INCOME TAXES

9 Months Ended

Sep. 30, 2013

4. INCOME TAXES

Innotrac utilizes the liability method of accounting for income taxes in accordance with ASC topic No. 740 – Income Taxes. Under the liability method, deferred taxes are determined based on the difference between the financial and tax basis of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse.

Management assesses the ability to realize the benefit of deferred tax assets and records a valuation allowance if it is more likely than not that all or a portion of the deferred tax assets will not be realized. We consider the probability of future taxable income and our historical profitability, among other factors, in assessing the amount of the valuation allowance. We recorded a valuation allowance against the Company’s net deferred tax assets as of December 31, 2012, 2011 and 2010 because operating losses at the time created uncertainty about the realization of deferred tax assets in future years. During the period ended September 30, 2013, we released $17.2 million of our valuation allowance related to our deferred tax assets. These deferred tax assets relate primarily to net operating loss carryforwards, which we determined it is more likely than not we will be able to utilize due to the expected generation of sufficient taxable income in the future. All of the $17.2 million valuation allowance release was recorded as an income tax benefit in the Condensed Consolidated Statements of Operations. As a result, the Company’s effective tax rate for the three and nine months ended September 30, 2013 was ($1,350.9%) and (520.8%), respectively. The valuation allowance remaining at September 30, 2013 is $1.9 million, which primarily relates to a reserve against state and local taxes, where there is sufficient uncertainty as to whether we will be able to utilize this deferred tax asset in the future to necessitate maintaining an allowance.

A valuation allowance is required when it is more likely than not that all or a portion of deferred tax assets may not be realized. Establishment and removal of a valuation allowance requires management to consider all positive and negative evidence and make a judgmental decision regarding the amount of valuation allowance required as of a reporting date. The weight given to the evidence is commensurate with the extent to which it can be objectively verified. In the evaluation as of September 30, 2013, management has considered all available evidence, both positive and negative, including but not limited to the following:

Positive evidence

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The cumulative net income for the last twelve quarters;

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The significant growth in revenues and earnings the Company has experienced over the past eight quarters;

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The implementation and providing services to several new customers and the healthy sales pipeline with several large customers who are close to the point of contract negotiation;

Negative evidence

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The loss of one large customer in the third quarter ended September 30, 2013;

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The contract renewal of certain customer’s contracts in 2014;

The determination of when to adjust the valuation allowance requires significant judgment on the part of management. Although realization is not assured, management concluded that it is more likely than not that the majority of deferred tax assets at September 30, 2013 will be realized in the ordinary course of operations. Therefore a valuation allowance related to $17.2 million of deferred tax assets was determined to be unnecessary.

The Company did not generate any cash flow from the income tax benefit recorded to the Condensed Consolidated Statements of Operations in the period ended September 30, 2013, nor did this income tax benefit have any impact on business operations during the period.

Innotrac’s gross deferred tax asset as of September 30, 2013 and December 31, 2012 was approximately $21.5 million and $22.3 million, respectively. This deferred tax asset was generated primarily by net operating loss carryforwards created by net losses in prior years. Innotrac has Federal net operating loss carryforwards of $52.4 million at December 31, 2012 that expire between 2020 and 2032.

ASC topic No. 740 requires that the Company determine whether it is more likely than not that a tax position will be sustained upon audit, based on the technical merits of the position. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. The Company has recognized tax benefits from all tax positions we have taken, and there has been no adjustment to any net operating loss carryforwards as a result of ASC topic No. 740 and there are no unrecognized tax benefits and no related ASC topic No. 740 tax liabilities at September 30, 2013.

The Company generally recognizes interest and/or penalties related to income tax matters in general and administrative expenses. As of September 30, 2013, we have no accrued interest or penalties related to uncertain tax positions.

- Definition

The entire disclosure for income taxes. Disclosures may include net deferred tax liability or asset recognized in an enterprise's statement of financial position, net change during the year in the total valuation allowance, approximate tax effect of each type of temporary difference and carryforward that gives rise to a significant portion of deferred tax liabilities and deferred tax assets, utilization of a tax carryback, and tax uncertainties information.

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