Note 8. Income Taxes

Total income taxes for the years ended December 31, 2017, 2016, and 2015 were allocated as follows:

The components of income tax expense for the years ended December 31, 2017, 2016, and 2015 are as follows:

The sources and tax effects of temporary differences that give rise to significant portions of the deferred tax assets (liabilities) at December 31, 2017 and 2016 are presented below:

A portion of the annual change in the net deferred tax asset relates to unrealized gains and losses on securities available for sale. The related 2017 and 2016 deferred tax expense (benefit) of approximately $321,000 and ($685,000) respectively, has been recorded directly to shareholders’ equity. Additionally, a portion of the annual change in the net deferred tax asset relates to pension adjustments. The related 2017 and 2016 deferred tax expense (benefit) of $668,000 and ($36,000) respectively, has been recorded directly to shareholders’ equity. The change in the net deferred tax liability was also impacted by the recording of a net deferred tax asset of approximately $4,146,000 relating to acquisition transactions that occurred during the year. The balance of the 2017 increase in the net deferred tax liability of $8,485,000 is reflected as a deferred income tax expense, and the balance of the 2016 decrease in the net deferred tax asset of $118,000 is reflected as a deferred income tax expense in the consolidated statement of income.

The valuation allowances for 2017 and 2016 relate primarily to state net operating loss carryforwards. It is management’s belief that the realization of the remaining net deferred tax assets is more likely than not. The Company adjusted its net deferred income tax asset as a result of reductions in the North Carolina income tax rate, which reduced the state income tax rate to 3% effective January 1, 2017.

The Company had no significant uncertain tax positions, and thus no reserve for uncertain tax positions has been recorded. Additionally, the Company determined that it has no material unrecognized tax benefits that if recognized would affect the effective tax rate. The Company’s general policy is to record tax penalties and interest as a component of “other operating expenses”.

The Company is subject to routine audits of its tax returns by the Internal Revenue Service and various state taxing authorities.  The Company’s federal tax returns are subject to income tax audit by state agencies beginning with the year 2014. The Company’s state tax returns are subject to income tax audit by state agencies beginning with the year 2013.  There are no indications of any material adjustments relating to any examination currently being conducted by any taxing authority.

Retained earnings at December 31, 2017 and 2016 includes approximately $6,869,000 representing pre-1988 tax bad debt reserve base year amounts for which no deferred income tax liability has been provided since these reserves are not expected to reverse or may never reverse. Circumstances that would require an accrual of a portion or all of this unrecorded tax liability are a reduction in qualifying loan levels relative to the end of 1987, failure to meet the definition of a bank, dividend payments in excess of accumulated tax earnings and profits, or other distributions in dissolution, liquidation or redemption of the Bank’s stock.

The following is a reconcilement of federal income tax expense at the statutory rate of 35% to the income tax provision reported in the financial statements.

On December 22, 2017, the Tax Act was signed into law. Among other things, the Tax Act permanently reduced the corporate tax rate to 21% from the prior maximum rate of 35%, effective for tax years including or commencing January 1, 2018. As a result of the reduction of the corporate tax rate to 21%, companies are required to revalue their deferred tax assets and liabilities as of the date of enactment, with resulting tax effects accounted for in the fourth quarter of 2017. The Company continues to evaluate the impact on its 2017 tax expense/benefit of the revaluation required by the lower corporate tax rate implemented by the Tax Act, which management has estimated to be a tax benefit between $1.0 million and $1.5 million. During the fourth quarter of 2017, the Company recorded $1.3 million in tax benefit based on the Company's preliminary analysis of the impact of the Tax Act. The Company's preliminary estimate of the impact of the Tax Act is based on currently available information and interpretation of its provisions. The actual results may differ from the current estimate due to, among other things, further guidance that may be issued by U.S. tax authorities or regulatory bodies and/or changes in interpretations and assumptions that the Company has preliminarily made. The Company's evaluation of the impact of the Tax Act is subject to refinement for up to one year after enactment