Income Taxes

12 Months Ended

Dec. 31, 2011

Income Taxes [Abstract]

Income Taxes

13. Income Taxes

Income tax expense includes current and deferred taxes as follows (in thousands):

	Current		Deferred			Total
Year Ended December 31, 2011:
Federal	$	5,734	$	15,735		$	21,469
State		2,211		(1,309	)		902
	$	7,945	$	14,426		$	22,371
	Current		Deferred			Total
Year Ended December 31, 2010:
Federal	$	—	$	6,898		$	6,898
State		373		1,341			1,714
	$	373	$	8,239		$	8,612

The reconciliation between the income tax computed by applying the U.S. federal statutory rate and the effective tax rate on net income is as follows for the year ended December 31, 2011 and 2010 (dollars in thousands):

	Dec. 31, 2011			Dec. 31, 2010
Pre-tax book income	$	64,421		$	25,601
Less: pre-tax income allocated to noncontrolling interest holder		(2,044	)		(6,135	)
Pre-tax book income after noncontrolling interest	$	62,377		$	19,466

	December 31,
	2011						2010
Income Tax expense				Rate						Rate
Taxes computed at federal rate	$	21,832			35.0	%	$	6,813			35.0	%
State and local taxes, net of federal tax benefit		3,287			5.3	%		840			4.3	%
Effect of deferred tax rate change		(2,694	)		(4.3	)%		711			3.7	%
Effect of change in valuation allowance		(1,113	)		(1.8	)%		17			0.1	%
Change in income tax benefit payable to stockholder		(782	)		(1.3	)%		177			0.9	%
Stock compensation		41			0.1	%		120			0.6	%
Meals and entertainment		437			0.7	%		190			1.0	%
Other		1,363			2.2	%		(256	)		(1.3	)%
	$	22,371			35.9	%	$	8,612			44.2	%

Total income tax expense recorded for the year ended December 31, 2011 and 2010, included income tax expense of $13,000 and $39,000 of state and local taxes on income allocated to the noncontrolling interest holder, which represents 0.02% and 0.2% of the total effective rate, respectively.

Deferred income tax assets and liabilities consist of the following at December 31, 2011 and 2010 (in thousands):

	December 31,
	2011			2010
Deferred income tax assets:
Section 754 election tax basis step-up	$	176,365		$	175,008
Tenant improvements		1,882			1,523
Net operating loss carryforward		1,144			11,727
Restricted stock units		1,144			503
Compensation		4,369			1,764
Intangible asset		857			—
Tax credits		123			123
Other		205			276
		186,089			190,924
Less: valuation allowance		(21,902	)		(20,848	)
Deferred income tax asset		164,187			170,076
Deferred income tax liabilities:
Goodwill		(1,248	)		(1,016	)
Servicing rights		(4,829	)		(3,649	)
Deferred rent		(1,473	)		(1,158	)
Investment in partnership		(857	)		—
Deferred income tax liability		(8,407	)		(5,823	)
Net deferred income tax asset	$	155,780		$	164,253

