| 13. |
Income Taxes |
Income tax expense includes current and deferred taxes as follows (in thousands):
| Current | Deferred | Total | ||||||||||
|
Year Ended December 31, 2017: |
||||||||||||
|
Federal |
$38,321 | $60,587 | $98,908 | |||||||||
|
State |
6,764 | 2,126 | 8,890 | |||||||||
|
Foreign |
— | (1,030 | ) | (1,030 | ) | |||||||
|
|
|
|
|
|
|
|||||||
| $45,085 | $61,683 | $106,768 | ||||||||||
|
|
|
|
|
|
|
|||||||
| Current | Deferred | Total | ||||||||||
|
Year Ended December 31, 2016: |
||||||||||||
|
Federal |
$28,515 | $15,772 | $44,287 | |||||||||
|
State |
5,987 | 762 | 6,749 | |||||||||
|
|
|
|
|
|
|
|||||||
| $34,502 | $16,534 | $51,036 | ||||||||||
| Current | Deferred | Total | ||||||||||
|
Year Ended December 31, 2015: |
||||||||||||
|
Federal |
$35,682 | $13,131 | $48,813 | |||||||||
|
State |
6,094 | 3,042 | 9,136 | |||||||||
|
|
|
|
|
|
|
|||||||
| $41,776 | $16,173 | $57,949 | ||||||||||
|
|
|
|
|
|
|
|||||||
The reconciliation between the income tax computed by applying the U.S. federal statutory rate and the effective tax rate on net income is as follows for the years ended December 31, 2017, 2016 and 2015 (dollars in thousands):
| Year Ended December 31, | ||||||||||||
| 2017 | 2016 | 2015 | ||||||||||
|
Income before taxes |
$ | 201,728 | $ | 128,231 | $ | 141,912 | ||||||
| December 31, | ||||||||||||||||||||||||
| 2017 | 2016 | 2015 | ||||||||||||||||||||||
|
Income Tax expense |
Rate | Rate | Rate | |||||||||||||||||||||
|
Taxes computed at federal rate |
$ | 70,639 | 35.0 | % | $ | 44,881 | 35.0 | % | $ | 49,669 | 35.0 | % | ||||||||||||
|
State and local taxes, net of federal tax benefit |
6,398 | 3.2 | % | 5,258 | 4.1 | % | 5,251 | 3.7 | % | |||||||||||||||
|
Rate differential on non-US income |
954 | 0.5 | % | — | — | — | — | |||||||||||||||||
|
Effect of deferred tax rate change |
41,834 | 20.7 | % | (1,188 | ) | (0.9 | )% | 2,621 | 1.8 | % | ||||||||||||||
|
Change in income tax benefit / payable to stockholder |
(13,724 | ) | (6.8 | )% | 359 | 0.3 | % | (750 | ) | (0.5 | )% | |||||||||||||
|
Effect of windfalls related to equity compensation |
(1,139 | ) | (0.6 | )% | — | — | — | — | ||||||||||||||||
|
Return to provision adjustment |
(131 | ) | (0.1 | )% | 196 | 0.1 | % | (130 | ) | (0.1 | )% | |||||||||||||
|
Meals and entertainment |
1,757 | 0.9 | % | 1,484 | 1.2 | % | 1,267 | 0.9 | % | |||||||||||||||
|
Other |
180 | 0.1 | % | 46 | 0.0 | % | 21 | 0.0 | % | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| $ | 106,768 | 52.9 | % | $ | 51,036 | 39.8 | % | $ | 57,949 | 40.8 | % | |||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
Deferred income tax assets and liabilities consist of the following at December 31, 2017 and 2016 (in thousands):
| December 31, | ||||||||
| 2017 | 2016 | |||||||
|
Deferred income tax assets: |
||||||||
|
Section 754 election tax basis step-up |
$ | 57,766 | $ | 117,749 | ||||
|
Tenant improvements |
2,678 | 3,571 | ||||||
|
Restricted stock units |
6,830 | 8,564 | ||||||
|
Intangible asset |
228 | 389 | ||||||
|
Net operating loss |
1,070 | — | ||||||
|
Other |
779 | 932 | ||||||
|
|
|
|
|
|||||
|
Deferred income tax asset |
69,351 | 131,205 | ||||||
|
Deferred income tax liabilities: |
||||||||
|
Goodwill |
(669 | ) | (1,272 | ) | ||||
|
Servicing rights |
(15,150 | ) | (15,003 | ) | ||||
|
Deferred rent |
(1,428 | ) | (1,671 | ) | ||||
|
Compensation |
(851 | ) | (120 | ) | ||||
|
Investment in partnership |
(379 | ) | (582 | ) | ||||
|
|
|
|
|
|||||
|
Deferred income tax liability |
(18,477 | ) | (18,648 | ) | ||||
|
|
|
|
|
|||||
|
Net deferred income tax asset |
$ | 50,874 | $ | 112,557 | ||||
|
|
|
|
|
|||||
The 2017 Tax Act significantly revises the U.S. corporate income tax by, among other things, lowering the statutory corporate tax rate from 35% to 21%, eliminating certain deductions, imposing a mandatory one-time tax on accumulated earnings of foreign subsidiaries, introducing new tax regimes, and changing how foreign earnings are subject to U.S. tax. The 2017 Tax Act also enhanced and extended through 2026 the option to claim accelerated depreciation deductions on qualified property. We have not completed our determination of the accounting implications of the 2017 Tax Act on our tax accruals. However, we have reasonably estimated the effects of the 2017 Tax Act and recorded a provisional tax expense of $41.4 million in our financial statements as of December 31, 2017. The tax expense relates to the remeasurement of the U.S. deferred tax assets and liabilities from 35% to 21%. As we complete our analysis of the 2017 Tax Act, collect and prepare necessary data, and interpret any additional guidance issued by the U.S. Treasury Department, the IRS, and other standard-setting bodies, we may make adjustments to the provisional amounts. Those adjustments may materially impact our provision for income taxes in the period in which the adjustments are made.
