Income Taxes

On December 22, 2017, H.R.1, also known as the Tax Cuts and Jobs Act ("Tax Reform"), was enacted in the U.S. Tax Reform significantly lowered the amount of our current and future income tax expense primarily due to the reduction in the U.S. statutory income tax rate from 35.0% to 21.0%. This provision went into effect on January 1, 2018 and required us to remeasure our deferred tax assets and liabilities. In fiscal 2019 and beyond, Tax Reform will result in the loss of our ability to take the domestic production activities deduction, which has been repealed, and is also likely to result in lower tax deductions for certain executive compensation expenses.

For fiscal 2018, we were subject to a 35.0% statutory income tax rate with respect to the period August 1, 2017 through December 31, 2017 and a 21.0% statutory income tax rate with respect to the period January 1, 2018 through July 31, 2018, or a blended statutory income tax rate for fiscal 2018 of approximately 27.0%. As such, our effective tax rate for accounting purposes in fiscal 2018, excluding discrete items, was 27.0%. We expect to fully benefit from the lower statutory income tax rate in fiscal 2019 and thereafter.

During fiscal 2018, we recorded a net discrete tax benefit of $11,792,000 which, as a result of Tax Reform, primarily related to the remeasurement of deferred tax liabilities associated with non-deductible amortization related to intangible assets. The remeasurement was recorded pursuant to ASC 740 "Income Taxes" and SEC Staff Accounting Bulletin ("SAB") 118, using estimates based on reasonable and supportable assumptions and available information as of the reporting date. As such, the remeasurement of deferred taxes is an estimate and will be finalized after we file our federal and state income tax returns for fiscal 2018. The estimated impact recorded in fiscal 2018 will change if the timing of the deferred tax impacts shift between fiscal 2018 and fiscal 2019 and beyond. In addition, it is possible that the Internal Revenue Service ("IRS") will issue clarifying or interpretive guidance related to Tax Reform, which may ultimately result in a change to our estimated income tax.

Income (loss) before (benefit from) provision for income taxes consists of the following:



	Fiscal Years Ended July 31,
	2018		2017	2016
U.S.	$	22,243,000	23,732,000	(7,666,000	)
Foreign	2,383,000		1,749,000	(526,000	)
	$	24,626,000	25,481,000	(8,192,000	)

The (benefit from) provision for income taxes included in the accompanying Consolidated Statements of Operations consists of the following:



	Fiscal Years Ended July 31,
	2018			2017		2016
Federal – current	$	367,000		(441,000	)	2,297,000
Federal – deferred	(7,499,000		)	8,399,000		(2,930,000	)

State and local – current	440,000			608,000		408,000
State and local – deferred	1,115,000			659,000		(310,000	)

Foreign – current	429,000			413,000		81,000
Foreign – deferred	5,000			16,000		—
(Benefit from) provision for income taxes	$	(5,143,000	)	9,654,000		(454,000	)

The (benefit from) provision for income taxes differed from the amounts computed by applying the U.S. Federal income tax rate as a result of the following:



	Fiscal Years Ended July 31,
	2018					2017				2016
	Amount			Rate		Amount		Rate		Amount		Rate
Computed "expected" tax expense (benefit)	$	6,615,000		27.0	%	8,919,000		35.0	%	(2,867,000	)	35.0	%
Increase (reduction) in income taxes resulting from:
State and local income taxes, net of federal benefit	1,193,000			4.8		1,257,000		4.9		23,000		(0.3	)
Stock-based compensation	(1,112,000		)	(4.5	)	78,000		0.3		68,000		(0.8	)
Research and experimentation credits	(678,000		)	(2.8	)	(919,000	)	(3.6	)	(1,106,000	)	13.5
Acquisition-related tax contingencies	—			—		—		—		1,962,000		(24.0	)
Nondeductible transaction costs	—			—		—		—		1,279,000		(15.6	)
Tax Reform remeasurement of deferred taxes	(11,317,000		)	(46.0	)	—		—		—		—
Foreign income taxes	(221,000		)	(0.9	)	(151,000	)	(0.6	)	289,000		(3.5	)
Other	377,000			1.4		470,000		1.9		(102,000	)	1.2
(Benefit from) provision for income taxes	$	(5,143,000	)	(21.0	)%	9,654,000		37.9	%	(454,000	)	5.5	%

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at July 31, 2018 and 2017 are presented below:



	2018			2017
Deferred tax assets:
Inventory and warranty reserves	$	5,089,000		7,854,000
Compensation and commissions	3,511,000			3,807,000
Federal, state and foreign research and experimentation credits	18,816,000			16,286,000
Federal alternative minimum tax credit	3,243,000			2,652,000
Stock-based compensation	5,092,000			7,767,000
Acquisition-related contingent liabilities	2,477,000			4,687,000
Federal and state net operating losses	7,349,000			19,880,000
Other	4,672,000			8,764,000
Less valuation allowance	(11,854,000		)	(8,633,000	)
Total deferred tax assets	38,395,000			63,064,000
Deferred tax liabilities:
Plant and equipment	(1,155,000		)	(1,309,000	)
Intangibles	(48,167,000		)	(79,061,000	)
Total deferred tax liabilities	(49,322,000		)	(80,370,000	)
Net deferred tax liabilities	$	(10,927,000	)	(17,306,000	)

We provide for income taxes under the provisions of FASB ASC 740 "Income Taxes." FASB ASC 740 requires an asset and liability based approach in accounting for income taxes. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of them will not be realized. If management determines that it is more likely than not that some or all of its deferred tax assets will not be realized, a valuation allowance will be recorded against such deferred tax assets.

