The Company files a consolidated U.S. federal income tax return that includes all wholly owned subsidiaries. State tax returns are filed on a consolidated or separate return basis depending on applicable laws. The Company records adjustments related to prior years’ taxes during the period when they are identified, generally when the tax returns are filed. The effect of these adjustments on the current and prior periods (during which the differences originated) is evaluated based upon quantitative and qualitative factors and are considered in relation to the consolidated financial statements taken as a whole for the respective periods.
The provision for income taxes is comprised of the following:
| Years ended December 31, | 2017 | 2016 | ||||||
| Current federal income tax expense | $ | 4,317,686 | $ | 4,824,655 | ||||
| Current state income tax expense (benefit) | 7,353 | (12,590 | ) | |||||
| Deferred federal and state income tax benefit | (1,809 | ) | (293,364 | ) | ||||
| Provision for income taxes | $ | 4,323,230 | $ | 4,518,701 | ||||
A reconciliation of the federal statutory rate to the Company’s effective tax rate is as follows:
| Years ended December 31, | 2017 | 2016 | ||||||||||||||
| Computed expected tax expense | $ | 5,008,400 | 35.0 | % | $ | 4,696,463 | 35.0 | % | ||||||||
| Change in enacted tax rates on net deferred tax liabilities | (405,218 | ) | (2.8 | ) | — | — | ||||||||||
| State taxes, net of Federal benefit | (101,858 | ) | (0.7 | ) | (71,428 | ) | (0.5 | ) | ||||||||
| State valuation allowance | 124,486 | 0.9 | 85,714 | 0.6 | ||||||||||||
| Benefit of lower tax brackets | (100,000 | ) | (0.7 | ) | (100,000 | ) | (0.7 | ) | ||||||||
| Permanent differences | ||||||||||||||||
| Dividends received deduction | (138,197 | ) | (1.0 | ) | (136,690 | ) | (1.0 | ) | ||||||||
| Non-taxable investment income | (85,684 | ) | (0.6 | ) | (110,784 | ) | (0.8 | ) | ||||||||
| Stock-based compensation | (25,821 | ) | (0.2 | ) | ||||||||||||
| Other permanent differences | 46,962 | 0.3 | 48,139 | 0.3 | ||||||||||||
| Prior year tax matters | 4,172 | — | 123,976 | 0.9 | ||||||||||||
| Other | (4,012 | ) | — | (16,689 | ) | (0.1 | ) | |||||||||
| Total tax | $ | 4,323,230 | 30.2 | % | $ | 4,518,701 | 33.7 | % | ||||||||
Deferred tax assets and liabilities are determined using the enacted tax rates applicable to the period the temporary differences are expected to be recovered. Accordingly, the current period income tax provision can be affected by the enactment of new tax rates. The net deferred income taxes on the balance sheets reflect temporary differences between the carrying amounts of the assets and liabilities for financial reporting purposes and income tax purposes, tax effected at a various rates depending on whether the temporary differences are subject to federal taxes, state taxes, or both.
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the “Act”), was enacted by the U.S. federal government. The Act provides for significant changes to corporate taxation including the decrease of the corporate tax rate to 21%. The Company has accounted for the material impacts of the Act by re-measuring its deferred tax assets/(liabilities) at the 21% enacted tax rate as of December 31, 2017.
Deferred income tax liability for unrealized gains on available-for-sale securities that were re-measured due to the Act resulted in a stranded tax effect within Accumulated Other Comprehensive Income (“AOCI”). This is due to the effect of the tax rate change being recorded through continuing operations as required under Accounting Standards Codification 740. On February 14, 2018, Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2018-02, Income Statement – Reporting Comprehensive Income (Topic 220) – Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”), which allows for the reclassification of the stranded tax effects as a result of the Act from AOCI to retained earnings and requires certain other disclosures. The Company chose to early adopt the provisions of ASU 2018-02 and recorded a one-time reclassification of $182,912 from AOCI to retained earnings for the stranded tax effects resulting from the newly enacted corporate tax rate. The amount of the reclassification was the difference between the historical corporate tax rate and the newly enacted 21% corporate tax rate (see Consolidated Statement of Consolidated Stockholders’ Equity).
The impact of the change in tax rate was a decrease in net deferred income tax liabilities of $405,218 with a corresponding increase in deferred income tax benefit. Additionally, the Company re-measured the deferred tax effects of unrealized gains recorded in AOCI of $182,912 through a reclassification between AOCI and retained earnings. The Company’s net deferred income tax liability for the year ended December 31, 2016 remains at the previously enacted tax rate.
Upon completion of the 2017 U.S. income tax return in 2018 the Company may identify additional re-measurement adjustments to its recorded deferred tax liabilities and the one-time transition tax. The Company will continue to assess its provision for income taxes as future guidance is issued, but do not currently anticipate significant revisions will be necessary. Any such revisions will be treated in accordance with the measurement period guidance outlined in Staff Accounting Bulletin No. 118.
