NOTE 20. INCOME TAXES
On December 22, 2017, the President of the United States signed into law the Tax Reform. The Tax Reform includes a number of changes to existing U.S. tax laws that impact the Company, most notably a reduction of the U.S. corporate income tax rate from 35 percent to 21 percent for tax years beginning after December 31, 2017.
The Company recognized the income tax effects of the Tax Reform in its 2017 financial statements in accordance with Staff Accounting Bulletin No. 118 (“SAB 118”), which provides SEC staff guidance for the application of ASC Topic 740, Income Taxes, in the reporting period in which the Tax Reform was signed into law. SAB 118 requires a company’s financial results to reflect the income tax effects of the Tax Reform for which the accounting is complete and provisional amounts for those specific income tax effects of the Tax Reform for which the accounting is incomplete but a reasonable estimate could be determined. As such, the Company has recorded a provisional amount totaling $4.9 million related to the revaluation of its deferred tax assets and liabilities and expects the accounting to be completed no later than the fourth quarter of 2018. The final amount may differ from the provisional amount due to additional analysis or changes in interpretation by management or federal regulatory guidance that may be issued.
Income tax expense (benefit) is summarized as follows:
| For the Year Ended December 31, | ||||||||||||
| 2017 | 2016 | 2015 | ||||||||||
| (Dollars in thousands) | ||||||||||||
| Current | ||||||||||||
| Federal | $ | 365 | $ | 549 | $ | (150 | ) | |||||
| State | 66 | 24 | — | |||||||||
| Deferred | ||||||||||||
| Federal | 6,729 | 2,370 | 2,252 | |||||||||
| State | 368 | 552 | 109 | |||||||||
| Change in valuation allowance | — | — | (18,950 | ) | ||||||||
| Total income tax expense (benefit) | $ | 7,528 | $ | 3,495 | $ | (16,739 | ) | |||||
The differences between actual income tax expense and the amount computed by applying the federal statutory income tax rate of 35% to income before income taxes for the periods indicated is reconciled as follows:
| For the Year Ended December 31, | ||||||||||||
| 2017 | 2016 | 2015 | ||||||||||
| (Dollars in thousands) | ||||||||||||
| Computed income tax expense | $ | 3,537 | $ | 3,455 | $ | 2,480 | ||||||
| Deferred tax valuation allowance | — | — | (18,950 | ) | ||||||||
| State income tax, net of federal benefit | 282 | 218 | 165 | |||||||||
| Nontaxable municipal security income | (1,036 | ) | (544 | ) | (126 | ) | ||||||
| Nontaxable BOLI income | (243 | ) | (107 | ) | (160 | ) | ||||||
| Change in federal and state rates applied to deferreds | 4,871 | 353 | — | |||||||||
| Low income housing tax credit investments | (44 | ) | — | — | ||||||||
| Other | 161 | 120 | (148 | ) | ||||||||
| Actual income tax expense (benefit) | $ | 7,528 | $ | 3,495 | $ | (16,739 | ) | |||||
| Effective tax rate | 74.5 | % | 35.4 | % | -236.2 | % | ||||||
The components of net deferred taxes as of the periods indicated are summarized as follows:
| As of December 31, | ||||||||
| 2017 | 2016 | |||||||
| (Dollars in thousands) | ||||||||
| Deferred tax assets: | ||||||||
| Allowance for loan losses | $ | 2,356 | $ | 3,245 | ||||
| Deferred compensation and post employment benefits | 1,993 | 3,365 | ||||||
| Non-accrual interest | 204 | 375 | ||||||
| Valuation reserve for other real estate | 346 | 693 | ||||||
| North Carolina NOL carryover | 475 | 557 | ||||||
| Federal NOL carryover | 3,507 | 8,560 | ||||||
| AMT credit carryforward | 645 | 414 | ||||||
| Unrealized losses on securities | 149 | 3,255 | ||||||
| Loan basis differences | 77 | 238 | ||||||
| Deposit premium | 104 | 155 | ||||||
| Fixed assets | 63 | — | ||||||
| Other | 1,009 | 966 | ||||||
| Total deferred tax assets | 10,928 | 21,823 | ||||||
| Deferred tax liabilities: | ||||||||
| Fixed assets | — | 263 | ||||||
| Loan servicing rights | 620 | 962 | ||||||
| Goodwill | 126 | 18 | ||||||
| Core deposit intangible | 37 | 158 | ||||||
| Deferred loan costs | 757 | 1,002 | ||||||
| Prepaid expenses | 31 | 57 | ||||||
| Unrealized gains on securities | 377 | 201 | ||||||
| Derivative instruments | 128 | 176 | ||||||
| Other | 21 | 1 | ||||||
| Total deferred tax liabilities | 2,097 | 2,838 | ||||||
| Net deferred tax asset | $ | 8,831 | $ | 18,985 | ||||
The Company measures deferred tax assets and liabilities using enacted tax rates that will apply in the years in which the temporary differences are expected to be recovered or paid. Accordingly, the Company’s deferred tax assets and liabilities were remeasured to reflect the reduction in the U.S. corporate income tax rate from 35 percent to 21 percent, resulting in a $4.9 million increase in income tax expense for the year ended December 31, 2017 and a corresponding $4.9 million decrease in net deferred tax assets as of December 31, 2017. In addition, the Company recognized reductions in its net deferred tax assets of approximately $0.1 and $0.4 million during both the years ended December 31, 2017 and 2016 as a result of a reduction in the expected North Carolina income tax rate from 3.0% to 2.5% and from 4.0% to 3.0%, respectively.
During 2015, the Company completed an analysis of all positive and negative evidence in assessing the need to maintain the valuation allowance against its net deferred tax asset. As a result of this analysis, the Company determined that significant positive evidence existed that would support the reversal of the valuation allowance including the following:
| · | A pattern of sustained profitability, excluding non-recurring items, since the first quarter of 2014; |
| · | A three year cumulative profit; |
| · | Forecasted earnings sufficient to utilize all remaining net operating losses prior to expiration beginning in 2024 for North Carolina and 2027 for federal; |
| · | Significant improvements in asset quality; |
| · | Resolution of all remaining regulatory orders; and |
| · | A strong capital position enabling future earnings investments. |
As of December 31, 2016, $0.2 million in valuation allowance related to net deferred tax assets on investment securities remained in accumulated other comprehensive income. This valuation allowance was recognized as tax expense upon the sale or maturity of the individual securities and was fully recognized as of December 31, 2017.
The following table summarizes the amount and expiration dates of the Company’s unused net operating losses:
| As of December 31, 2017 | ||||||||
| (Dollars in thousands) | Amount | Expiration Dates |
||||||
| Federal | $ | 16,702 | 2031-2034 | |||||
| North Carolina | $ | 24,060 | 2026-2029 | |||||
The Company is subject to examination for federal and state purposes for the tax years 2014 through 2017. As of December 31, 2017 and 2016, the Company does not have any material unrecognized tax positions.