(15)Income Taxes

 

The Company’s provision (benefit) for income taxes was based upon management’s estimate of taxable income or loss for each respective accounting period.  The Company recognizes an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets including net operating loss and credit carryforwards and liabilities and the amounts reported in the financial statements.  These temporary differences would result in taxable or deductible amounts in future years when the reported amounts of the assets are recovered or liabilities are settled.

 

On February 2, 2015, Skilled, along with its subsidiary healthcare companies (the Skilled Companies) and FC-GEN, along with its subsidiary companies (the Genesis HealthCare Companies) completed the Combination pursuant to which the businesses of the Skilled Companies and the Genesis HealthCare Companies were combined and now operate under the name Genesis Healthcare, Inc. 

 

The Internal Revenue Code (IRC) imposes limitations on a corporation’s ability to utilize federal tax attributes (such as net unrealized built-in-deductions), including federal income tax credits, in the event of an “ownership change.”  States may impose similar limitations.  In general terms, an ownership change may result from transactions increasing the ownership of certain shareholders in the stock of a corporation by more than 50 percentage points over a three year period.  The Combination generated such an ownership change.  The Skilled Companies were treated as being purchased for accounting and tax purposes.  As a result of the Combination, the tax bases of its assets and attributes such as net operating losses and tax credit carryforwards were carried over and subject to the provisions of IRC Sec. 382.

 

Following the Combination and as of December 31, 2017, the Company now effectively owns 61.4% of FC-GEN, an entity taxed as a partnership for U.S. income tax purposes.  This is the Company’s only source of taxable income.  The taxable income of the partnership is subject to the income allocation rules of IRC Sec. 704.  Management believes the mechanics of IRC Sec. 704 will cause a greater portion of the temporary tax deductions to be allocated to the Company.  This allocation will reduce the Company’s taxable income. 

 

Income Tax (Benefit) Provision

 

Total income tax (benefit) expense was as follows (in thousands):

 

The components of the provision for income taxes on income (loss) from continuing operations for the periods presented were as follows (in thousands):

 

At December 31, 2017, the current income taxes were primarily generated on the taxable income of the Company’s Bermuda captive insurance company.  At December 31, 2016, the current income taxes benefit was primarily generated from the release of a FASB Interpretation No. 48 (FIN 48) reserve the Company acquired in the acquisition of Sun Healthcare Group, Inc.  The FIN 48 reserve was released due to the lapse of statute of limitations.  At December 31, 2015, the current income taxes were primarily generated on the taxable income of the Company’s Bermuda captive insurance company.

 

Beginning with the fourth quarter of 2014, the Company initiated rehabilitation therapy services within the People’s Republic of China.  In the quarter ended March 31, 2016, the Company expanded rehabilitation therapy services within Hong Kong.  At December 31, 2016 and 2015, these business operations remain in their respective startup stage.  During the year ended December, 31, 2017, these foreign operations generated both U.S. federal and foreign taxable losses.  The deferred tax assets generated by the foreign operations are fully valued at December 31, 2017.  Management does not anticipate these operations will generate taxable income in the near term.  The operations currently do not have a material effect on the Company’s effective tax rate.

 

In assessing the requirement for, and amount of, a valuation allowance in accordance with the more likely than not standard for all periods, the Company gives appropriate consideration to all positive and negative evidence related to the realization of the deferred tax assets. The assessment considers the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, the duration of statutory carryforward periods and the Company’s experience with operating loss and tax credit expirations. A history of cumulative losses is a significant piece of negative evidence used in the assessment.

 

At December 31, 2017 and 2016, the Company has established a valuation allowance in the amount of $264.1 million and $280.6 million, respectively.  The valuation allowance in 2017 and 2016 has been established due to management’s assessment that the Company will not realize its deferred tax assets.  Therefore, management recorded a full valuation allowance against the majority of its net deferred tax assets in the amount of $264.1 million and $280.6 million, respectively, except for the discounted unpaid loss reserve deferred tax asset of the Company’s captive insurance company.  The carrying value of the Company’s deferred tax assets and liabilities at December 31, 2017, is less than the values at December 31, 2016, due to the reduction of the U.S. federal corporate income tax rate down from 35% to 21% as a result of the U.S. Tax Cuts and Jobs Act enacted on December 22, 2017, which reduced the income tax rate imposed upon corporations from 35% to 21%. 