The primary deferred tax asset represents a tax basis step-up election under Section 754 of the Internal Revenue Code, as amended (“Section 754”), made by HFF, Inc. relating to the initial purchase of units of the Operating Partnerships in connection with the Reorganization Transactions and a tax basis step-up on subsequent exchanges of Operating Partnership units for the Company’s Class A common stock since the date of the Reorganization Transactions. As a result of the step-up in basis from these transactions, the Company is entitled to annual future tax benefits in the form of amortization for income tax purposes. During 2011, the deferred tax asset for the Section 754 election tax basis step-up increased $6.0 million due to the exchanges of Operating Partnership units for the Company’s Class A common stock. The annual pre-tax benefit is approximately $25.6 million at December 31, 2011 and will increase as future exchanges of Operating Partnership units occur (see Note 14). To the extent that the Company does not have sufficient taxable income in a year to fully utilize this annual deduction, the unused benefit is recharacterized as a net operating loss and can then be carried back three years or carried forward for twenty years. The Company measured the deferred tax asset based on the estimated income tax effects of the increase in the tax basis of the assets owned by the Operating Partnerships utilizing the enacted tax rates at the date of the transaction. In accordance with ASC 740, the tax effects of transactions with shareholders that result in changes in the tax basis of a company’s assets and liabilities are recognized in equity. The Company recorded a valuation allowance on a portion of the recognized deferred tax assets recorded in connection with the Reorganization Transactions and the subsequent exercise of exchange rights due to the uncertainty in the timing and level of tax benefits that would be realized when payments are made to HFF Holdings under the Tax Receivable Agreement (see further discussion below). Changes in the measurement of the deferred tax assets or the valuation allowance due to changes in the enacted tax rates upon the finalization of the income tax returns for the year of the exchange transaction are recorded in equity. All subsequent changes in the measurement of the deferred tax assets due to changes in the enacted tax rates or changes in the valuation allowance are recorded as a component of income tax expense.

In evaluating the realizability of the deferred tax assets, management makes estimates and judgments regarding the level and timing of future taxable income, including projecting future revenue growth and changes to the cost structure. In order to realize the annual pre-tax benefit of approximately $25.6 million, the Company needs to generate approximately $169.0 million in revenue each year, assuming a constant cost structure. In the event that the Company cannot realize the annual pre-tax benefit of $25.6 million each year, the shortfall becomes a net operating loss that can be carried back 3 years to offset prior years’ taxable income or carried forward 20 years to offset future taxable income. Based on this analysis and other quantitative and qualitative factors, management believes that it is currently more likely than not that the Company will be able to generate sufficient taxable income to realize the net deferred tax assets resulting from the basis step up transactions (initial sale of units in the Operating Partnerships and subsequent exchanges of Operating Partnership units since the date of the Reorganization Transactions). Deferred tax assets representing the tax benefits to be realized when future payments are made to HFF Holdings under the Tax Receivable Agreement of $21.9 million are currently not more likely than not to be realized and, therefore, have a valuation allowance of $21.9 million recorded against them. The combined federal and state tax effected net operating loss carryforwards of $1.1 million at December 31, 2011 represent the cumulative excess of the Section 754 annual tax deductions over taxable income for 2011 and prior years. The net operating loss of is subject to limitation under Section 382 of the Internal Revenue Code, as amended. The limitation on the use of the net operating loss in 2011 is $1.1 million, which can be used in future years. The net operating loss limitation does not impact the Company’s ability to fully utilize the net operating loss before its expiration. The federal net operating loss carryforwards expire from 2028 to 2030 while the state net operating loss carryforwards expire from 2013 through 2030.

The Company will recognize interest and penalties related to unrecognized tax benefits in interest and other income, net in the consolidated statements of income. There were no interest or penalties recorded in the twelve months ended December 31, 2011 or December 31, 2010.

Tax Receivable Agreement

In connection with the Reorganization Transactions, HFF LP and HFF Securities made an election under Section 754 for 2007 and intend to keep that election in effect for each taxable year in which an exchange of partnership units for shares occurs. The initial sale as a result of the offering and the subsequent exchanges of partnership units increased the tax basis of the assets owned by HFF LP and HFF Securities to their fair market value. This increase in tax basis allows the Company to reduce the amount of future tax payments to the extent that the Company has future taxable income. During 2011, the deferred tax asset for the Section 754 election tax basis step-up increased $6.0 million due to the exchanges of Operating Partnership units for the Company’s Class A common stock. As a result of the increase in tax basis, the Company is entitled to future tax benefits of $176.4 million and has recorded this amount as a deferred tax asset on its consolidated balance sheet. The Company has updated its estimate of these future tax benefits based on the changes to the estimated annual effective tax rate for 2011 and 2010. The Company is obligated, however, pursuant to its Tax Receivable Agreement with HFF Holdings, to pay to HFF Holdings, 85% of the amount of cash savings, if any, in U.S. federal, state and local income tax that the Company actually realizes as a result of these increases in tax basis and as a result of certain other tax benefits arising from the Company entering into the tax receivable agreement and making payments under that agreement. For purposes of the tax receivable agreement, actual cash savings in income tax will be computed by comparing the Company’s actual income tax liability to the amount of such taxes that it would have been required to pay had there been no increase to the tax basis of the assets of HFF LP and HFF Securities as a result of the initial sale and later exchanges and had the Company not entered into the tax receivable agreement.