The Company’s primary deferred tax asset represents a tax basis step-up election under Section 754 of the Internal Revenue Code, as amended (“Section 754”), made by HFF, Inc. relating to the initial purchase of units of the Operating Partnerships in connection with the Reorganization Transactions and a tax basis step-up on subsequent exchanges of Operating Partnership units for the Company’s Class A common stock since the date of the Reorganization Transactions. As a result of the step-up in basis from these transactions, the Company is entitled to annual future tax benefits in the form of amortization for income tax purposes. The annual pre-tax benefit on the Section 754 basis step up and past payments under the tax receivable agreement was approximately $36.4 million at December 31, 2017. The current year reduction in the deferred tax asset was principally attributable to the 2017 Tax Act.
To the extent that the Company does not have sufficient taxable income in a year to fully utilize this annual deduction, the unused benefit is recharacterized as a net operating loss and can then be carried forward indefinitely. The Company measured the deferred tax asset based on the estimated income tax effects of the increase in the tax basis of the assets owned by the Operating Partnerships utilizing the enacted tax rates at the date of the transaction. In accordance with ASC 740, the tax effects of transactions with shareholders that result in changes in the tax basis of a company’s assets and liabilities are recognized in equity. Changes in the measurement of the deferred tax assets or the valuation allowance due to changes in the enacted tax rates upon the finalization of the income tax returns for the year of the exchange transaction were recorded in equity. All subsequent changes in the measurement of the deferred tax assets due to changes in the enacted tax rates or changes in the valuation allowance are recorded as a component of income tax expense.
In evaluating the realizability of the deferred tax assets, management makes estimates and judgments regarding the level and timing of future taxable income, including projecting future revenue growth and changes to the cost structure. In order to realize the anticipated 2017 pre-taxbenefit associated with the Section 754 basis step up and payments under the tax receivable agreement of approximately $38.4 million, the Company needs to generate approximately $369 million in revenue each year, assuming a constant cost structure. In the event that the Company cannot realize the anticipated 2018 pre-tax benefit of $38.4 the shortfall becomes a net operating loss that can be carried forward indefinitely to offset future taxable income. Based on this analysis and other quantitative and qualitative factors, management believes that it is currently more likely than not that the Company will be able to generate sufficient taxable income to realize the net deferred tax assets resulting from the basis step up transactions (initial sale of units in the Operating Partnerships and subsequent exchanges of Operating Partnership units since the date of the Reorganization Transactions). The Company has no federal or state net operating losses at December 31, 2017.
The Company has analyzed the need for a reserve for unrecognized tax benefits under ASC 740-10 and has determined that any such tax benefits do not have a material impact on the financial statements. It is not expected that there will be a significant increase or decrease in the amount of unrecognized tax benefits within the next 12 months. With few exceptions, the Company is no longer subject to U.S. federal or state and local tax examinations by tax authorities before 2013.
The Company will recognize interest and penalties related to unrecognized tax benefits in interest and other income, net in the consolidated statements of comprehensive income. There were no interest or penalties recorded in the twelve months ended December 31, 2017 or December 31, 2016.