 

The Securities and Exchange Commission issued Staff Accounting Bulletin No. 118 (SAB 118) on December 23, 2017. SAB 118 provides a one-year measurement period from a registrant’s reporting period that includes the U.S. Tax Act’s enactment date to allow the registrant sufficient time to obtain, prepare and analyze information to complete the accounting required under ASC 740.  In addition to the aforementioned impacts to the Company's consolidated financial statements as of December 31, 2017, the U.S. Tax Cuts and Jobs Act could have other impacts on the Company in the future. The Company's federal net operating losses that have been incurred prior to December 31, 2017 will continue to have a 20-year carryforward limitation applied and will need to be evaluated for recoverability in the future as such. For net operating losses created after December 31, 2017, the net operating losses will have an indefinite life, but usage will be limited to 80% of taxable income in any given year. The Company has estimated the impact of the U.S. Tax Cuts and Jobs Act on state income taxes reflected in its income tax benefit for the year ended December 31, 2017. Reasonable estimates for the Company’s state and local provision were made based on the Company's analysis of tax reform. These provisional amounts may be adjusted in future periods during 2018 when additional information is obtained. Additional information that may affect the Company's provisional amounts would include further clarification and guidance on how the Internal Revenue Service will implement tax reform and further clarification and guidance on how state taxing authorities will implement tax reform and the related effect on our state and local income tax returns, state and local net operating losses and corresponding valuation allowances.

 

Total income tax (benefit) expense for the periods presented differed from the amounts computed by applying the federal income tax rate of 35% to income (loss) before income taxes as illustrated below (in thousands):

 

 

The Company’s effective income tax rate was 1.1% in 2017, 12.9% in 2016, and (48.9)% in 2015.  The change in the effective income tax rate from 2016 to 2017 was largely due to the reduction in the carrying value of the Company’s deferred tax asset and deferred tax liability caused by the U.S. Tax Cuts and Jobs Act enacted on December 22, 2017, which reduced the income tax rate imposed upon corporations from 35% to 21%.  The reduction in the income tax rate resulted in a $108.3 million reduction to the Company's deferred tax assets.  The change in the effective income tax rate from 2015 to 2016 was largely due to the release of a FIN 48 reserve in 2016 and the establishment of a full valuation allowance in 2015 of $221.9 million.    

 

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2017 and 2016 are presented below (in thousands):

 

 

Uncertain Tax Positions

 

The Company follows the provisions of the authoritative guidance for accounting for uncertainty in income taxes which clarifies the accounting for uncertain income tax issues recognized in an entity’s financial statements. The guidance prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in an income tax return.

 

The Company, excluding its corporate groups, is only subject to state and local income tax in certain jurisdictions.  The Company’s corporate groups are subject to federal, state and local income taxes.  The Company is also subject to income based taxes in Hong Kong and China.  However, since these operations began in year 2014, they have historically generated current taxable losses. Significant judgment is required in evaluating its uncertain tax positions and determining its provision for income taxes.  Under U.S. GAAP, the Company utilizes a two-step approach to recognizing and measuring uncertain tax positions.  The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes.  The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement.

 

The Company is subject to various federal and state income tax audits in the ordinary course of business. Such audits could result in increased tax payments, interest and penalties. While the Company believes its tax positions are appropriate, it cannot assure that the various authorities engaged in the examination of its income tax returns will not challenge the Company’s positions.  The Company believes it has adequately reserved for its uncertain tax positions, though no assurance can be given that the final tax outcome of these matters will not be different.  The Company adjusts these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the expiration of the statute of limitations.  To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made.  The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest.

 

A reconciliation of unrecognized tax benefits follows (in thousands):

 

 

The Company’s unrecognized tax benefits reserve for uncertain tax positions primarily relates to certain tax exposure items acquired as a result of the Sun Merger, the most significant item is an IRC 382 realized built-in-gain resulting in utilization of the net operating loss carryforward. The liability related to the Sun Merger reserve was accounted for as part of the purchase price and was not charged to income tax expense.  In the third quarter of 2016, the Company was able to release this FIN 48 reserve as the statute of limitations upon the return the position was initially recognized expired.

 

All of the gross unrecognized tax benefits would affect the effective tax rate if recognized.  Unrecognized tax benefits are adjusted in the period in which new information about a tax position becomes available or the final outcome differs from the amount recorded.  Unrecognized tax benefits are not expected to change significantly over the next twelve months.  The Company recognizes potential accrued interest related to unrecognized tax benefits in income tax expense.  Penalties, if incurred, would also be recognized as a component of income tax expense.  The amount of accrued interest related to unrecognized tax benefits as of December 31, 2017, 2016, and 2015 was less than $0.1 million, $0.1 million, and $0.4 million, respectively.  Generally, the Company has open tax years for state purposes subject to tax audit on average of between three years to six years. The Company’s U.S. income tax returns from 2011 are open and could be subject to examination.

