allowance | 172,857 |
| 167,422 |
|
Valuation allowance | (780 | ) | (60,695 | ) |
Total deferred tax assets | 172,077 |
| 106,727 |
|
Deferred tax liabilities: | | |
Unearned loan costs in excess of loan fees | 1,739 |
| 1,040 |
|
Prepaid expenses | 727 |
| 631 |
|
Other acquisition accounting adjustments | 9,466 |
| 10,255 |
|
Core deposit intangibles | 921 |
| — |
|
Fixed asset related | 644 |
| 2,302 |
|
Unrealized gains on securities | 381 |
| 318 |
|
Other tax liabilities | 374 |
| 39 |
|
Gross deferred tax liabilities | 14,252 |
| 14,585 |
|
Net deferred tax asset | $ | 157,825 |
| $ | 92,142 |
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A valuation allowance related to all components of net deferred tax asset was established in 2009 and was adjusted, as necessary, each reporting period. The valuation allowance was established based upon a determination at the time that it was not more likely than not that the deferred tax assets would be fully realized primarily as a result of the significant operating losses experienced by the Company during 2009 and several years thereafter. For the year ended December 31, 2015, management determined that is was more likely than not that a portion of its deferred tax assets would be realized and released a portion of its valuation allowance in the amount of $95.1 million. In the third quarter of 2016, management determined that it was more likely than not that substantially all of its net deferred tax asset would be realized and released substantially all of the remaining valuation allowance, which totaled $60.0 million.
ASC 740, paragraph 740-10-30-18, states that four possible sources of taxable income may be available under the tax law to realize a tax benefit for deductible temporary differences. In determining the need for a valuation allowance and in accordance with ASC 740-10-30-17, management evaluated all available evidence, both positive and negative, assessing the objectivity of the evidence and giving more weight to that evidence which is more objective than evidence which is subjective. Positive and negative evidence refers to factors affecting the predictability of one or more of the four sources of taxable income.
The positive evidence in the third quarter of 2016 included the fact that the Company has been in a positive cumulative pre-tax income position for the previous three years, and the Company expects to generate taxable income in future years sufficient to absorb substantially all of its net deferred tax assets. A significant component of the Company’s deferred tax assets relates to federal net operating losses ("NOLs") carrying forward of approximately $300.0 million as of September 30, 2016, which under current law can be carried forward 20 years. Legacy Xenith did not have federal NOLs carrying forward.
The table below summarizes deferred tax assets related to federal and state NOLs and tax credits and the periods over which they expire, as of December 31, 2016:
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| | | | | | | | | | |
Type of NOL | Expiration Dates | Deferred Tax Asset | Valuation Allowance | Net Deferred Tax Asset |
Federal | 2030-2036 | $ | 114,965 |
| $ | — |
| $ | 114,965 |
|
State | 2030-2036 | 3,841 |
| (780 | ) | 3,061 |
|
Alternative Minimum Tax | None | 502 |
| — |
| 502 |
|
Total |
| $ | 119,308 |
| $ | (780 | ) | $ | 118,528 |
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Management’s estimate of future taxable income was based on internal projections, which consider historical performance, various internal estimates and assumptions, as well as certain external data, all of which, while inherently subject to judgment, management believed to be reasonable. At December 31, 2015, management concluded that the Company did not have sufficient future income to absorb all NOLs carrying forward and only a portion of the deferred tax asset related to NOLs would be realized, thus releasing only a portion of the valuation allowance. In the third quarter of 2016, as a result of the Merger, management believed the Company had sufficient future income to absorb substantially all of the deferred tax assets, including assets relating to NOLs, and substantially all of the remaining valuation allowance was released. The remaining valuation allowance relates to the deferred tax asset related to NOLs in the Commonwealth of Virginia, where Xenith Bankshares, Inc. (the parent company) files a standalone tax return. The parent company is not expected to generate taxable income in future periods; therefore, management has concluded that it is not more likely than not that the deferred tax asset related to these NOLs, which totals approximately $780 thousand as of December 31, 2016 will be utilized.
If actual results differ significantly from the current estimates of future taxable income, even if caused by adverse macro-economic conditions, the valuation allowance may need to be increased for some or all of the Company’s net deferred tax assets. An increase to the deferred tax asset valuation allowance could have a material adverse effect on the Company’s financial condition and results of operations.
Federal tax returns filed by the Company for tax years 2010 through 2015 are subject to examination. Federal tax returns filed by Legacy Xenith for the years 2013 through 2015 are subject to examination. Tax returns filed in various states are subject to examination for tax years varying from the 2009 through 2015.