The Company accounts for the income tax effects and corresponding tax receivable agreement effects as a result of the initial purchase and the sale of units of the Operating Partnerships in connection with the Reorganization Transactions and future exchanges of Operating Partnership units for the Company’s Class A shares by recognizing a deferred tax asset for the estimated income tax effects of the increase in the tax basis of the assets owned by the Operating Partnerships, based on enacted tax rates at the date of the transaction, less any tax valuation allowance the Company believes is required. In accordance with ASC 740, the tax effects of transactions with shareholders that result in changes in the tax basis of a company’s assets and liabilities will be recognized in equity. If transactions with shareholders result in the recognition of deferred tax assets from changes in the company’s tax basis of assets and liabilities, the valuation allowance initially required upon recognition of these deferred assets will be recorded in equity. Subsequent changes in enacted tax rates or any valuation allowance are recorded as a component of income tax expense.

The Company believes it is more likely than not that it will realize a portion of the benefit represented by the deferred tax asset, and, therefore, the Company recorded 85% of this estimated amount of the increase in deferred tax assets, as a liability to HFF Holdings under the tax receivable agreement and the remaining 15% of the increase in deferred tax assets directly in additional paid-in capital in stockholders’ equity. Deferred tax assets representing the tax benefits to be realized when future payments are made to HFF Holdings under the tax receivable agreement are currently not likely to be realized and, therefore, have a valuation allowance of $21.9 million recorded against them.

While the actual amount and timing of payments under the tax receivable agreement will depend upon a number of factors, including the amount and timing of taxable income generated in the future, changes in future tax rates, the value of individual assets, the portion of the Company’s payments under the tax receivable agreement constituting imputed interest and increases in the tax basis of the Company’s assets resulting in payments to HFF Holdings, the Company has estimated that the payments that will be made to HFF Holdings will be $149.8 million and has recorded this obligation to HFF Holdings as a liability on the consolidated balance sheet. During the year ended December 31, 2011, the tax rates used to measure the deferred tax assets were updated which resulted in an increase of deferred tax assets of $4.6 million, which resulted in an increase in the payable under the tax receivable agreement of $3.9 million. In addition, during the year ended December 31, 2010, the tax rates used to measure the deferred tax assets were updated which resulted in a reduction of deferred tax assets of $1.0 million, which resulted in a reduction in the payable under the tax receivable agreement of $0.8 million. To the extent the Company does not realize all of the tax benefits in future years, this liability to HFF Holdings may be reduced.

In conjunction with the filing of the Company’s 2010 federal and state tax returns, the benefit for 2010 relating to the Section 754 basis step-up was finalized resulting in $7.4 million in tax benefits realized by the Company for 2010. As discussed above, the Company is obligated to remit to HFF Holdings 85% of any such cash savings in federal and state tax. As such, during August 2010, the Company paid $6.3 million to HFF Holdings under this tax receivable agreement. In conjunction with filing of the Company’s 2009 federal and state tax returns, the benefit for 2009 relating to the Section 754 basis step-up was finalized resulting in no tax benefits being realized by the Company for 2009. As such during 2010, the Company did not make any payments to HFF Holdings under the tax receivable agreement. As of December 31, 2011, the Company has made payments to HFF Holdings pursuant to the terms of the tax receivable agreement in an aggregate amount of approximately $13.8 million and the Company anticipates to make a payment of $17.9 million to HFF Holdings in 2012.