Note 12—Income Taxes

The Company and its subsidiaries are subject to U.S. federal and state income taxes. Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Income tax expense (benefit) was as follows:


	2011			2010
	(In thousands)
Current
Federal	$	(2,260	)	$	1,502
State		(192	)		280
Deferred
Federal		(296	)		(443	)
State		(1,181	)		(299	)
Change in valuation allowance		5,771			301

Total	$	1,842		$	1,341

Effective tax rates differ from the federal statutory rate of 34% applied to earnings before income taxes due to the following:


	2011			2010
	(In thousands)
Federal statutory rate times financial statement income (loss)	$	(2,611	)	$	1,107
Effect of:
State taxes, net of federal benefit		(546	)		233
Enterprise zone net interest deduction		(428	)		(283	)
Earnings from bank owned life insurance		(36	)		(43	)
Low income housing credits		(388	)		-
Change in valuation allowance		5,771			301
Other, net		80			26

Total	$	1,842		$	1,341

Year-end deferred tax assets and liabilities were due to the following:


	2011			2010
	(In thousands)
Deferred tax assets:
Allowance for loan losses	$	5,723		$	6,397
Accrued liabilities		181			171
Lower of cost or market adjustment		-			6
State income taxes		39			105
Deferred compensation		339			266
Stock compensation		218			182
Real estate owned		-			141
Unrealized gain/loss on loans held for sale		183			527
Net operating loss carryforward		2,679			119
Nonaccrual loan interest		637			717
Basis difference on fixed assets		101			-
Partnership investment		10			-
General business credit		332			-
Alternative minimum tax credit		119			-
Other		2			4

Total deferred tax assets		10,563			8,635

Deferred tax liabilities:
Deferred loan fees/costs		(1,878	)		(1,743	)
Real estate owned		(337	)		-
Net unrealized appreciation on available-for-sale securities		(400	)		(176	)
FHLB stock dividends		(644	)		(581	)
Mortgage servicing rights		(149	)		(201	)
Basis difference on fixed assets		-			(28	)
Prepaid expenses		(27	)		(30	)

Total deferred tax liabilities		(3,435	)		(2,759	)
Valuation allowance		(6,278	)		(507	)

Net deferred tax assets	$	850		$	5,369

Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion, or all, of the deferred tax asset will not be realized. In assessing the realization of deferred tax assets, management evaluates both positive and negative evidence, including the existence of any cumulative losses in the current year and the prior two years, the amount of taxes paid in available carry-back years, the forecasts of future income and tax planning strategies. This analysis is updated quarterly. Based on this analysis, the Company determined that a valuation allowance of $6.3 million was required as of December 31, 2011. The Company had recorded a valuation allowance of $507 thousand as of December 31, 2010. The increase in the valuation allowance against its federal and state deferred tax assets was due to current year losses and the Company's inability to project sufficient future taxable income. The remaining net deferred tax asset of $850 thousand at December 31, 2011 is supported by a near term tax planning strategy of selling the Company's headquarters building at a gain. This sale is expected to close in second quarter.

Federal income tax laws previously allowed the Company additional bad debt deductions based on the reserve method of computing the federal bad debt deduction. This method of computing the Company's federal bad debt deduction was permitted to be used by the Company until the end of 1987. As of December 31, 1987, the tax bad debt reserve balance totaled $3.0 million. Accounting standards do not require a deferred tax liability to be recorded on this amount, which otherwise would total $1.0 million at year end 2011 and 2010. If the Bank were liquidated, or otherwise ceases to be a bank, or if tax laws were to change, this amount would be expensed.

A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:


	2011		2010
	(In thousands)
Balance at beginning of year	$	214	$	91
Additions based on tax positions related to the current year		108		107
Additions for tax positions of prior year		1		107
Reductions for tax positions of prior years		-		(4	)
Settlements		-		(87	)

Balance at end of year	$	323	$	214

Of this total, $323 thousand represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the income tax provision in future periods. The Company does not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months. The Company's continuing practice is to recognize interest and/or penalties related to income tax matters in income tax expense. During 2011, $3 thousand was accrued for potential interest related to these unrecognized tax benefits. There was no accrual for potential interest related to unrecognized tax benefits in 2010.

Federal tax years 2008 through 2011 remain open for the assessment of Federal income tax. California tax years 2007 through 2011 remain open for the assessment of California income tax.