11. INCOME TAXES

We file a consolidated federal income tax return. Income tax expense allocated to our subsidiaries is based upon their respective taxable incomes and tax credits. FPU has been included in our consolidated federal return since the completion of the merger on October 28, 2009. State income tax returns are filed on a separate company basis in most states where we have operations and/or are required to file. FPU continues to file a separate state income tax return in Florida.

The Internal Revenue Service (“IRS”) performed its examination of FPU’s consolidated federal returns for 2008 and for the period from January 1, 2009 to October 28, 2009 (the pre-merger period in 2009, during which FPU was required to file a separate federal tax return) and proposed a disallowance of approximately $135,000 and $256,000, respectively, of the environmental expenditure deductions taken by FPU related to one of the environmental remediation sites. We disagreed with the IRS finding and filed an appeal, which is currently underway. The IRS finding is based on the failure of FPU to follow a technical requirement to label these environmental expenditures in a specific way on the returns. At our request, the IRS granted relief in 2012, which allowed us to correctly label such expenditures for 2008 and 2009. We believe that those deductions will likely be sustained during the appeal process based on the IRS’ grant of such relief. Accordingly, we did not record any accrual as of December 31, 2012 and 2011, related to the examination by the IRS of the FPU returns.

The IRS performed its examination of Chesapeake’s consolidated federal return for 2009. The IRS completed its examination in 2012 without any findings.

The State of Florida performed its examination of Chesapeake’s state return for 2008, 2009 and 2010. The State of Florida completed its examination in 2012 without any material findings.

The State of Texas is currently performing its examination of Chesapeake’s amended state tax return for 2007. We amended the 2007 Texas state tax return due to a change in the methodology used to calculate the gross receipts used to determine the Texas apportionment. This new methodology was used in Chesapeake’s Texas tax returns for all years after 2006. In 2012, we recorded a total liability of $300,000 associated with the unrecognized tax benefit related to this change in methodology given the unknown outcome of this examination. We recorded this liability associated with the unrecognized tax benefit as an income tax payable, which reduced the income tax receivable in the accompanying balance sheet at December 31, 2012.

We generated net operating losses of $2.0 million in 2011 for federal income tax purposes, primarily from increased book-to-tax timing differences authorized by The Tax Relief Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which allowed bonus depreciation for certain assets. The federal net operating losses from 2011 are expected to be fully utilized upon the filing of our 2012 federal income tax return. None of the federal net operating losses from 2011 remained at December 31, 2012. We had previously generated net operating losses in 2008 for federal income tax purposes, which were carried forward to fully offset our taxable income in 2009 and partially offset our taxable income in 2010. None of the federal net operating losses from 2008 remained at December 31, 2012. We also had state net operating losses of $28.1 million in various states as of December 31, 2012, almost all of which will expire in 2030. We have recorded a deferred tax asset of $1.6 million and $2.4 million related to the net operating loss carry-forwards at December 31, 2012 and 2011, respectively. We have not recorded a valuation allowance to reduce the future benefit of the tax net operating losses because we believe they will be fully utilized.

The following tables provide: (a) the components of income tax expense in 2012, 2011, and 2010; (b) the reconciliation between the statutory federal income tax rate and the effective income tax rate for 2012, 2011, and 2010; and (c) the components of accumulated deferred income tax assets and liabilities at December 31, 2012 and 2011.


For the Years Ended December 31,	2012			2011			2010
(in thousands)
Current Income Tax Expense
Federal	$	3,483		$	0		$	1,566
State		1,990			742			2,116
Investment tax credit adjustments, net		(58	)		(73	)		(91	)

Total current income tax expense		5,415			669			3,591

Deferred Income Tax Expense ⁽¹⁾
Property, plant and equipment		14,301			16,885			16,964
Deferred gas costs		515			591			(2,505	)
Pensions and other employee benefits		553			786			(402	)
FPU merger related premium cost and deferred gain		(509	)		—			(13	)
Amortization of intangibles		80			17			(211	)
Environmental expenditures		(82	)		(65	)		32
Net operating loss carryforwards		740			(1,000	)		99
Reserve for insurance deductibles		—			18			(419	)
Other		(1,717	)		88			(213	)

Total deferred income tax expense		13,881			17,320			13,332

Total Income Tax Expense	$	19,296		$	17,989		$	16,923

Reconciliation of Effective Income Tax Rates
Continuing Operations
Federal income tax expense (2)	$	16,745		$	16,146		$	15,053
State income taxes, net of federal benefit		2,659			2,216			2,083
Merger related costs		—			—			70
ESOP dividend deduction		(235	)		(236	)		(266	)
Other		127			(137	)		(17	)

Total income tax expense	$	19,296		$	17,989		$	16,923

Effective income tax rate		40.07	%		39.44	%		39.38	%



At December 31,	2012		2011
(in thousands)
Deferred Income Taxes
Deferred income tax liabilities:
Property, plant and equipment	$	118,212	$	105,850
Acquisition adjustment		17,440		18,090
Deferred gas costs		816		301
Loss on reacquired debt		572		608
Other		2,784		3,872

Total deferred income tax liabilities		139,824		128,721

Deferred income tax assets:
Pension and other employee benefits		7,382		7,796
Environmental costs		1,917		1,835
Net operating loss carryforwards		1,587		2,401
Self insurance		484		452
Storm reserve liability		1,058		1,085
Other		2,982		2,240

Total deferred income tax assets		15,410		15,809

Deferred Income Taxes Per Consolidated Balance Sheet	$	124,414	$	112,912

⁽¹⁾	Includes $1,934,000, $2,280,000, and $1,963,000 of deferred state income taxes for the years 2012, 2011 and 2010, respectively.

⁽²⁾	Federal income taxes were recorded at 35% for each year represented.