INCOME TAXES

The Company’s income tax expense (benefit) was attributable to income (loss) from operations and consisted of the following for the years indicated:



	Year Ended December 31,
	2012		2011			2010
	(Dollars in thousands)
Current tax expense (benefit):
Federal	$	—	$	—		$	183
State	—		—			—
Deferred tax expense (benefit):
Federal	1,441		(3,440		)	474
State	85		(1,922		)	50
Change in valuation allowance	166		6,307			—
	$	1,692	$	945		$	707

A reconciliation of the differences between the federal income tax expense (benefit) recorded and the amount computed by applying the federal statutory rate to income before income taxes is as follows:



	Year Ended December 31,
	2012			2011			2010
	(Dollars in thousands)
Income tax expense (benefit) at statutory rate (34%)	$	2,162		$	(3,240	)	$	1,417
Increase (decrease) from:
State taxes, net	155			(559		)	(46		)
Bank-owned life insurance	(367		)	(276		)	(304		)
Low-income housing tax credits	(308		)	(308		)	(331		)
Municipal bond interest	(38		)	(46		)	(53		)
Change in federal deferred tax asset valuation allowance	64			5,296			—
Other	24			78			24
Tax expense	$	1,692		$	945		$	707

Significant components of deferred tax assets and liabilities are as follows:



	December 31,
	2012			2011
	(Dollars in thousands)
Deferred tax assets:
Allowance for loan losses	$	4,694		$	4,855
Specific reserves on other real estate owned	1,464			2,363
Deferred compensation	141			209
Deferred loan fees	94			184
Depreciation/amortization	476			523
Net operating loss carryforwards	7,098			6,323
Alternative minimum tax carryforwards	1,437			1,928
General business tax credits	3,922			3,630
Other-than-temporary impairments on investment securities available-for-sale	77			78
Other	946			1,672
	20,349			21,765
Deferred tax liabilities:
FHLB stock dividends	274			278
Other	964			184
	1,238			462
Net deferred tax assets before valuation allowance and adjustments	19,111			21,303
Valuation allowance	(6,473		)	(6,307		)
Tax effect of adjustment related to unrealized (appreciation) depreciation on investment securities available-for-sale	(1,336		)	1,277
Total net deferred tax assets including adjustments	$	11,302		$	16,273

The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning the Company’s evaluation of both positive and negative evidence, forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. Positive evidence includes current positive earnings trends, the existence of taxes paid in available carryback years, and the probability that taxable income will continue to be generated in future periods, while negative evidence includes any cumulative losses in the current year and prior two years and general business and economic trends. The tax planning strategies the Company considered in its deferred tax asset analysis include, but are not limited to, the sale/leaseback of its owned office properties and the sale of its municipal securities with reinvestment of the proceeds in taxable securities.

At December 31, 2012, based on the results of its regular assessment of the ability to realize its deferred tax assets, the Company concluded that, based on all available evidence, both positive and negative, approximately $6.5 million of its deferred tax assets did not meet the “more likely than not” threshold for realization. Of the $6.5 million valuation allowance, $166,000 was recorded in 2012 and $6.3 million in 2011, of which $5.3 million was related to federal deferred tax assets and $1.0 million was related to state deferred tax assets. Although realization of the remaining net deferred tax assets of $11.3 million is not assured, management believes it is more likely than not that all of the recorded deferred tax assets will be realized based on available tax planning strategies and our projections of future taxable income. The positive evidence considered in management’s analysis of the remaining deferred tax assets included the Company’s long-term history of generating taxable income; the cyclical nature of the industry in which it operates; the fact that a portion of the losses realized in 2011 were partly attributable to syndicated/participation lending which the Company stopped purchasing during 2007; its history of fully realizing net operating losses, including the federal net operating loss from a $45.0 million taxable loss in 2004; the relatively long remaining tax loss carryforward periods (19 years for federal income tax purposes, seven years for the state of Indiana, and 12 years for the state of Illinois); and the 2012 liquidation of CFS Holdings, Inc. with the portfolio being transferred to the Bank, which will generate additional future state taxable income. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during tax loss carryforward periods are reduced. Any reduction in estimated future taxable income may require the Company to record an additional valuation allowance against its deferred tax assets, which would result in additional income tax expense in the period and could have a significant impact on the Company’s future earnings.

The Bank qualifies as a bank under provisions of the Internal Revenue Code which permitted it to deduct from taxable income an allowance for bad debts, which differed from the provision for such losses charged to income. Retained earnings at December 31, 2012 and 2011 included approximately $12.5 million, for which no provision for income taxes has been made. If in the future this portion of retained earnings is distributed, or the Bank no longer qualifies as a bank for tax purposes, income taxes may be imposed at the then applicable tax rates. The unrecorded deferred tax liability at December 31, 2012 and 2011 would have been approximately $4.9 million.

At December 31, 2012, the Company had federal and state net operating losses of $12.7 million and $11.4 million, respectively, which are being carried forward to reduce future taxable income. The federal carryforward expires in 2031and the state carryforwards expire between 2019 and 2024. At December 31, 2012, the Company had approximately $1.4 million of alternative minimum tax credits with no expiration date that are available to offset future federal income tax expense. At December 31, 2012, the Company also had approximately $3.9 million of low-income housing tax credits available to offset future federal income tax expense. These credits expire between 2022 and 2030.