Significant components of the Company’s deferred tax assets and liabilities are as follows:
| December 31, | December 31, | |||||||
| 2017 | 2016 | |||||||
| Deferred tax asset: | ||||||||
| Net operating loss carryovers (1) | $ | 103,655 | $ | 131,626 | ||||
| Claims reserve discount | 300,005 | 417,349 | ||||||
| Unearned premium | 2,431,301 | 2,877,365 | ||||||
| Deferred ceding commission revenue | 895,947 | 2,329,626 | ||||||
| Other | 382,522 | 188,675 | ||||||
| Total deferred tax assets | 4,113,430 | 5,944,641 | ||||||
| Deferred tax liability: | ||||||||
| Investment in KICO (2) | 759,543 | 1,169,000 | ||||||
| Deferred acquisition costs | 3,117,920 | 4,161,526 | ||||||
| Intangibles | 212,100 | 459,000 | ||||||
| Depreciation and amortization | 328,735 | 265,671 | ||||||
| Net unrealized appreciation of securities - available for sale | 295,474 | 56,393 | ||||||
| Total deferred tax liabilities | 4,713,772 | 6,111,590 | ||||||
| Net deferred income tax liability | $ | (600,342 | ) | $ | (166,949 | ) | ||
| (1) | The deferred tax assets from net operating loss carryovers are as follows: |
| Type of NOL | 2017 | 2016 | Expiration | |||||||||
| State only (A) | $ | 824,996 | $ | 655,719 | December 31, 2037 | |||||||
| Valuation allowance | (725,541 | ) | (534,293 | ) | ||||||||
| State only, net of valuation allowance | 99,455 | 121,426 | ||||||||||
| Amount subject to Annual Limitation, federal only (B) | 4,200 | 10,200 | December 31, 2019 | |||||||||
| Total deferred tax asset from net operating loss carryovers | $ | 103,655 | $ | 131,626 | ||||||||
(A) Kingstone generates operating losses for state purposes and has prior year NOLs available. The state NOL as of December 31, 2017 and 2016 was approximately $12,692,000 and $10,088,000, respectively. KICO, the Company’s insurance underwriting subsidiary, is not subject to state income taxes. KICO’s state tax obligations are paid through a gross premiums tax, which is included in the consolidated statements of income and comprehensive income within other underwriting expenses. Kingstone has recorded a valuation allowance due to the uncertainty of generating enough state taxable income to utilize 100% of the available state NOLs over their remaining lives, which expire between 2027 and 2037.
(B) The Company has an NOL of $20,000 that is subject to Internal Revenue Code Section 382, which places a limitation on the utilization of the federal net operating loss to approximately $10,000 per year (“Annual Limitation”) as a result of a greater than 50% ownership change of the Company in 1999. The losses subject to the Annual Limitation will be available for future years, expiring through December 31, 2019.
| (2) | Deferred tax liability - investment in KICO |
On July 1, 2009, the Company completed the acquisition of 100% of the issued and outstanding common stock of KICO (formerly known as Commercial Mutual Insurance Company (“CMIC”)) pursuant to the conversion of CMIC from an advance premium cooperative to a stock property and casualty insurance company. Pursuant to the plan of conversion, the Company acquired a 100% equity interest in KICO, in consideration for the exchange of $3,750,000 principal amount of surplus notes of CMIC. In addition, the Company forgave all accrued and unpaid interest on the surplus notes as of the date of conversion. As of the date of acquisition, unpaid accrued interest on the surplus notes along with the accretion of the discount on the original purchase of the surplus notes totaled $2,921,319 (together “Untaxed Interest”). As of the date of acquisition, the deferred tax liability on the Untaxed Interest was $1,169,000. Under GAAP guidance for business combinations, a temporary difference with an indefinite life exists when the parent has a lower carrying value of its subsidiary for income tax purposes. The Company is required to maintain its deferred tax liability related to this temporary difference until the stock of KICO is sold, or the assets of KICO are sold or KICO and the parent are merged.
The table below reconciles the changes in net deferred income tax liability to the deferred income tax provision for the year ended December 31, 2017:
| Change in net deferred income tax liabilities | $ | 433,393 | ||
| Deferred tax expense allocated to other comprehensive income | 435,202 | |||
| Deferred income tax benefit | $ | (1,809 | ) |
In assessing the valuation of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. No valuation allowance against deferred tax assets has been established, except for NOL limitations, as the Company believes it is more likely than not the deferred tax assets will be realized based on the historical taxable income of KICO, or by offset to deferred tax liabilities.
The Company had no material unrecognized tax benefit and no adjustments to liabilities or operations were required. There were no material interest or penalties related to income taxes that have been accrued or recognized as of and for the years ended December 31, 2017 and 2016. If any had been recognized these would be reported in income tax expense.
Generally, taxing authorities may examine the Company’s tax returns for the three years from the date of filing. The Company’s tax returns for the years ended December 31, 2014 through December 31, 2016 remain subject to examination. In March 2018, the Company received a notice that its federal income tax return for the year ended December 31, 2016 was selected for examination by the Internal Revenue Service.