11. Income Taxes

The Company records federal and state income tax liabilities associated with its status as a corporation. The Company recognizes a tax liability on its share of pre-tax book income, exclusive of the non-controlling interest. JEH is not subject to income tax at the federal level and only recognizes Texas franchise tax expense.

On December 22, 2017, the US Congress enacted the Tax Reform Legislation, which made significant changes to US federal income tax law, including a reduction of the federal corporate tax rate to 21% effective January 1, 2018. We are required to recognize the effect of a rate change on deferred tax assets and liabilities in the period in which the tax rate change is enacted. Therefore, the rate change enacted by the Tax Reform Legislation resulted in the recognition of a tax benefit of $17.2 million along with a benefit from the reduction of the liability under the Tax Receivable Agreement of $59.5 million.

The Tax Reform Legislation is a comprehensive bill containing other provisions, such as limitations on the deductibility of interest expense and certain executive compensation, that are not expected to materially affect us. The ultimate impact of Tax Reform Legislation may differ from our estimates due to changes in interpretations and assumptions made by us, as well as additional regulatory guidance that may be issued. The impact on our deferred tax assets and liabilities may be adjusted in future periods, as an adjustment to income tax expense or benefit, in the period in which the final amounts are determined.

The following table summarizes the tax provision for the years ended December 31, 2017, 2016, and 2015:

 

A reconciliation of the Company’s provision for income taxes as reported and the amount computed by multiplying income before taxes, less non‑controlling interest, by the U.S. federal statutory rate of 35%:

 

(1)   Statutory rate will decrease to 21% for fiscal year 2018. The effect of the rate change on deferred tax assets and liabilities is recognized in the period in which the tax rate change is enacted, which also results in the reduction of the TRA liability.

 

The Company is subject to federal, state, and local income and franchise taxes. As such, deferred income taxes result from temporary differences between the carrying amounts of assets and liabilities of the Company for financial reporting purposes and the amounts used for income tax purposes. Deferred tax assets and liabilities are measured using enacted tax rates in effect in the years in which those temporary differences are expected to reverse.

In 2017, the United States enacted legislation that reduced the federal corporate tax rate from 35% to 21% for tax years beginning on or after January 1, 2018. The Company is required to recognize the effect of this rate change on its deferred tax assets and liabilities in the period the tax rate change is enacted. We recorded tax benefit of $17.2 million, net of valuation allowance, as a result of revaluing our deferred tax assets and liabilities at the newly enacted rate. The Company also recognized non-taxable income from the reduction of the liability under the Tax Receivable Agreement as a result of remeasuring the liability to reflect the revised federal statutory rate that had an impact on the effective rate of $20.8 million.

In 2015, Texas enacted legislation that reduced the Texas franchise tax rate from 1.0% to 0.75%. We recorded a tax benefit of $1.7 million as a result of revaluing our deferred tax assets and liabilities at the newly enacted rate, of which $1.0 million was attributable to the non-controlling interest.

Significant components of the Company’s deferred tax assets and deferred tax liabilities consisted of the following:

 

Internal Revenue Code ("IRC") Section 382 limits a corporation’s utilization of federal net operating loss carryforwards and certain other tax attributes on an annual basis following an ownership change of the corporation. The Company has a federal net operating loss carry-forward totaling $53.0 million and state net operating loss carry-forward of $47.4 million, after giving effect to an IRC Section 382 limitation. These federal and state net operating loss carryforwards expire between 2033 and 2037. Net operating losses generated in 2018 and future years will have an indefinite carryforward as a result of Tax Reform Legislation. The tax benefits of carryforwards are recorded as an asset to the extent that management assesses the utilization of such carryforwards to be more likely than not. When the future utilization of some portion of the carryforwards is determined not to be more likely than not, a valuation allowance is provided to reduce the recorded tax benefits from such assets. As of December 31, 2017 and 2016, we had a valuation allowance of $10.2 million and $3.2 million, respectively as a result of management’s assessment of the realizability of federal and state deferred tax assets. Management believes that there will be sufficient future taxable income based on the reversal of temporary differences to enable utilization of substantially all other tax carryforwards.

The Company experienced ownership changes within the meaning of IRC Section 382 during 2017 and 2015 that subject a portion of its federal net operating loss carryforwards to IRC Section 382 limitations. The Company estimates that the IRC Section 382 limitation that applies to the Company’s 2017 ownership change will result in a permanent loss of federal and state deferred tax assets totaling $13.8 net operating loss carryforwards and other tax attributes, as measured at the 21% enacted rate and adjusted for the modified loss carryforward provisions of Tax Reform Legislation. The reduction in state net operating loss carryforwards is off-set by a corresponding $2.4 million adjustment to the valuation allowance. 

