Note 11. Income Taxes

We do not believe that we have included any "uncertain tax positions" in our federal income tax return or any of the state income tax returns we are currently filing. We have made an evaluation of the potential effect of additional state taxes being assessed by jurisdictions in which we do not currently consider ourselves liable. We do not anticipate that such additional taxes, if any, would result in a material change to our financial position. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:

Balance at March 31, 2011	$	105
Additions based on current year tax positions		-
Additions for prior year tax positions		-
Reductions related to lapse of statute of limitations		(30	)
Balance at March 31, 2012	$	75

If recognized, the entire amount of unrecognized tax benefits would be recorded as a reduction in income tax expense. The amount accrued for payment of interest as of March 31, 2012 and 2011 was $4,000 and $9,000, respectively. We do not expect the total amount of unrecognized tax benefits to significantly increase or decrease within the next twelve months.

We file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. Tax years ended on or after March 31, 2008 remain open to examination by federal authorities; however, we recently closed an IRS examination for the March 31, 2008 and March 31, 2009 tax years that resulted in no adjustments. Tax years ended on or after March 31, 2007 remain open to examination by state authorities.

Valuation of Deferred Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We must assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent that it is more likely than not that such deferred tax assets will not be realized, we must establish a valuation allowance. The establishment, or increase, of a valuation allowance increases income tax expense for such year. We have a valuation allowance against 100% of our net deferred tax assets, which are composed primarily of net operating loss (or NOL) carryforwards. Even though we have fully reserved these net deferred tax assets for book purposes, we would still be able to utilize them to reduce future income taxes payable should we have future earnings. To the extent such deferred tax assets relate to NOL carryforwards, the ability to use such NOLs against future earnings will be subject to applicable carryforward periods. As of March 31, 2012, we had NOL carryforwards for federal and state tax purposes of $16.3 million and $20.2 million, respectively, which are available to offset taxable income through 2032. These amounts reflect that the utilization of Image's NOLs carryforwards is subject to a substantial annual limitation due to ownership change (such as the one that occurred at Image in 2010) limitations as required by Section 382 of the Internal Revenue Code of 1986, as amended (the "Code"), as well as similar state limitations. This resulted in approximately $25.3 million and $22.7 million of federal and state NOL carryforwards, respectively, being subject to limitations that caused these carryforwards to expire without utilization in 2010. As a result, Image has written-off the deferred tax assets associated with the excess net operating losses, along with the corresponding valuation allowance. In addition, Image may incur further limitations on the use the available NOLs in connection with the proposed RLJ transaction. We are currently in consultation with outside tax counsel with respect to quantifying post-transaction NOL usage.

Income tax expense (benefit) for each of the years ended March 31, 2012 and 2011, is summarized as follows:

(In thousands)	2012			2011
Current
Federal	$	-		$	-
State		(66	)		26
Foreign		-			-
		(66	)		26
Deferred
Federal		-			-
State		-			-
		-			-

Total Tax Expense (Benefit)	$	(66	)	$	26

The tax effects of temporary differences that give rise to a significant portion of the net deferred tax assets at March 31, 2012 and 2011, are presented below:

(In thousands)	2012			2011
Deferred tax assets:
Provision for lower of cost or market inventory write-downs	$	2,194		$	2,681
Net operating loss carryforwards		6,663			5,161
Allowance for sales returns		-			96
Deferred revenue		-			235
Allowance for doubtful accounts receivable		4			663
Accrued compensation and benefits		228			276
Legal settlement accrual		132			39
Depreciation and amortization		664			853
Tax credits		723			663
Stock options		488			100
Partnership investment		-			243
Other		44			77
Deferred tax assets		11,140			11,087
Less valuation allowance		(9,537	)		(9,984	)
Deferred tax assets		1,603			1,103

Deferred tax liabilities:
Unrealized gain/loss		(1,150	)		(1,090	)
Allowance for sales returns		(135	)		-
Deferred revenue		(111	)		-
Partnership investment		(207	)		-
Other		-			(13	)
Deferred tax liabilities		(1,603	)		(1,103	)
Net deferred tax assets	$	-		$	-

Expected income tax expense (benefit) based on federal statutory rates for the years ended March 31, 2012 and 2011, differed from actual income tax expense (benefit) as follows:

(In thousands)	2012			2011
Expected income tax benefit	$	(1,111	)	$	(404	)
State income tax benefit, net of Federal benefit		49			162
Change in valuation allowance		(447	)		(319	)
Dividends on preferred stock		1,113
Non-deductible expenses		156			177
Provision to return adjustments		265			152
Change in tax rate		(103	)		220
Other		12			38
	$	(66	)	$	26