Potbelly Corporation

(7) Income Taxes

Income (loss) before income taxes for the Company’s domestic and foreign operations was as follows (in thousands):

	Fiscal Year
	2017			2016		2015
Domestic operations	$	(2,513	)	$	12,411	$	8,660
Foreign operations		466			468		548
Total	$	(2,047	)	$	12,879	$	9,208

Income tax expense consisted of the following (in thousands):

	Fiscal Year
	2017			2016			2015
Federal:
Current	$	(3,728	)	$	4,652		$	2,450
Deferred		8,792			(1,386	)		209
		5,064			3,266			2,659
State and Local:
Current		150			1,426			1,047
Deferred		(584	)		(273	)		(281	)
		(434	)		1,153			766
Foreign:
Current		13			24			41
		13			24			41
Income tax expense	$	4,643		$	4,443		$	3,466

Income tax expense differed from the amounts computed by applying the U.S. federal income tax rates to income (loss) before income taxes as a result of the following (in thousands):

	Fiscal Year
	2017			2016			2015
Computed “expected” tax expense (benefit)	$	(716	)	$	4,508		$	3,223
Increase (reduction) resulting from:
Minority interest		(105	)		(89	)		(45	)
Permanent differences		96			131			51
State and local income taxes, net of federal income tax effect		5			673			533
FICA and other tax credits		(502	)		(556	)		(392	)
Equity Compensation		2,112			—			—
Adjustments		(93	)		(300	)		(72	)
Rate change		3,846			76			236
Change in valuation allowance		—			—			(68	)
	$	4,643		$	4,443		$	3,466

On December 22, 2017, the Tax Act was enacted into law making significant changes to the U.S. tax code, including: (1) reducing the U.S. federal corporate tax rate from 35 percent to 21 percent; (2) implementing bonus depreciation that will allow for full expensing of qualified property; (3) implementing limitations on the deductibility of certain executive compensation; and (4) changing rules related to uses and limitations of net operating loss carryforwards created in tax years beginning after December 31, 2017.

On that same date, the SEC staff also issued Staff Accounting Bulletin (SAB) 118, which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 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. A company must reflect the income tax effects of those aspects of the Act for which 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.

At December 31, 2017, the Company has not completed the accounting for the tax effects of enactment of the Tax Act; however, the Company made a reasonable estimate of the effects. The Company is still analyzing certain aspects of the Act and refining its calculations, which could potentially affect the measurement of the amounts recorded at December 31, 2017.

In connection with the Company’s initial analysis of the impact of the Tax Act, Potbelly recorded a provisional tax expense of $3.8 million for the fiscal year 2017, the period in which the legislation was enacted. This expense was due to the remeasurement of certain deferred tax assets and liabilities using the lower U.S. corporate tax rate at which the assets are expected to reverse in the future. Consequently, the Company recorded a net decrease to deferred tax assets of $3.8 million with a corresponding adjustment to deferred income tax expense of $3.8 million for the fiscal year 2017.

Due to the adoption of ASU 2016-09 in 2017, all excess tax benefits and deficiencies are recognized as income tax expense in the Company’s Consolidated Statement of Operations.

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities reflected in the consolidated balance sheets are presented below (in thousands):

	December 31,			December 25,
	2017			2016
Deferred tax assets:
Net operating loss carryforwards	$	11		$	—
Accrued liabilities		842			1,848
Deferred revenue		120			323
Stock-based compensation		4,495			8,104
Property and equipment		3,258			6,293
Deferred rent		4,229			5,656
Tax credits and charitable contribution carryforwards		273			—
Other		127			234
Total deferred tax assets		13,355			22,458
Net deferred tax assets		13,355			22,458
Deferred tax liabilities:
Prepaids		(452	)		(635	)
Intangible assets		(977	)		(1,351	)
Smallwares		(574	)		(801	)
Other		(150	)		(261	)
Total deferred tax liabilities		(2,153	)		(3,048	)
Net deferred tax assets	$	11,202		$	19,410

As of December 31, 2017 and December 25, 2016, the Company has no valuation allowances recorded based on management’s assessment of the amount of its deferred tax assets that are more likely than not to be realized.

In accordance with its accounting policy, the Company recognizes accrued interest and penalties related to unrecognized tax benefits as a component of income tax expense. As of December 31, 2017 and December 25, 2016, the Company had no interest or penalties accrued.

The tax years prior to 2014 are generally closed for examination by the United States Internal Revenue Service. However, certain of these tax years are open for examination as a result of net operating losses generated in these years and utilized in subsequent years. The Company’s last IRS examination was for the 2014 tax year; no IRS audits are currently ongoing. State statutes are generally open for audit for the 2013 to 2017 tax years. Additionally, certain tax years through 2017 are open for examination by certain state tax authorities.