Tax Receivable Agreement
In connection with the Reorganization Transactions, HFF LP and HFF Securities made an election under Section 754 for 2007 and maintained that election in effect for each taxable year in which an exchange of Operating Partnership partnership units for shares of the Company’s Class A common stock occurred. The initial sale as a result of the offering and the subsequent exchanges of partnership units increased the tax basis of the assets owned by HFF LP and HFF Securities to their fair market value. This increase in tax basis allows the Company to reduce the amount of future tax payments to the extent that the Company has future taxable income. As a result of the increase in tax basis, the Company is entitled to future tax benefits of $57.8 million and has recorded this amount as a deferred tax asset on its consolidated balance sheet. The Company has updated its estimate of these future tax benefits based on the changes to the estimated annual effective tax rate for 2017 and 2016. The Company is obligated, however, pursuant to its Tax Receivable Agreement with HFF Holdings, to pay to HFF Holdings, 85% of the amount of cash savings, if any, in U.S. federal, state and local income tax that the Company actually realizes as a result of these increases in tax basis and as a result of certain other tax benefits arising from the Company entering into the tax receivable agreement and making payments under that agreement. For purposes of the tax receivable agreement, actual cash savings in income tax will be computed by comparing the Company’s actual income tax liability to the amount of such taxes that it would have been required to pay had there been no increase to the tax basis of the assets of HFF LP and HFF Securities as a result of the initial sale and later exchanges and had the Company not entered into the tax receivable agreement.
The Company accounts for the income tax effects and corresponding tax receivable agreement effects as a result of the initial purchase and the sale of units of the Operating Partnerships in connection with the Reorganization Transactions and exchanges of Operating Partnership units for the Company’s Class A shares by recognizing a deferred tax asset for the estimated income tax effects of the increase in the tax basis of the assets owned by the Operating Partnerships, based on enacted tax rates at the date of the transaction, less any tax valuation allowance the Company believes is required. In accordance with ASC 740, the tax effects of transactions with shareholders that result in changes in the tax basis of a company’s assets and liabilities will be recognized in equity. If transactions with shareholders result in the recognition of deferred tax assets from changes in the company’s tax basis of assets and liabilities, the valuation allowance initially required upon recognition of these deferred assets will be recorded in equity. Subsequent changes in enacted tax rates or any valuation allowance are recorded as a component of income tax expense.
The Company believes it is more likely than not that it will realize the benefit represented by the deferred tax asset, and, therefore, the Company recorded 85% of this estimated amount of the increase in deferred tax assets, as a liability to HFF Holdings under the tax receivable agreement and the remaining 15% of the increase in deferred tax assets directly in additional paid-in capital in stockholders’ equity.
While the actual amount and timing of payments under the tax receivable agreement will depend upon a number of factors, including the amount and timing of taxable income generated in the future, changes in future tax rates, the value of individual assets, the portion of the Company’s payments under the tax receivable agreement constituting imputed interest and increases in the tax basis of the Company’s assets resulting in payments to HFF Holdings, the Company has estimated that the payments that will be made to HFF Holdings will be $60.9 million and has recorded this obligation to HFF Holdings as a liability on the consolidated balance sheet. During the year ended December 31, 2017, the tax rates used to measure the deferred tax assets were updated to reflect the reduction in statutory rates inclusive of the 2017 Tax Act which resulted in a decrease of deferred tax assets of $41.8 million and a corresponding decrease in the payable under the tax receivable agreement of $39.2 million. The tax rates used to measure the deferred tax assets were also updated during the year ended December 31, 2016, which resulted in a decrease of deferred tax assets of $1.2 million which resulted in an increase in the payable under the tax receivable agreement of $1.0 million. To the extent the Company does not realize all of the tax benefits in future years, this liability to HFF Holdings may be reduced.
In conjunction with filing of the Company’s 2016 federal and state tax returns, the benefit for 2016 relating to the Section 754 basis step-up was finalized resulting in $13.2 million of tax benefits being realized by the Company. As discussed above, the Company is obligated to remit to HFF Holdings 85% of any such cash savings in federal and state tax. As such during 2017, the Company paid $11.2 million to HFF Holdings under the tax receivable agreement. In conjunction with the filing of the Company’s 2015 federal and state tax returns, the benefit for 2015 relating to the Section 754 basis step-up was finalized resulting in $12.7 million in tax benefits realized by the Company for 2015. During August 2016, the Company paid $10.8 million to HFF Holdings under this tax receivable agreement. As of December 31, 2017, the Company has made payments to HFF Holdings pursuant to the terms of the tax receivable agreement in an aggregate amount of approximately $85.5 million and the Company anticipates to make a payment of approximately $11.8 million to HFF Holdings in 2018.