11. Income Taxes

The components of domestic and foreign income before the provision for income taxes are as follows (in thousands):


	2013		2012		2011
U.S.	$	34,060	$	27,354	$	22,561
Foreign		13,888		16,826		12,059

Total income before provision for income taxes	$	47,948	$	44,180	$	34,620

The components of the provision for income taxes are as follows (in thousands):


	December 31,
	2013			2012			2011
Current
U.S. Federal	$	6,414		$	6,586		$	6,251
State and local		968			462			445
Foreign jurisdictions		4,511			5,355			3,621

		11,893			12,403			10,317
Deferred
U.S. Federal		5,009			2,842			1,491
State and local		424			555			(35	)
Foreign jurisdictions		(463	)		(585	)		178

		4,970			2,812			1,634

Total provision	$	16,863		$	15,215		$	11,951

A reconciliation of income taxes computed at federal statutory rates to income tax expense is as follows (dollar amounts in thousands):


	December 31,
	2013					2012					2011
Provision for income taxes at statutory rate	$	16,782		35.0	%	$	15,462		35.0	%	$	12,117		35.0	%
State and local income taxes, net of federal tax benefit		791		1.7	%		429		1.0	%		343		1.0	%
Foreign rate differential		(150	)	(0.3	)%		(220	)	(0.5	)%		(171	)	(0.5	)%
Effect of rate changes on deferred taxes		110		0.2	%		232		0.5	%		(76	)	(0.2	)%
Stock compensation		60		0.1	%		113		0.2	%		68		0.2	%
Research credits		(535	)	(1.1	)%		—		—			(212	)	(0.6	)%
Reversal of reserve for income taxes		(86	)	(0.2	)%		(361	)	(0.8	)%		(111	)	(0.4	)%
Other, net		(109	)	(0.2	)%		(440	)	(1.0	)%		(7	)	(0.0	)%

Reported income tax provision	$	16,863		35.2	%	$	15,215		34.4	%	$	11,951		34.5	%

For the year ended December 31, 2013, our effective tax rate was 35.2%. The effective tax rate included a benefit of 1.1% for federal research tax credits, as the credit expired in 2011 but was renewed in 2013. The 2013 benefit included both the 2012 and 2013 research credits. The effective tax rate included a charge of 1.7% for state and local income taxes, net of federal benefit, as compared to a charge of 1.0% in 2012.

For the year ended December 31, 2012, our effective tax rate was 34.4%. The effective tax rate for 2012 did not include a benefit for federal research tax credits, as the credit expired at the end of 2011. In 2011, the research tax credit provided a benefit of 0.6%. The effect of rate changes on deferred taxes was a charge of 0.5% in 2012 resulting from an increase in our state tax rates, and in 2011, the effect of rate changes on deferred taxes provided a benefit of 0.2%.

For the year ended December 31, 2011, our effective tax rate was 34.5%. The income tax benefit received from the reversal of reserve for income taxes was lower in 2011, as compared to 2012, which resulted in a higher effective tax rate. A reduction of non-deductible equity compensation also contributed to a higher 2011 effective tax rate.

The provision for income taxes includes $6.4 million, $1.5 million and $1.4 million for the years ended December 31, 2013, 2012 and 2011, respectively, that was credited directly to stockholders’ equity, rather than to the provision for income taxes for the exercise of non-qualified stock options by employees. In addition, the 2013, 2012 and 2011 provision does not include a provision of $0.7 million, $0.1 million, and a benefit of $0.5 million, respectively, related to other amounts recorded directly to accumulated other comprehensive income.

Significant components of the Company’s deferred tax assets and liabilities consisted of the following (in thousands):


	December 31,
	2013			2012
Deferred tax assets:
Compensation related deductions	$	5,982		$	7,288
Tax credit carryforwards		3,032			3,019
Federal and state net operating losses		2,775			4,313
Accrued expenses		1,890			332

Subtotal deferred tax assets		13,679			14,952
Valuation allowance		(2,266	)		(2,287	)

Total deferred income tax assets	$	11,413		$	12,665

Deferred tax liabilities:
Fixed assets	$	299		$	—
Intangible assets		6,108			11,818
Goodwill		33,177			24,841
Unrealized gains		42			—
Unremitted earnings of foreign subsidiaries		—			6
Other		710			473

Total deferred tax liabilities	$	40,336		$	37,138

Net deferred tax liabilities	$	28,923		$	24,473

Deferred tax assets and liabilities as classified in the consolidated balance sheets, based on the tax jurisdiction in which they reside as follows:
Net deferred income tax assets—short-term	$	3,557		$	2,218
Net deferred income tax assets—long-term (1)		130			155
Net deferred income tax liabilities—short-term (2)		(10	)		(14	)
Net deferred income tax liabilities—long-term		(32,600	)		(26,832	)

Net deferred income tax liabilities	$	(28,923	)	$	(24,473	)

(1)	Included in other assets in the accompanying consolidated balance sheet.

