ZAIS Group Holdings, Inc.

9. Income Taxes

ZAIS is taxable as a corporation for U.S. tax purposes while ZGP and its subsidiaries operate as pass-through entities for U.S. income tax purposes not subject to entity level income taxes. Accordingly, the Company’s consolidated financial statements include U.S. federal, state and local income taxes on ZAIS’s allocable share of the consolidated results of operations, as well as taxes payable to jurisdictions outside the U.S related to the foreign subsidiaries.

On December 22, 2017, new tax reform legislation became effective for January 1, 2018. The new legislation that, among other things, reduced the corporate tax rate from a graduated set of rates with a maximum 35 percent tax rate to a flat 21 percent tax rate, also made changes to the net operating loss (NOL) deduction rules.

Under U.S. GAAP, changes in tax rates and tax law are accounted for in the period of enactment and the enactment date for U.S. GAAP is the date the new bill is signed into law. Deferred tax assets and liabilities are measured at the enacted tax rate expected to apply when temporary differences are to be realized or settled. Thus, at the date of enactment, ZAIS measured its deferred tax balances based upon the new 21% tax rate and re-assessed its valuation allowance due to tax reform to continuing operations in the tax provision. The tax rate change resulted in a decrease in deferred tax asset balance and corresponding valuation allowance of approximately $2.0 million as of December 31, 2017.

The following details the components of income tax (benefit) expense:

	Year Ended December 31,
	(Dollars in thousands)
	2017		2016
Current provision:
Federal	$	—	$	—
State and local		—		—
Foreign		22		(5)
Total current (benefit) expense		22		(5)
Deferred provision:
Federal		—		—
State and local		—		—
Foreign		—		—
Total deferred (benefit) expense		—		—
Total income tax (benefit) expense	$	22	$	(5)

The following is a reconciliation of the U.S. statutory federal income tax to the Company’s effective tax:

	December 31,
	2017		2016
	(Dollars in thousands)
Income tax (benefit) expense at the US federal statutory income tax rate	$	(408)	$	(1,288)
State and local income tax, net of federal benefit		(249)		(290)
Foreign Tax		22		(5
Effect of permanent differences		275		6
Income attributable to non-controlling interests in Consolidated Funds not subject to tax		(1,854)		(1,192)
Income attributable to non-controlling interests in ZGP not subject to tax		754		724
Equity compensation shortfall adjustment		1,903		56
Remeasurement of deferred tax balances due to rate change		2,012		42
Provision to return adjustment		1		54
Valuation Allowance		(2,434)		1,888
Total	$	22	$	(5)

The Company’s effective tax for the years presented above includes a benefit attributable to the fact that the Company’s subsidiaries operate as limited liability companies and limited partnerships which are treated as pass-through entities for U.S. federal and state income tax purposes. Accordingly, the Company’s consolidated financial statements include U.S. federal, state and local income taxes on the Company’s allocable share of the consolidated results of operations. The tax liability or benefit related to the partnership income or loss not allocable to the Company rests with the equity holders owning such non-controlling interests in ZAIS subsidiaries. The effective tax for the year is also impacted by a shortfall adjustment related to equity compensation that vested during the year. Finally, as discussed above, the Company re-measured its deferred tax balances based upon the new 21% tax rate the impact of which was fully offset by a full valuation allowance. Due to the full valuation allowance, the net effective tax represents the taxes accrued related to the Company’s operations in jurisdictions outside the U.S.

Deferred income taxes are provided for the effects of temporary differences between the tax basis of an asset or liability and are reported in the accompanying Consolidated Statements of Financial Condition. These temporary differences result in taxable or deductible amounts in future years. Details of the Company's deferred tax assets and liabilities, measured at the enacted rate of 21% as of December 31, 2017 and a rate of 34% as of December 31, 2016, offset by a full valuation allowance are summarized as follows:

	Year Ended December 31
	(Dollars in thousands)
	2017		2016
Deferred tax assets:
Net operating losses	$	3,473	$	3,104
Equity compensation		13		2,277
Start-up costs		378		591
Unrealized loss on investments and other temporary differences		658		984
Total deferred tax assets		4,522		6,956
Valuation allowance		(4,522)		(6,956)
Total deferred tax assets (net of valuation allowance)		—		—

Deferred tax liabilities:
Unrealized gain on investments and other temporary differences		—		—
Total deferred tax liabilities		—		—
Total net deferred tax assets (liabilities)	$	—	$	—

The Company’s net deferred tax assets relate to net operating losses and other temporary differences related to the Company’s allocable share of the consolidated results of operations as well as the Company’s net operating losses and development stage start-up expenses incurred during the period from its inception and prior to the closing of the Business Combination with ZGP.

