Income Taxes and Tax Receivable Agreement

As part of the Reorganization that was effective September 30, 2015, the Company entered into a Tax Receivable Agreement (“TRA”) under which generally the Company will be required to pay to its stockholders as of immediately prior to the IPO 85% of the cash savings, if any, in U.S. federal, state or local tax that the Company actually realizes (or is deemed to realize in certain circumstances) as a result of (i) certain tax attributes, including NOLs, capital losses, charitable deductions, alternative minimum tax credit carryforwards and federal and state tax credits of Surgery Partners, Inc. and its affiliates relating to taxable years ending on or before the date of the Reorganization (calculated by assuming the taxable year of the relevant entity closes on the date of the Reorganization) that are or become available to the Company and its wholly-owned subsidiaries as a result of the Reorganization, and (ii) tax benefits attributable to payments made under the TRA, together with interest accrued at a rate of LIBOR plus 300 basis points from the date the applicable tax return is due (without extension) until paid. The Company expects the payments it will be required to make under the TRA will be substantial.

The amounts payable under the TRA will vary depending upon a number of factors, including the amount, character and timing of the taxable income of Surgery Partners, Inc. in the future. The Company estimates the total amounts payable to be approximately $123.3 million, if the tax benefits of related deferred tax assets are ultimately realized. Of the total amount payable, the Company expects to pay approximately $1.0 million of the liability during the year ending December 31, 2017.

The Company and its subsidiaries file a consolidated federal income tax return. The partnerships, limited liability companies, and certain non-consolidated physician practice corporations file separate income tax returns. The Company's allocable portion of each partnership's and limited liability company's income or loss is included in taxable income of the Company. The remaining income or loss of each partnership and limited liability company is allocated to the other owners.

The Company, or one or more of its subsidiaries, files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal income tax examinations for years prior to 2013 or state income tax examinations for years prior to 2012.

The Company made income tax payments of $661,000, $1.1 million and $676,000 for the years ended December 31, 2016, 2015 and 2014, respectively.

Income tax expense (benefit) is comprised of the following (in thousands):



	Year Ended December 31,
	2016			2015			2014

Current:
Federal	$	(31	)	$	—		$	—
State	244			909			1,669
Deferred:
Federal	7,326			(132,311		)	13,235
State	(444		)	(17,580		)	854
Total income tax expense (benefit)	$	7,095		$	(148,982	)	$	15,758

A reconciliation of the provision for income taxes as reported in the consolidated statements of operations and the amount of income tax expense (benefit) computed by multiplying consolidated income (loss) in each year by the U.S. federal statutory rate of 35% follows (in thousands):



	Year Ended December 31,
	2016			2015			2014

Tax expense (benefit) at U.S.federal statutory rate	$	32,263		$	(26,648	)	$	(3,840	)
State income tax, net of U.S. federal tax benefit	(86		)	1,059			1,402
Change in valuation allowance	354			(137,721		)	29,336
Expiration of carryforwards and stock option forfeitures	—			—			1,286
Net income attributable to non-controlling interests	(26,470		)	(24,996		)	(13,207		)
Changes in measurement of uncertain tax positions	(262		)	(10		)	589
Stock option compensation	(200		)	—			—
Nondeductible transaction costs	—			3,442			4,230
Tax return reconciling differences	1,635			(1,574		)	(4,419		)
Change in effective tax rate	—			(2,143		)	—
TRA liability	(327		)	39,428			—
Other	188			181			381
Total income tax expense (benefit)	$	7,095		$	(148,982	)	$	15,758

The components of temporary differences and the approximate tax effects that give rise to the Company’s net deferred tax asset are as follows (in thousands):



	December 31,
	2016			2015

Deferred tax assets:
Medical malpractice liability	$	4,194		$	869
Accrued vacation and incentive compensation	1,112			2,212
Net operating loss carryforwards	158,796			146,663
Allowance for bad debts	8,343			1,846
Capital loss carryforwards	2,785			2,052
Deferred rent	1,371			2,288
Depreciation on property and equipment	530			—
Deferred financing costs	—			3,083
TRA liability	4,542			2,750
Other deferred assets	4,879			3,286
Total gross deferred tax assets	186,552			165,049
Less: Valuation allowance	(7,358		)	(6,949		)
Total deferred tax assets	179,194			158,100
Deferred tax liabilities:
Deferred financing costs	(8,797		)	—
Depreciation on property and equipment	—			(806		)
Amortization of intangible assets	(15,241		)	(16,083		)
Basis differences of partnerships and joint ventures	(68,160		)	(46,494		)
Other deferred liabilities	(3,203		)	(612		)
Total deferred tax liabilities	(95,401		)	(63,995		)
Net deferred tax assets	$	83,793		$	94,105

The Company had federal net operating loss carryforwards of $390.6 million as of December 31, 2016, which expire between 2025 and 2036 and state net operating loss carryforwards of $542.7 million as of December 31, 2016, which expire between 2017 and 2036. The Company had capital loss carryforwards of $7.4 million as of December 31, 2016, which expire between 2018 and 2021. The Company had federal and state credit carryforwards of $714,000 as of December 31, 2016. The federal credits do not expire, and the state credits expire between 2017 and 2028.

The Company has recorded a valuation allowance against deferred tax assets at December 31, 2016 and 2015 totaling $7.4 million and $6.9 million, respectively, which represents an increase of $500,000. The valuation allowance continues to be provided for certain deferred tax assets for which the Company believes it is more likely than not that the tax benefits will not be realized, which are primarily certain state net operating losses and capital loss carryforwards.

Included in the increase in the valuation allowance for the year ended December 31, 2016 was an increase of approximately $336,000 that was recorded to additional-paid-in-capital as the result of the tax effect of the disposals of shares of noncontrolling interests. Approximately $2.4 million of the valuation allowance as of December 31, 2016 is recorded against deferred tax assets that, if subsequently recognized, will be credited directly to contributed capital.

A reconciliation of the beginning and ending liability for gross unrecognized tax benefits for the years ended December 31, 2016 and 2015 is as follows (in thousands):



	Year Ended December 31,
	2016			2015

Unrecognized tax benefits at beginning of year	$	1,403		$	2,755
Additions for tax positions of prior years	60			136
Reductions for tax positions of prior year	(398		)	(996		)
Settlements	(4		)	(492		)
Unrecognized tax benefits at end of year	$	1,061		$	1,403

The Company recognizes interest and penalties related to uncertain tax positions in its provision for income taxes in the consolidated statements of operations. For the years ended December 31, 2016 and 2015, the Company had approximately $163,000 and $322,000, respectively, of accrued interest and penalties related to uncertain tax positions. The total amount of accrued liabilities related to uncertain tax positions that would affect the Company's effective tax rate, if recognized, is $309,000 as of December 31, 2016. The reserves are included in long-term taxes payable and long-term deferred tax assets in the consolidated balance sheet as of December 31, 2016.