Separate federal and state income tax returns are filed for Jones Energy, Inc. and Jones Energy Holdings, LLC. JEH’s Texas franchise tax returns are subject to audit for 2013 through 2016. The tax years 2014 through 2016 remain open to examination by the major taxing jurisdictions to which the Company is subject, however net operating losses originating in prior years are subject to examination when utilized. The Internal Revenue Service is currently examining the 2013 federal partnership income tax return for JEH, but has indicated that the audit will be concluded with no change. The Company’s other income tax returns have not been audited by the Internal Revenue Service or any state jurisdiction.

Accounting for uncertainty in income taxes prescribes a recognition threshold and measurement methodology for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. As of December 31, 2017, 2016 and 2015 there was no material liability or expense for the periods then ended recorded for payments of interest and penalties associated with uncertain tax positions or material unrecognized tax positions and the Company’s unrecognized tax benefits were not material.

Tax Receivable Agreement

In connection with the IPO, the Company entered into a Tax Receivable Agreement (the “TRA”) which obligates the Company to make payments to certain current and former owners equal to 85% of the applicable cash savings that the Company realizes as a result of tax attributes arising from exchanges of JEH Units and shares of the Company’s Class B common stock held by those owners for shares of the Company’s Class A common stock. The Company will retain the benefit of the remaining 15% of these tax savings. At the time of an exchange, the company records a liability to reflect the future payments under the TRA.

The TRA liability is recorded based upon the projected tax savings at the time of an exchange. As a result of the tax reform legislation, the amount of the TRA liability was remeasured to reflect the reduction of the federal corporate tax rate from 35% to 21%. We recorded a benefit for the reduction of the TRA liability of $59.5 million as a result of the newly enacted rate. The amount is included in other income (expense) on the Company’s Consolidated Statement of Operations.

The actual amount and timing of payments to be made under the TRA 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 use of loss carryovers, and the portion of the Company’s payments under the TRA constituting imputed interest. As of December 31, 2017 and December 31, 2016, the Company had a gross TRA liability of $69.9 million and $45.7 million, respectively. As a result of the valuation allowance recorded against its deferred tax assets associated with prior exchanges, the TRA liability was reduced, as the payment of the TRA liability is dependent upon the realizability of the associated deferred tax assets. As of December 31, 2017 and 2016, the amount of the TRA liability was reduced by $8.7 million, and $2.7 million, respectively, as a result of the valuation allowance recorded against the Company’s deferred tax assets. To the extent the Company does not realize all of the tax benefits in future years or in the event of a change in future tax rates, this liability may change.

As of December 31, 2017, and 2016 the Company had recorded a net TRA liability of $61.2 million and $43.0 million, respectively, for the estimated payments that will be made to the Class B shareholders who have exchanged shares, after adjusting for the TRA liability reduction. As of December 31, 2017, of the $61.2 million net TRA liability, $1.6 million was recorded within other current liabilities on the Company’s Consolidated Balance Sheet. As of December 31, 2017 and 2016 there were corresponding deferred tax assets, net of valuation allowance, of $72.3 million, and $50.6 million, respectively, as a result of the increase in tax basis generated arising from such exchanges.

As of December 31, 2017, the Company had not made any payments under the TRA to Class B shareholders who have exchanged JEH units and Class B common stock for Class A common stock. The Company made a payment of  $1.6 million of the TRA liability with respect to cash savings that the Company realized on its 2016 tax return as a result of tax attributes arising from prior exchanges in the first quarter of 2018. The Company does not anticipate it will realize cash savings on its 2017 tax return as a result of tax attributes arising from prior exchanges, and therefore does not anticipate a payment under the TRA for the 2017 tax year.

 

Cash Tax Distributions

 

The holders of JEH Units, including Jones Energy, Inc., incur U.S. federal, state and local income taxes on their share of any taxable income of JEH. Under the terms of its operating agreement, JEH is generally required to make quarterly pro-rata cash tax distributions to its unitholders (including us) based on income allocated to its unitholders through the end of each relevant quarter, as adjusted to take into account good faith projections by the Company of taxable income or loss for the remainder of the calendar year, to the extent JEH has cash available for such distributions and subject to certain other restrictions.

 

A Special Committee of the Board of Directors comprised solely of directors who do not have a direct or indirect interest in such distribution approved, and JEH made, aggregate cash tax distributions during 2017 and 2016 of $1.7 million and $41.0 million, respectively, (including distributions to us) to its unitholders towards its total 2016 projected tax distribution obligation. Distributions during 2017 were made pro-rata to all members of JEH, and included a $1.1 million payment to the Company and a $0.6 million payment to JEH unitholders other than the Company. Distributions during 2016 were made pro-rata to all members of JEH, and included a $23.7 million payment to the Company and a $17.3 million payment to Class B shareholders. The 2016 tax distributions are the result of taxable income generated by JEH’s operations and debt extinguishment. All tax distributions were paid as a result of JEH’s 2016 taxable income.