(2)	Included in accrued expenses and other current liabilities in the accompanying consolidated balance sheet.

In assessing the realizability of the deferred tax assets within each jurisdiction, the primary evidence we considered included the cumulative pre-tax income for financial reporting purposes over the past three years, and the estimated future taxable income based on historical, as well as subsequent interim period operating results. After giving consideration to these factors, we concluded that it was more likely than not that the domestic deferred tax assets would be fully realized, and as a result, no valuation allowance against the domestic deferred tax assets was deemed necessary at December 31, 2013 and 2012, except as described below.

A valuation allowance has been established for potential U.S. foreign tax credits that may be generated by Monotype Germany’s deferred tax liability related to temporary differences. As of December 31, 2013, the valuation allowance against these credits was $2.3 million. Monotype Germany is a branch for U.S. tax purposes, and therefore we are eligible to claim a foreign tax credit for taxes paid to Germany. As a result of the complexity of the U.S. foreign tax credit computation, and the uncertainty related to whether we will be entitled to a foreign tax credit when the related deferred taxes are paid or accrued, we have established a partial valuation allowance against these credits.

In accordance with ASC Topic No. 740, the Company has classified approximately $6.2 million to its reserve for uncertain tax positions at December 31, 2013. The following is a reconciliation of the Company’s gross uncertain tax positions at December 31, 2013 and 2012 (in thousands):


December 31, 2011	$	909
Decrease related to lapse of applicable statutes of limitations		(253	)
Increases related to positions taken and acquired in the current year		3,963

December 31, 2012	$	4,619
Decrease related to positions taken in prior years		(357	)
Increase related to positions taken in prior years		1,654
Increases related to positions taken in the current year		258

December 31, 2013	$	6,174

Of this amount of unrecognized tax benefits, approximately $4.8 million, $4.6 million and $0.9 million, if recognized, would result in a reduction of the Company’s effective tax rate at December 31, 2013, 2012 and 2011, respectively. The Company recognizes interest and penalties as a component of income tax expense. As of December 31, 2013, 2012 and 2011, the Company has accrued approximately $56 thousand, $78 thousand and $0.3 million, respectively, related to interest and penalties. The tax provision for the year ended December 31, 2013 includes a net benefit of $14 thousand related to interest. In 2012 and 2011, the net benefit was $0.1 million and $25 thousand, respectively. The increase in unrecognized tax benefits at December 31, 2013 relates to potential uncertainty surrounding the timing of deductions for certain accrued liabilities. The Company does not anticipate a significant change in the balance of uncertain tax positions over the next twelve months.

The Company monitors the undistributed earnings of foreign subsidiaries and, as necessary, provides for income taxes on those earnings that are not deemed permanently invested. As of December 31, 2012, with the exception of our UK subsidiary, there were no significant undistributed earnings of foreign subsidiaries that were deemed permanently invested. During the fourth quarter of 2012, we determined that unremitted earnings with respect to our UK foreign subsidiary are permanently invested. This determination arose in connection with our acquisition of Design by Front and management’s intent to reinvest in that business going forward.

As of December 31, 2013, the Company does not have any material amount of undistributed earnings at its foreign subsidiaries.

As of December 31, 2013, federal and state net operating loss carryforwards of $7.0 million and $3.3 million, respectively, are available, which begin to expire in 2020. These net operating losses were acquired in connection with the Bitstream acquisition and are therefore subject to limitation pursuant to Internal Revenue Code Section 382. The annual limitation on these losses is $4.9 million per year in 2013 through 2016.

The Company is currently subject to audit by the Internal Revenue Service and foreign jurisdictions for the years 2010 through 2013. The Company and its subsidiaries state income tax returns are subject to audit for the years 2009 through 2013.