At July 31, 2018, we had $19,069,000 of U.S. federal net operating loss carryforwards reflected in deferred tax assets. Of the total loss carryforwards, $18,422,000 were generated by TCS in the tax period from January 1, 2016 to February 23, 2016 and will begin to expire in 2035. $183,000 is the remaining net operating loss carryforwards acquired in an acquisition by TCS in 2001 and will expire in 2021 if unused at that time. The remaining U.S. federal net operating loss carryforwards generated in fiscal year 2016 of $464,000 will expire in 2036.

At July 31, 2018, we had federal alternative minimum tax credit carryforwards of $3,243,000, which are available to offset future regular federal taxes. We have federal research and experimentation credits of $10,948,000 that will begin to expire in 2019. The timing and manner in which we may utilize net operating loss carryforwards and tax credits in future tax years will be limited by the amounts and timing of future taxable income and by the application of the ownership change rules under Section 382 and 383 of the Internal Revenue Code.

We have state net operating loss carryforwards available of $3,345,000 which expire through 2037, utilization of which will be limited in a manner similar to the federal net operating loss carryforwards. We believe that it is more likely than not that the benefit from certain state net operating loss carryforwards will not be realized. In recognition of this risk, we have provided a valuation allowance of $3,138,000 on the deferred tax assets relating to these state net operating loss carryforwards. We have state research and experimentation credit carryforwards of $6,982,000 expiring through 2037. We believe that it is more likely than not that the benefit from certain state research and experimentation credits will not be realized. In recognition of this risk, we have provided a valuation allowance of $6,771,000 on the deferred tax assets relating to these state credits.

At July 31, 2018 and 2017, our foreign deferred tax assets relating to research and experimentation credits have been offset by a valuation allowance as they may not be utilized in a future period. Our foreign earnings and profits are insignificant and, as such, we have not recorded any deferred tax liability on unremitted foreign earnings.

We must generate $158,700,000 of taxable income in the future to fully utilize our net deferred tax assets as of July 31, 2018. Management believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the net deferred tax assets.

At July 31, 2018 and 2017, total unrecognized tax benefits were $9,339,000 and $8,681,000, respectively, including interest of $202,000 and $95,000, respectively. At July 31, 2018, $2,572,000 of our unrecognized tax benefits were recorded as non-current income taxes payable in our Consolidated Balance Sheet. The remaining unrecognized tax benefits of $6,767,000 were presented as an offset to the associated non-current deferred tax assets in our Consolidated Balance Sheet. At July 31, 2017, $2,515,000 of our unrecognized tax benefits were recorded as non-current income taxes payable in our Consolidated Balance Sheet. The remaining unrecognized tax benefit of $6,166,000 was presented as an offset to the associated non-current deferred tax assets in our Consolidated Balance Sheet. Of the total unrecognized tax benefits, $8,563,000 and $7,727,000 at July 31, 2018 and 2017, respectively, net of the reversal of the federal benefit recognized as a deferred tax asset relating to state reserves, would favorably impact our effective tax rate, if recognized. Unrecognized tax benefits result from income tax positions taken or expected to be taken on our income tax returns for which a tax benefit has not been recorded in our financial statements. We do not expect that there will be any significant changes to our total unrecognized tax benefits within the next twelve months.

Our policy is to recognize interest and penalties relating to uncertain tax positions in income tax expense. The following table summarizes the activity related to our unrecognized tax benefits for fiscal years 2018, 2017 and 2016 (excluding interest):



	2018			2017		2016
Balance at beginning of period	$	8,586,000		9,108,000		2,728,000
Increase related to current period	645,000			587,000		2,487,000
Increase related to prior periods	49,000			86,000		4,490,000
Expiration of statute of limitations	(81,000		)	(404,000	)	(580,000	)
Decrease related to prior periods	(62,000		)	(791,000	)	(17,000	)
Balance at end of period	$	9,137,000		8,586,000		9,108,000

Since November 2017, our federal income tax return for fiscal 2016 has been under audit by the IRS. The audit is ongoing and we are unaware of any proposed adjustments by the IRS. Our federal income tax returns for fiscal 2015 and 2017 are also subject to potential future IRS audit. None of our state income tax returns prior to fiscal 2014 are subject to audit. TCS' federal income tax returns for tax years 2014 and 2015 and the tax period from January 1, 2016 to February 23, 2016 are subject to potential future IRS audit. None of TCS' state income tax returns prior to calendar year 2013 are subject to audit. The results of the IRS tax audit for fiscal 2016, future tax assessments or settlements could have a material adverse effect on our consolidated results of operations and financial condition.