10. Income Taxes

Total income tax expense or benefit for 2012, 2011 and 2010 was as follows (in thousands):

Holdings

	Year ended December 31,
	2012		2011			2010
Current:
Federal	$	—	$	—		$	(268	)
State	1,943		4,254			3,469
Total current tax provision	1,943		4,254			3,201

Deferred:
Federal	—		(20,991		)	(28,797		)
State	549		(4,430		)	(3,544		)
Total deferred tax provision	549		(25,421		)	(32,341		)

Total income tax expense (benefit)	$	2,492	$	(21,167	)	$	(29,140	)

Guitar Center

	Year ended December 31,
	2012			2011			2010
Current:
Federal	$	20,005		$	4,917		$	16,004
State	4,750			3,620			1,335
Total current tax provision	24,755			8,537			17,339

Deferred:
Federal	(16,584		)	(29,171		)	(16,823		)
State	(1,268		)	(3,516		)	(2,778		)
Total deferred tax provision	(17,852		)	(32,687		)	(19,601		)

Total income tax expense (benefit)	$	6,903		$	(24,150	)	$	(2,262	)

Actual income taxes differ from the statutory tax rate of 35% as applied to net income or loss before income taxes as follows (in thousands):

Holdings

	Year ended December 31,
	2012			2011			2010
Expected income tax benefit	$	(24,387	)	$	(90,337	)	$	(29,622	)
State income taxes, net of federal tax benefit	2,492			(1,463		)	(440		)
Goodwill impairment	—			37,460			—
Stock options	567			—			(159		)
Change in valuation allowance	23,348			32,247			—
Meals & entertainment and non-deductible items	352			348			337
Other	120			578			744

Actual income tax expense (benefit)	$	2,492		$	(21,167	)	$	(29,140	)

Guitar Center

	Year ended December 31,
	2012		2011			2010
Expected income tax expense (benefit)	$	3,604	$	(62,249	)	$	(3,894	)
State income taxes, net of federal tax benefit	2,280		(253		)	746
Goodwill impairment	—		37,460			—
Stock options	567		—			(159		)
Meals & entertainment and non-deductible items	352		348			337
Other	100		544			708

Actual income tax expense (benefit)	$	6,903	$	(24,150	)	$	(2,262	)

The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities are presented below (in thousands):

	Holdings						Guitar Center
	December 31,						December 31,
	2012			2011			2012			2011
Deferred tax assets:
Net operating loss	$	50,194		$	43,179		$	—		$	—
State net operating loss carryforward	2,247			2,042			—			—
Accrued liabilities	26,488			26,572			26,688			26,572
Merchandise inventories	3,215			2,961			3,215			2,961
Intangibles	8,743			8,084			8,743			8,084
Stock options	2,504			2,652			2,504			2,652
Capital loss carryover	133			129			133			129
Fixed assets	4,893			(2,203		)	4,893			(2,203		)
Total gross deferred tax assets	98,417			83,416			46,176			38,195
Less valuation allowance	(58,210		)	(32,558		)	(310		)	(310		)
Net deferred tax assets	40,207			50,858			45,866			37,885

Deferred tax liabilities:
Depreciation	(5,534		)	(5,813		)	(5,534		)	(5,813		)
Intangibles	(110,864		)	(120,196		)	(110,864		)	(120,196		)
Other	(181		)	(441		)	(181		)	(441		)
Total gross deferred tax liabilities	(116,579		)	(126,450		)	(116,579		)	(126,450		)

Net deferred tax liabilities	$	(76,372	)	$	(75,592	)	$	(70,713	)	$	(88,565	)

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible.

We consider scheduled reversals of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment.

Based on the available objective evidence, management believes it is more likely than not that Holdings will not fully realize the benefits of its deductible temporary differences. Accordingly, we increased the valuation allowance on Holdings’ federal and state net operating losses and other deferred tax assets by $25.7 million in 2012 and $32.2 million in 2011.

Holdings’ available unused net operating loss carryforwards, which may be applied against future taxable income, expire in tax years between 2027 and 2031.

We account for the tax benefit resulting from the employee exercises of non-qualifying stock options or the disqualified disposition of incentive stock options as a reduction in income tax payable and an increase to additional paid-in capital.

Holdings’ charge in lieu of taxes attributable to tax benefit from employee stock options was $0.6 million in 2010. There was no charge in lieu of taxes attributable to tax benefit from employee stock options in 2012 or 2011.

The reconciliation of unrecognized tax benefits in 2012, the balance of which is classified as other current assets in the consolidated balance sheet, is as follows (in thousands):

Balance at January 1, 2012	$	1,245
Additions based on tax positions of current years	—
Additions based on tax positions of prior years	181
Reductions based on tax positions of prior years	(133		)
Balance at December 31, 2012	$	1,293

The amount of unrecognized tax benefits that, if recognized, would impact the effective rate as of December 31, 2012 was $1.3 million.

As of December 31, 2012 and 2011, accrued interest and penalties related to uncertain tax positions were not material. Our policy is to classify interest and penalties as income tax expense.

Tax years that remain subject to examination are 2009 and forward by the Internal Revenue Service and 2008 and forward by other state and local jurisdictions. It is reasonably possible that our recognized tax benefit could change. However, we do not expect any such change to be material.