 

Exchange Rights and Tax Receivable Agreement

 

Following the Combination, the owners of FC-GEN have the right to exchange their membership units in FC-GEN,  along with an equivalent number of Class C shares, for shares of Class A common stock of the Company or cash, at the Company’s option..  As a result of such exchanges, the Company’s membership interest in FC-GEN will increase and its purchase price will be reflected in its share of the tax basis of FC-GEN’s tangible and intangible assets.  Any resulting increases in tax basis are likely to increase tax depreciation and amortization deductions and, therefore, reduce the amount of income tax the Company would otherwise be required to pay in the future.  Any such increase would also decrease gain (or increase loss) on future dispositions of the affected assets.  There were exchanges of 2,287,987 FC-GEN units and Class C shares during the twelve months ended December 31, 2017 equating to 2,288,381 Class A shares.  The exchanges during the twelve months ended December 31, 2017 resulted in a $14.9 million IRC Section 754 tax basis step-up in the tax deductible goodwill of FC-GEN.  There were exchanges of 600,000 FC-GEN units and Class C shares during the twelve months ended December 31, 2016 equating to 600,102 Class A shares.  The exchanges during the twelve months ended December 31, 2016 resulted in a $3.1 million IRC Section 754 tax basis step-up in the tax deductible goodwill of FC-GEN.

 

Concurrent with the Combination, the Company entered into a tax receivable agreement (TRA) with the owners of FC-GEN.  The agreement provides for the payment by the Company to the owners of FC-GEN of 90% of the cash savings, if any, in U.S. federal, state and local income tax that the Company actually realizes as a result of (i) the increases in tax basis attributable to the owners of FC-GEN and (ii) tax benefits related to imputed interest deemed to be paid by the Company as a result of the TRA.  Under the TRA, the benefits deemed realized by the Company as a result of the increase in tax basis attributable to the owners of FC-GEN generally will be computed by comparing the actual income tax liability of the Company to the amount of such taxes that the Company would have been required to pay had there been no such increase in tax basis.

 

Estimating the amount of payments that may be made under the TRA is by its nature imprecise, insofar as the calculation of amounts payable depends on a variety of factors. The actual increase in tax basis and deductions, as well as the amount and timing of any payments under the TRA, will vary depending upon a number of factors, including:

 

the timing of exchanges—for instance, the increase in any tax deductions will vary depending on the fair value of the depreciable or amortizable assets of FC-GEN and its subsidiaries at the time of each exchange, which fair value may fluctuate over time;

 

the price of shares of Company Class A Common Stock at the time of the exchange—the increase in any tax deductions, and the tax basis increase in other assets of FC-GEN and its subsidiaries is directly proportional to the price of shares of Company Class A Common Stock at the time of the exchange;

 

the amount and timing of the Company’s income—the Company is required to pay 90% of the deemed benefits as and when deemed realized. If FC-GEN does not have taxable income, the Company is generally not required (absent a change of control or circumstances requiring an early termination payment) to make payments under the TRA for that taxable year because no benefit will have been actually realized.  However, any tax benefits that do not result in realized benefits in a given tax year likely will generate tax attributes that may be utilized to generate benefits in previous or future tax years. The utilization of such tax attributes will result in payments under the TRA; and

 

future tax rates of jurisdictions in which the Company has tax liability.

 

The TRA also provides that upon certain mergers, asset sales, other forms of business combinations or other changes of control, FC-GEN (or its successor’s) obligations under the TRA would be based on certain assumptions defined in the TRA. As a result of these assumptions, FC-GEN could be required to make payments under the TRA that are greater or less than the specified percentage of the actual benefits realized by the Company that are subject to the TRA.  In addition, if FC-GEN elects to terminate the TRA early, it would be required to make an early termination payment, which upfront payment may be made significantly in advance of the anticipated future tax benefits.

 

Payments generally are due under the TRA within a specified period of time following the filing of FC-GEN’s U.S. federal and state income tax return for the taxable year with respect to which the payment obligation arises.  Payments under the TRA generally will be based on the tax reporting positions that FC-GEN will determine.  Although FC-GEN does not expect the Internal Revenue Service (IRS) to challenge the Company’s tax reporting positions, FC-GEN will not be reimbursed for any overpayments previously made under the TRA, but any overpayments will reduce future payments.  As a result, in certain circumstances, payments could be made under the TRA in excess of the benefits that FC-GEN actually realizes in respect of the tax attributes subject to the TRA.

 

The term of the TRA generally will continue until all applicable tax benefits have been utilized or expired, unless the Company exercises its right to terminate the TRA and make an early termination payment.

 

In certain circumstances (such as certain changes in control, the election of the Company to exercise its right to terminate the agreement and make an early termination payment or an IRS challenge to a tax basis increase) it is possible that cash payments under the TRA may exceed actual cash savings.