11.      Income Taxes

Income Taxes

The Company is a corporation and, as a result is subject to U.S. federal, state and local income taxes. Solaris LLC is treated as a pass-through entity for U.S. federal tax purposes and in most state and local jurisdictions. As such, Solaris LLC's members, including the Company, are liable for federal and state income taxes on their respective shares of Solaris LLC's taxable income. Solaris LLC is liable for income taxes in those states not recognizing its pass-through status.

On December 22, 2017, the U.S. government enacted in Public Law No. 115-97, commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”), comprehensive tax legislation. The provisions of the Tax Act that impact us include, but are not limited to, (1) reducing the U.S. federal corporate income tax rate from 35% to 21%; (2) eliminating of the corporate alternative minimum tax (AMT); (3) allowing businesses to immediately expense the cost of new investments in certain qualified depreciable assets acquired after September 27, 2017 (with a phase-down of such expensing starting in 2023), and (4) reducing the maximum deduction for net operating loss (NOL) carryforwards generated in tax years beginning after December 31, 2017, to 80 percent of a taxpayer’s taxable income. In conjunction with the Tax Act, the SEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (SAB 118), which provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.

In connection with our initial analysis of the impact of the Tax Act, we have recorded a discrete net tax expense of $22.6 million and a gain pursuant to the Tax Receivable Agreement of $21.9 million in the period ending December 31, 2017. This net expense primarily relates to impact of remeasuring our existing net deferred tax asset as a result of the corporate income tax rate reduction from 35% to 21%. Based on a continued analysis of the estimates, it is anticipated that additional revisions may occur during the allowable measurement period.

Income Tax Expense

The components of the income tax expense are:

 

Income tax expense differs from the amount computed by applying the statutory federal income tax rate of 35% to income (loss) before taxes as follows:

 

The effective combined U.S. federal and state income tax rates were 53.5% and 1.5% for the years ended December 31, 2017 and 2016, respectively. The year-over-year increase in the effective tax rate was primarily attributable to remeasuring our existing net deferred tax asset from 35% to 21% due to the federal corporate income tax rate change enacted under the Tax Act. The effective tax rate also increased as a result of the Reorganization Transactions in 2017 and an increase in net income during the period. These increases in the effective tax rate were offset by a favorable tax adjustment related to the revaluation of the Tax Receivable Agreement due to the Tax Act. The revaluation of the Tax Receivable Agreement under the Tax Act resulted in an increase to non-operating income of $21.9 million.  This income is not taxable and thus lowered the overall effective tax rate.

Deferred Tax Assets and Liabilities

The Company’s deferred tax position reflects the net tax effects of the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax reporting. Significant components of the deferred tax assets and liabilities are as follows:

 

As of December 31, 2017, the Company had approximately $24.5 million of federal net operating loss carryovers and $6.1 million of state net operating loss carryovers that expire in year 2037.

The Company regularly reviews its deferred tax assets, including net operating loss carryovers, for recoverability and a valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset may not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the temporary differences are deductible. In assessing the need for a valuation allowance, the Company makes estimates and assumptions regarding projected future taxable income, its ability to carry back operating losses to prior periods, the reversal of deferred tax liabilities and the implementation of tax planning strategies. Based on our cumulative earnings history and forecasted future sources of taxable income, we believe that we will be able to realize our deferred tax assets in the future. As the Company reassesses these assumptions in the future, changes in forecasted taxable income may alter this expectation and may result in an increase to the valuation allowance and an increase in the effective tax rate.

Uncertain Tax Benefits

The Company evaluates its tax positions and recognizes only tax benefits that, more likely than not, will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The tax position is measured at the largest amount of benefit that has a greater than 50.0% likelihood of being realized upon settlement. At December 31, 2017, 2016 and 2015, the Company’s uncertain tax benefits totaling $812,  $0 and $0, respectively, are reported as a component of the net deferred tax asset in the consolidated balance sheets. The current year addition to uncertain tax benefits relates to the treatment of certain costs incurred in connection with the Company’s initial and secondary public offerings. Changes in the Company’s gross unrecognized tax benefits are as follows:

 

The full balance of unrecognized tax benefits as of December 31, 2017, if recognized, would affect the effective tax rate. However, we do not believe that any of the unrecognized tax benefits will be realized within the coming year. The Company has elected to recognize interest and penalties related to unrecognized tax benefits in income tax expense; notwithstanding, as of December 31, 2017, the Company has not accrued any penalties or interest.

Payables Related to Parties Pursuant to Tax Receivable Agreement

As of December 31, 2017, our liability under the Tax Receivable Agreement was $24.7 million, representing 85% of the calculated net cash savings in U.S. federal, state and local income tax or franchise tax that Solaris Inc. anticipates realizing in future years from additional depreciation and amortization related to basis adjustments under Section 754 of the Internal Revenue Code of 1986, as amended (the “Code”), created in connection with the IPO or pursuant to an exercise of the Redemption Right or the Call Right (each as defined in Solaris LLC’s amended and restated Limited Liability Company Agreement).

The projection of future taxable income involves significant judgment. Actual taxable income may differ from our estimates, which could significantly impact our liability under the Tax Receivable Agreement. We have determined it is more-likely-than-not that we will be able to utilize all of our deferred tax assets subject to the Tax Receivable Agreement; therefore, we have recorded a liability under the Tax Receivable Agreement related to the tax savings we may realize from the depreciation and amortization related to basis adjustments under Section 754 of the Code, created in connection with the IPO or pursuant to an exercise of the Redemption Right or the Call Right. If we determine the utilization of these deferred tax assets is not more-likely-than-not in the future, our estimate of amounts to be paid under the Tax Receivable Agreement would be reduced. In this scenario, the reduction of the liability under the Tax Receivable Agreement would result in a benefit to our consolidated statement of operations.