K12 INC

5. Income Taxes

The provision for income taxes is based on earnings reported in the consolidated financial statements. A deferred income tax asset or liability is determined by applying currently enacted tax laws and rates to the expected reversal of the cumulative temporary differences between the carrying value of assets and liabilities for financial statement and income tax purposes. Deferred income tax expense or benefit is measured by the change in the deferred income tax asset or liability during the year.

Deferred tax assets and liabilities result primarily from temporary differences in book versus tax basis accounting. Deferred tax assets and liabilities consist of the following:


	June 30,
	2017		2016
	(In thousands)
Deferred tax assets (liabilities):
Net operating loss carryforward	$	8,033	$	5,464
Reserves		7,400		5,892
Accrued expenses		10,695		11,494
Stock compensation expense		11,449		11,735
Other assets		1,720		2,628
Deferred rent		3,299		1,922
Deferred revenue		401		—
Federal tax credits		20		20
State tax credits		390		841
Total deferred tax assets		43,407		39,996
Deferred tax liabilities
Capitalized curriculum development		(15,323)		(13,821)
Capitalized software and website development costs		(23,288)		(25,435)
Property and equipment		(2,649)		(1,931)
Investment in Middlebury Interactive Languages		—		(20)
Returned materials		(4,559)		(4,883)
Deferred revenue		—		(128)
Purchased intangibles		(7,161)		(7,897)
Total deferred tax liabilities		(52,980)		(54,115)
Net deferred tax liability before valuation allowance		(9,573)		(14,119)
Valuation Allowance		(7,153)		(4,339)
Net deferred tax liability	$	(16,726)	$	(18,458)
Reported as:
Long-term deferred tax liabilities		(16,726)		(18,458)
Net deferred tax liability	$	(16,726)	$	(18,458)

The Company maintained a valuation allowance on net noncurrent deferred tax assets of $7.2 million and $4.3 million as of June 30, 2017 and 2016, respectively, predominantly related to foreign income tax net operating losses ("NOL") and operating losses related to its tax non-consolidating entity. The Company does not believe it is more likely than not that it will utilize these deferred tax assets.

The Company has not provided for U.S. deferred income taxes on undistributed foreign earnings because such earnings are considered to be indefinitely reinvested. Undistributed earnings of certain consolidated foreign subsidiaries at June 30, 2017 amounted to $22.8 million. If such earnings were not indefinitely reinvested, a U.S. deferred income tax liability of approximately $9.1 million would have been required.

At June 30, 2017, the Company had available federal and state NOL carryforwards of $1.6 million and $0.2 million, respectively, net of valuation allowances. The federal NOLs, if unused, expire in 2020 and the state NOLs expire on various dates.

For the years ended June 30, 2017 and 2016, the Company has evaluated whether a change in the Company's ownership of outstanding classes of stock as defined in Internal Revenue Code Section 382 could prohibit or limit the Company's ability to utilize its NOLs. The Company has concluded it is more likely than not that the Company will be able to fully utilize its NOLs subject to the Section 382 limitation.

The related components of the income tax expense for the years ended June 30, 2017, 2016 and 2015 were as follows:


	Year Ended June 30,
	2017		2016		2015
	(In thousands)
Current:
Federal	$	8,756	$	4,651	$	6,490
State		3,153		1,152		1,964
Foreign		552		2,761		450
Total current		12,461		8,564		8,904
Deferred:
Federal		(6,505)		(1,648)		(2,291)
State		(560)		(97)		(1,635)
Foreign		—		(2,073)		832
Total deferred		(7,065)		(3,818)		(3,094)
Total income tax expense	$	5,396	$	4,746	$	5,810

The provision for income taxes can be reconciled to the income tax that would result from applying the statutory rate to the net income before income taxes as follows:


	Year Ended June 30,
	2017		2016		2015
U.S. federal tax at statutory rates	35.0	%	35.0	%	35.0	%
Permanent items	7.1		4.8		2.3
Lobbying	7.2		5.3		5.0
State taxes, net of federal benefit	19.5		3.8		1.8
Research and development tax credits	(8.2)		(8.1)		(1.7)
Domestic production activities deduction	(22.9)		(5.2)		(6.5)
Change in valuation allowance	53.3		2.9		5.2
Effects of foreign operations	2.6		(0.9)		(13.6)
Reserve for unrecognized tax benefits	3.3		(6.3)		6.1
Noncontrolling Interests	12.5		4.2		5.5
Other	(0.1)		0.2		(0.7)
Provision for income taxes	109.3	%	35.7	%	38.4	%

The effective income tax rates during the years ended June 30, 2017, 2016 and 2015 were 109.3%, 35.7%, and 38.4%, respectively. The increase in the effective tax rate for the year ended June 30, 2017 was primarily due to the Web impairment which resulted in substantial foreign losses with no tax benefit due to the full valuation allowance against these losses.

Tax Uncertainties

The Company follows the provisions of ASC 740-10 which applies to all tax positions related to income taxes. ASC 740-10 provides a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. ASC 740-10 clarifies accounting for income taxes by prescribing a minimum probability threshold that a tax position must meet before a financial statement benefit is recognized. If the probability for sustaining a tax position is greater than 50%, then the tax position is warranted and recognition should be at the highest amount which would be expected to be realized upon ultimate settlement.

The Company recognizes interest and penalties, if any, related to unrecognized tax benefits in income tax expense. As of June 30, 2017, 2016 and 2015, the Company had $0.1 million, $0.1 million and $0.2 million in accrued interest and penalties, respectively.

The unrecognized tax benefits for the years ended June 30, 2017, 2016 and 2015 were as follows:


	Year Ended June 30,
	2017		2016		2015
	(In thousands)
Balance at beginning of the year	$	2,224	$	3,558	$	2,555
Additions for prior year tax positions		951		351		137
Additions for current year tax positions		241		290		989
Reductions for prior year tax positions		(1,156)		(1,975)		(123)
Balance at end of the year	$	2,260	$	2,224	$	3,558

If recognized, all of the $2.3 million balance of unrecognized tax benefits would affect the effective tax rate. We do not anticipate a significant increase or decrease in unrecognized tax benefits in the next twelve months.

The Company remains subject to audit by the Internal Revenue Service for federal tax purposes for tax years after June 30, 2013. Certain state and foreign tax jurisdictions are also either currently under audit or remain open under the statute of limitations for the tax years after June 30, 2011.