12. Income Taxes

Income Tax Expense

Income before income taxes consists of the following (in thousands):


	2016		2015		2014
Domestic	$	17,874	$	5,701	$	8,350
Foreign		538		167		353
Income before income taxes	$	18,412	$	5,868	$	8,703

Income tax expense consists of the following (in thousands):


	2016		2015		2014
Current:
Federal	$	3,948	$	231	$	898
State		626		142		211
Foreign		353		160		99
		4,927		533		1,208
Deferred:
Federal		2,836		1,011		127
State		(9)		319		46
Foreign		(120)		--		--
		2,707		1,330		173
Income tax expense	$	7,634	$	1,863	$	1,381

The Company’s income tax expense in 2016, 2015, and 2014 included the Company’s federal, state, and foreign tax obligations. The Company’s effective income tax rate was approximately 41%, 32%, and 16% for the years ended December 31, 2016, 2015, and 2014, respectively. The Company’s income tax rate for the twelve months ended December 31, 2016 was unfavorably impacted by the tax treatment of certain expenses related to the On-X acquisition, which had a larger impact on the tax rate in the first quarter of 2016, and by book/tax basis differences related to the HeRO Sale. The Company’s income tax rate for the twelve months ended December 31, 2015 was favorably affected by the reversal of $869,000 in uncertain tax positions, primarily related to research and development tax credits for which the statute of limitations has expired, partially offset by the expiration of certain state net operating losses and other permanent differences. The Company’s income tax rate for the twelve months ended December 31, 2014 was favorably affected by the reduction in uncertain tax positions, nontaxable gains recorded as change in stock basis of subsidiary, and favorable deductions taken on the Company’s 2013 federal tax return, which was filed in 2014.

The income tax expense amounts differ from the amounts computed by applying the U.S. federal statutory income tax rate of 35% for the year ended December 31, 2016 and 34% for the years ended December 31, 2015 and 2014 to pretax income as a result of the following (in thousands):


	2016		2015		2014
Tax expense at statutory rate	$	6,444	$	1,995	$	2,959
Increase (reduction) in income taxes resulting from:
Non-Deductible transaction costs		908		--		--
State income taxes, net of federal benefit		531		499		220
Non-deductible loss on unit disposals		455		--		--
Non-deductible entertainment expenses		221		184		218
Equity compensation		135		144		63
Foreign income taxes		130		118		69
Provision to return adjustments		29		122		(321)
Non-deductible change in stock basis of subsidiary		--		--		(641)
Domestic production activities deduction		(456)		(87)		(153)
Research and development credit		(296)		(281)		(237)
Net change in uncertain tax positions		(153)		(869)		(781)
State valuation allowance adjustment		(84)		(19)		83
Other		(230)		57		(98)
Total Income tax expense	$	7,634	$	1,863	$	1,381

Deferred Taxes

The Company generates deferred tax assets primarily as a result of write-downs of inventory and deferred preservation costs; accruals for product and tissue processing liability claims; investment and asset impairments; and, in prior periods, due to operating losses. The Company acquired significant deferred tax assets, primarily net operating loss carryforwards, from its acquisitions of On-X in 2016, Hemosphere in 2012, and Cardiogenesis in 2011. The Company recorded significant deferred tax liabilities in 2016 related to the intangible assets acquired in the On-X acquisition.

The tax effects of temporary differences which give rise to deferred tax assets and liabilities at December 31 are as follows (in thousands):


	2016		2015
Deferred tax assets:
Allowance for bad debts	$	208	$	142
Inventory and deferred preservation costs write-downs		708		536
Investment in equity securities		58		58
Property		1,780		2,987
Intangible assets		2,034		591
Accrued expenses		4,215		3,276
Loss carryforwards		8,760		12,262
Credit carryforwards		1,001		616
Stock compensation		3,678		2,546
Transaction costs		122		1,048
Deferred compensation		973		957
UNICAP		371		55
Tax benefit of tax reserves		333		53
Other		409		382
Less valuation allowance		(2,157)		(2,109)
Total deferred tax assets		22,493		23,400

	2016		2015
Deferred tax liabilities:
Prepaid items		(436)		(471)
Intangible assets		(21,665)		(4,400)
Other		(399)		(341)
Total deferred tax liabilities		(22,500)		(5,212)

Total net deferred tax (liabilities) assets	$	(7)	$	18,188

As of December 31, 2016 the Company maintained a total of $2.2 million in valuation allowances against deferred tax assets, related to state net operating loss carryforwards, and a net deferred tax liability of $7,000. As of December 31, 2015 the Company maintained a total of $2.1 million in valuation allowances against deferred tax assets, related to state net operating loss carryforwards, and a net deferred tax asset of $18.2 million.

As of December 31, 2016 the Company had approximately $6.3 million tax-effected federal net operating loss carryforwards related to the acquisitions of Cardiogenesis and Hemosphere that will begin to expire in 2017, $2.4 million of tax-effected state net operating loss carryforwards that began to expire in 2016, $702,000 in research and development tax credit carryforwards that will begin to expire in 2022, and $150,000 in credits from the state of Texas that will fully expire by 2027.

Uncertain Tax Positions

A reconciliation of the beginning and ending balances of the Company’s uncertain tax position liability, excluding interest and penalties, is as follows (in thousands):


	2016		2015		2014
Beginning balance	$	969	$	1,437	$	2,100
Increases related to current year tax positions		86		103		92
Increases related to prior year tax positions		2,668		403		--
Decreases related to prior year tax positions		(40)		(70)		(265)
Decreases related to settlements		(66)		--		--
Decreases due to the lapsing of statutes of limitations		(227)		(904)		(490)
Ending balance	$	3,390	$	969	$	1,437

A reconciliation of the beginning and ending balances of the Company’s liability for interest and penalties on uncertain tax positions is as follows (in thousands):


	2016		2015		2014
Beginning balance	$	210	$	366	$	422
Accrual of interest and penalties		92		50		91
Decreases related to prior year tax positions		(94)		(206)		(147)
Ending balance	$	208	$	210	$	366

As of December 31, 2016 the Company’s uncertain tax liability, including interest and penalties, of $3.6 million, was recorded as a reduction to deferred tax assets of $234,000, and a non-current liability of $3.4 million on the Company’s Consolidated Balance Sheets, all of which, except for the portion related to interest and penalties, is expected to impact the Company’s tax rate when recognized. The uncertain tax position increase related to prior year tax positions is primarily due to positions taken by On-X on tax returns in prior years. As of December 31, 2015 the Company’s total uncertain tax liability, including interest and penalties of $1.2 million, was recorded as a reduction to deferred tax assets of $104,000, and a non-current liability of $1.1 million on the Company’s Consolidated Balance Sheets, all of which, except for the portion related to interest and penalties, is expected to impact the Company’s tax rate when recognized.

The Company believes it is reasonably possible that approximately $235,000 of its uncertain tax liability will be recognized in 2017 due to the lapsing of various federal and state statutes of limitations.

Other

The Company’s tax years 2013 through 2015 generally remain open to examination by the major taxing jurisdictions to which the Company is subject. However, certain returns from years prior to 2013, in which net operating losses and tax credits have arisen, are still open for examination by the tax authorities.