Income Taxes

The following table presents the provision for income taxes for the nine months ended September 30, 2012 and 2011:



	2012			2011
	(in thousands)
Current:
Federal	$	(342	)	$	1,627
State	—			—
	(342		)	1,627
Deferred:
Federal	1,575			(5,120		)
State	438			(602		)
	2,013			(5,722		)
Increase (decrease) in valuation allowance for deferred tax assets	(11,000		)	11,000
Total income taxes	$	(9,329	)	$	6,905

The following table presents the tax effects of significant components of the Company's net deferred tax assets as of September 30, 2012 and December 31, 2011:



	September 30,			December 31,
	2012			2011
	(in thousands)
Deferred tax assets:
Allowance for loan losses	$	10,671		$	12,880
Other than temporary impairment	807			807
Accrued liabilities	213			276
OREO property	1,594			1,268
Net operating loss	6,511			7,281
Sidus goodwill	953			1,050
Other	1,887			1,798
	22,636			25,360
Less: Valuation Allowance	—			(11,000		)
	$	22,636		$	14,360

Deferred tax liabilities:
Unrealized gain on available-for-sale securities	$	(3,002	)	$	(2,387	)
FMV adjustment related to mergers	(177		)	(255		)
Depreciation	(1,688		)	(1,980		)
Prepaid expenses	(358		)	(327		)
Core deposit intangible	(1,146		)	(1,468		)
Noncompete intangible	(149		)	(149		)
Other	(146		)	(195		)
	$	(6,666	)	$	(6,761	)
Net deferred tax asset	$	15,970		$	7,599

Our net deferred tax asset was $16.0 million at September 30, 2012 and $7.6 million at December 31, 2011. A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. All available evidence, both positive and negative, is used in the consideration to determine whether, based on the weight of that evidence, a valuation allowance is required.

As of June 30, 2012, the Company reversed a previously recorded $11 million valuation allowance which had been established as a measure of caution in 2011 after falling into a 3-year cumulative loss position at that time. After review of all available evidence at June 30, 2012 and based on the weight of such evidence, the Company believed the realization of the deferred tax asset was more likely than not and reversed the previously recorded $11.0 million valuation allowance. The reversal of the allowance was based primarily on a return to profitability as the Company had reported four consecutive quarters of net income. Based on net income trends, projected net income over the next 36 months and improving credit quality metrics, no valuation allowance was deemed necessary as of June 30, 2012.

At September 30, 2012, the Company considered the following negative and positive evidence in its evaluation of deferred tax assets:


•	The Company is in a cumulative tax income position for the 3-year period ending September 30, 2012 of $1.7 million. Significance: High



	September 30, 2012 Cumulative Loss Test
	2009*		2010			2011			2012**		Total
Income (loss) before income taxes	$	6,545	$	(1,402	)	$	(7,701	)	$	5,897	$	(3,206	)
Goodwill impairment	—		—			4,944			—		4,944
	$	6,545	$	(1,402	)	$	(2,757	)	$	5,897	$	1,738

*4th quarter of 2009

**First nine months of 2012

•

The Company has recorded $14.7 million in taxable income for five previous consecutive quarters as credit quality has improved and net interest margin has increased over the past year. Credit quality has improved, including significant decreases in classified loans and nonperforming loans. Credit losses have shown a dramatic reduction in the second half of 2011 and continuing into 2012 with only $16.5 million in charge-offs for the nine months ended September 30, 2012. Significance: High


•	The Company's strong history of earnings since the inception of the Bank, and particularly over the 10 year period prior to the current economic cycle, shows the Company has historically been profitable and has no history of expiration of loss carryforwards. Significance: Moderate


•	Management is not aware of any unsettled circumstances that, if resolved, would adversely affect future operations or earnings. Significance: Low


•	Credit quality has improved over the past twelve months, including significant decreases in classified loans and nonperforming loans. Credit losses have shown a dramatic reduction in the second half of 2011 and continuing into 2012, with only $25.3 million in gross charge-offs over the past twelve months as compared to $39.8 million in the twelve prior months. Significance: Moderate

•

Federal net operating losses can be deducted over the twenty year carryforward period. Currently, management is projecting full utilization of these tax benefits within 3 years from December 31, 2011. The Company's loss carryforwards for the tax period ending December 31, 2012 include net operating loss carryforwards generated in the acquisition of Cardinal State Bank in 2008 and American Community Bank in 2009, as well as net operating loss carryforwards for the Company. The expiration of the loss carryforwards for the tax period ending December 31, 2012 are as follows:

Significance: Moderate



	Net Operating Loss Carryforward at December 31, 2011		Expiration
	(in thousands)
Cardinal State Bank acquisition	$	2,424	2029
American Community Bank acquisition	345		2030
Yadkin Valley Federal Tax	14,517		2031
Yadkin Valley State Tax	16,166		2031
Total Loss Carryforwards	$	33,452

After review of all available evidence and based on the weight of such evidence, the Company believes the realization of the deferred tax asset is, more likely than not and no valuation allowance is deemed necessary at September 30, 2012 based primarily on a return to profitability (excluding projected losses related to management's de-risk plan) as the Company has reported five consecutive quarters of net income, net income trends, projected net income for the years 2013-2015 and improving credit quality metrics.

In October 2012, the Company announced a plan to reduce credit risk and reduce problem assets. As a result of this plan, the Company is projecting a loss for the year ended December 31, 2012. This loss will cause the Company to return to a cumulative loss position for the 3-year period ended. Although the Company estimates losses related to this effort will be between $40-45 million, the plan will help reduce problem assets that led to significant losses in the years 2010 and 2011 and capital raised as part of the Private Placement will better position the Company in the future. See Note 15 for further discussion on the Private Placement and de-risk plan. The Company has considered this potential transaction as part of our analysis of realizability of deferred tax assets at September 30, 2012 and concluded that it was still more likely than not that the deferred tax assets will be realized and that no valuation allowance is necessary at September 30, 2012.

The following table presents a reconciliation of applicable income taxes for the nine months ended September 30, 2012 and 2011 to the amount of tax expense computed at the statutory federal income tax rate of 35%:



	2012			2011
	(in thousands)
Tax expense (benefit) at statutory rate on income before income taxes	$	2,064		$	(3,645	)
Increases (decreases) resulting from:
Tax-exempt interest on investments	(589		)	(651		)
State income tax, net of federal benefits	285			(391		)
Income from bank-owned life insurance	(166		)	(172		)
Valuation allowance on deferred tax assets	(11,000		)	11,000
Other	77			764
Total income taxes	$	(9,329	)	$	6,905