Note 13 – 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:


	2012			2011
	(In thousands)
Current
Federal	$	(29	)	$	(2,261	)
State		8			(192	)
Deferred
Federal		431			(1,732	)
State		(282	)		(1,694	)
Change in valuation allowance		701			7,721

Total	$	829		$	1,842

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


	2012			2011
	(In thousands)
Federal statutory rate times financial statement income (loss)	$	482		$	(4,221	)
Effect of:
State taxes, net of federal benefit		104			(885	)
Enterprise zone net interest deduction		(356	)		(428	)
Earnings from bank owned life insurance		(32	)		(36	)
Low income housing credits		(167	)		(388	)
Change in valuation allowance		701			7,721
Other, net		97			79

Total	$	829		$	1,842

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


	2012		2011
	(In thousands)
Deferred tax assets:
Allowance for loan losses	$	3,235	$	5,633
Accrued liabilities		191		181
State income taxes		40		39
Deferred compensation		404		339
Stock compensation		251		218
Real estate owned		623		0
Unrealized gain/loss on loans held for sale		131		183
Net operating loss carryforward		5,767		4,847
Non-accrual loan interest		501		637
Basis difference on fixed assets		117		101
Partnership investment		0		10
General business credit		470		332
Alternative minimum tax credit		113		119
Other		29		2

Total deferred tax assets		11,872		12,641


Deferred tax liabilities:
Deferred loan fees/costs		(1,754	)		(1,878	)
Real estate owned		(0	)		(465	)
Net unrealized appreciation on available-for-sale securities		(295	)		(400	)
FHLB stock dividends		(644	)		(644	)
Mortgage servicing rights		(58	)		(149	)
Partnership investment		(5	)		0
Prepaid expenses		(82	)		(27	)

Total deferred tax liabilities		(2,838	)		(3,563	)
Valuation allowance		(9,034	)		(8,228	)

Net deferred tax assets	$	0		$	850

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 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 $9.0 million was required as of December 31, 2012, resulting in $0 net deferred tax assets. The Company had recorded a valuation allowance of $8.2 million and net deferred tax assets of $850 thousand as of December 31, 2011. The decrease in net deferred tax assets from $850 thousand at December 31, 2011 to $0 at December 31, 2012 was due to the Company’s inability to project future taxable income to be able to utilize its deferred tax assets and the execution of a tax planning strategy in 2012.

As of December 31, 2012, the Company has federal net operating loss carryforwards of $11.3 million, expiring beginning in 2031 through 2032 and California net operating loss carryforwards of $26.9 million, expiring beginning in 2029 through 2032. The Company also has federal general business credit of $470 thousand, expiring beginning in 2030 through 2032, and alternative minimum tax credit carryforwards of $113 thousand, which can be carried forward indefinitely.

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 2012 and 2011. 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:


	2012		2011
	(In thousands)
Balance at beginning of year	$	323	$	214
Additions based on tax positions related to the current year		108		108
Additions for tax positions of prior year		0		1
Reductions for tax positions of prior years		0		0
Settlements		0		0

Balance at end of year	$	431	$	323

Of this total, $431 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 2012 and 2011, $4 thousand and $3 thousand were accrued for potential interest related to these unrecognized tax benefits.

Federal tax years 2009 through 2012 remain open for the assessment of Federal income tax. California tax years 2008 through 2012 remain open for the assessment of California income tax.