The Company has established a full valuation allowance on the deferred tax asset as of December 31, 2017 and December 31, 2016.

As of December 31, 2017, the Company has estimated federal and state income tax net operating loss carryforwards, which will expire as follows:

	(Dollars in thousands)
2032	$	1
2033		83
2034		122
2035		5,990
2036		1,703
2037		4,773
Total	$	12,672

As of each reporting date, management considers new evidence, both positive and negative, that could affect its view of the future realization of deferred tax assets. As of December 31, 2017, the Company has determined that the current management business forecasts do not support the realization of net deferred tax assets recorded for the Company. The Company has reported a net book loss for the year ended December 31, 2017 and it is anticipated that expenses will exceed revenues in 2018. While the Company continues to work to grow its AUM, explore business development opportunities, and intends to pursue various initiatives with potential to alter the operating loss trend, there is no specific plan that has been implemented at this point in time that will alter the negative earnings trend.

Accordingly, management believes that it is not more likely than not that the Company’s deferred tax asset will be realized, and the Company has established a full valuation allowance against the deferred tax asset as of December 31, 2017.

The Company intends to continue maintaining a full valuation allowance on its deferred tax assets until there is sufficient evidence to support the reversal of all or some portion of the allowance.

The Company’s primary jurisdictions in which it and its subsidiaries operate are the United States, New Jersey, New York, California and the United Kingdom. In the normal course of business, the Company is subject to examination by federal and certain state, local and foreign tax authorities. With a few exceptions, as of December 31, 2017, the Company’s U.S. federal, state, local and foreign income tax returns for the years 2014 through 2017 are open under the general statute of limitations provisions and therefore subject to examination. Currently, the Company is not under examination of any tax authorities.

The Company does not believe it has any significant uncertain tax positions. Accordingly, the Company did not record any adjustments or recognize interest expense for uncertain tax positions for the years ended December 31, 2017 and 2016, respectively. In the future, if uncertain tax positions arise, interest and penalties will be accrued and included in the Income tax (benefit) expense on the Consolidated Statements of Comprehensive Income (Loss).

In connection with the Business Combination and pursuant to the Exchange Agreement by and among the Company, ZGP, the Company Unitholders and Christian M. Zugel, as trustee of the ZGH Class B Voting Trust (the "Exchange Agreement"), holders of Class A Units and any vested ZGP Class B Units (collectively, the "Units") (other than the Company) may, subject to certain conditions and transfer restrictions, exchange their Units for Class A Common Stock or cash or a combination of stock and cash at the election of ZAIS. These exchanges may result in increases in the Company’s allocable share of the tax basis of the tangible and intangible assets of ZGP. These increases in tax basis may increase (for tax purposes) depreciation and amortization deductions and therefore reduce the amount of income or franchise tax that the Company would otherwise be required to pay in the future.

In connection with the Business Combination, the Company also entered into the Tax Receivable Agreement (the "Tax Receivable Agreement"), which provides for payment by the Company to exchanging holders of Units of 85% of income or franchise tax benefits, if any, that the Company realizes as a result of these increases in tax basis and of certain other tax benefits related to entering into the Tax Receivable Agreement, including income or franchise tax benefits attributable to payments under the Tax Receivable Agreement. This payment obligation is an obligation of the Company and not of ZGP.

As of December 31, 2017 there have been no exchanges of Units into Class A common stock and the Company has not recorded a deferred tax asset for the future amortization of tax basis of the tangible and intangible assets of ZGP. Accordingly, the Company has not recorded a related tax receivable agreement liability in due to related parties in the consolidated statements of financial condition for the expected payments under the Tax Receivable Agreement.