ROYAL BANCSHARES OF PENNSYLVANIA INC

NOTE 12. INCOME TAXES

The components of income tax benefit are stated below:


	For the years ended December 31,
(In thousands)	2016		2015
Income tax (benefit) expense
Current-federal	$	171	$	21
Current-state		2		16
Deferred		(1,969)		(5,176)
Income tax benefit	$	(1,796)	$	(5,139)

The income tax benefit for 2016 and 2015 is largely due to the release of a portion of the valuation allowance against the net deferred tax assets (“DTA”) during the fourth quarters of 2016 and 2015.

The difference between the income tax benefit and the amount computed by applying the statutory federal income tax rate of 34% in 2016 and 2015 is as follows:


	For the years ended December 31,
(In thousands)	2016		2015
Computed tax expense at statutory rate	$	3,116	$	2,169
Non-controlling interest		(263)		(205)
Alternative minimum tax ("AMT") expense		133		21
Stock options expense		43		20
Nondeductible expense		92		146
Bank owned life insurance		(489)		(169)
Federal net operating loss-KNBT*		—		1,368
State taxes (benefit) expense (net of federal benefit)		(49)		8
Adjustment to prior year items		(82)		67
Decrease in valuation allowance		(4,297)		(8,564)
Income tax benefit	$	(1,796)	$	(5,139)

*KNBT: Knoblauch State Bank

Deferred tax assets and liabilities consist of the following:


	As of December 31,
(In thousands)	2016		2015
Deferred tax assets
Allowance for loan and lease losses and unfunded loan commitments	$	2,843	$	2,699
Net operating loss carryforwards		20,712		22,546
Security writedowns		1,085		1,020
OREO writedowns		94		139
Investment in partnerships		1,920		1,698
Pension obligation		3,782		3,858
Pension obligation-AOCI		1,407		1,250
Unrealized losses on debt securities		389		165
Share-based compensation cost		57		83
Non-accrual interest		203		366
Capital loss carryovers		1,258		1,618
Charitable contribution carryovers		12		24
Employee bonuses		238		184
Accrued liabilities		105		181
Alternative minimum tax credit carryforward		426		302
Derivative instruments		168		189
Other		73		311
Total deferred tax assets before valuation allowance		34,772		36,633
Less valuation allowance-AOCI		(1,407)		(1,099)
Less valuation allowance-Other		(25,177)		(29,474)
Deferred tax assets, net of valuation allowance		8,188		6,060
Deferred tax liabilities
Penalties on delinquent tax certificates		25		35
Unrealized gains on AFS equity securities		—		151
Prepaid deductions		121		43
Other		153		114
Total deferred tax liabilities		299		343
Net deferred tax asset, included in other assets	$	7,889	$	5,717

We recognize deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. We are required to establish a valuation allowance for DTAs and record a charge to income or shareholders' equity if management determines, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Management evaluates the DTAs for recoverability using a consistent approach which considers the relative impact of negative and positive evidence, including historical profitability and projections of future reversals of temporary differences and future taxable income based on management approved business plans. These estimates and judgments are inherently subjective. Based on the analysis of the DTAs at December 31, 2016, management concluded that it is more likely than not that a portion of the net DTA will be realized by the Company in the future. As a result of this assessment, we recorded an additional $1.9 million of DTA by reversing a portion of the valuation allowance and crediting income tax expense. In 2015, we released $5.4 million of our valuation allowance. In accordance with ASC 740, we considered the following sources of income in reaching our conclusion:

Future reversal of temporary differences

Future taxable income exclusive of reversing temporary differences and carryforwards

Taxable income in prior carryback year(s) if carryback is permitted under the tax law

Tax-planning strategies

The positive evidence that outweighed the negative evidence in management’s assessment included, but was not limited to, the following:

Positive cumulative pre-tax earnings over the prior three year period ended December 31, 2016.

Improvement in asset quality and net interest income.

Management’s consistent ability to exceed annual forecasted financial results.

Significant reductions in historical credit-related losses and investment impairment.

Net operating loss carryforwards do not begin to expire until 2028.

The total change to our valuation allowance on the net DTAs was $4.0 million. The change consisted of a decrease in the valuation allowance of $4.3 million related to items for which the change impacted income tax expense, offset by a $308 increase in the valuation allowance associated with certain equity investments related to AOCI items. The change in the valuation allowance for certain equity investments related to AOCI items is reflected in AOCI and not in income tax expense. The ability to recognize the remaining DTAs that continue to be subject to a valuation allowance will be evaluated on a quarterly basis to determine if there are any significant events that would affect the ability to utilize these deferred tax assets. There can be no assurance, however, as to when we could be in a position to reverse the remaining DTA valuation allowance. The deferred tax assets, net of valuation allowances, totaled $7.9 million and $5.7 million at December 31, 2016 and 2015, respectively.

A significant component of the DTAs at December 31, 2016 is our federal NOL carryforwards of approximately $57.7 million and state NOL carryforwards of $136.8 million which are available to be carried forward to future tax years. The federal loss carryforwards will begin to expire in 2028 and the state NOLs will begin to expire in 2026 if not fully utilized.

As of December 31, 2016, we have capital loss carryforwards of approximately $3.7 million which will begin to expire as of December 31, 2017 if not utilized. We also have charitable contribution carryovers of $35 thousand which will begin to expire as of December 31, 2019 if not utilized but would likely be converted to NOLs. We also have general business tax credit carryovers of $1 thousand that will begin to expire as of December 31, 2030 if not utilized and AMT tax credits of $426 thousand that have an indefinite life.

We had no material unrecognized tax benefits (“UTB”) or accrued interest and penalties as of December 31, 2016. We do not expect the total amount of UTB to significantly increase in the next twelve months. As of December 31, 2016 no significant changes to UTB are projected; however, tax audit examinations are possible. As of December 31, 2016, tax years 2013 through 2015 are subject to federal examination by the IRS and years 2012 through 2015 are subject to state examination by various state taxing authorities.