NOTE 12. INCOME TAXES

The Company is subject to taxation in the United States and Canada. However, business is conducted primarily in the United States. The effective tax rate differs from the statutory rate primarily due to state taxes, tax credits and changes in uncertain tax positions. The Company makes estimates and judgments about its future taxable income that are based on assumptions that are consistent with the Company’s plans and estimates. Should the actual amounts differ from these estimates, the amount of the valuation allowance could be materially affected.

Income taxes are computed using the asset and liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Changes in valuation allowances are reflected as a component of provision for income taxes.

Significant components of the Company’s deferred tax assets and liabilities are as follows (in thousands):

	December 31,
	2014			2013
Deferred tax assets:
Net operating losses (federal and state)	$	2,996		$	8,994
Accrued expenses		9,381			7,995
Accrued workers compensation costs		13,964			5,489
Stock-based compensation		2,508			1,669
Tax benefits relating to uncertain positions		20			72
Tax credits (federal and state)		9,865			4,318
Other		354			160
Total		39,088			28,697
Valuation allowance		(6,945	)		(5,194	)
Total deferred tax assets		32,143			23,503
Deferred tax liabilities:
Depreciation and amortization		(10,643	)		(22,259	)
Deferred service revenues		(77,827	)		(24,456	)
Prepaid health plan expenses		(2,202	)		(1,143	)
Total deferred tax liabilities		(90,672	)		(47,858	)
Net deferred tax liabilities	$	(58,529	)	$	(24,355	)

The deferred tax assets and liabilities presented above are classified in the accompanying consolidated balance sheets as follows (in thousands):

	December 31,
	2014			2013
Net current deferred tax liabilities	$	(65,713	)	$	(16,535	)
Net non-current deferred tax liabilities		-			(8,888	)
Net current deferred tax assets		-			68
Net non-current deferred tax assets		7,184			1,000
Net deferred tax liabilities	$	(58,529	)	$	(24,355	)

The provision for income taxes consists of the following (in thousands):

	Year Ended December 31
	2014			2013			2012
Current:
Federal	$	(31,111	)	$	11,319		$	10,699
Foreign		230			217			142
State		4,618			3,081			1,845
		(26,263	)		14,617			12,686
Deferred:
Federal		38,297			(5,659	)		6,610
State		5,545			(1,021	)		1,048
		43,842			(6,680	)		7,658
	$	17,579		$	7,937		$	20,344

The U.S. federal statutory income tax rate reconciled to the Company’s effective tax rate is as follows:

	Year Ended December 31
	2014			2013			2012
U.S. federal statutory tax rate		35.00	%		35.00	%		35.00	%
State income taxes, net of federal benefit		3.8			3.8			3.4
Tax rate change		7.8			1.5			0.7
Nondeductible transaction costs		0.9			-			0.6
Nondeductible meals, entertainment and penalties		4.3			4.1			0.9
Stock-based compensation		4.5			(0.1	)		0.1
Uncertain tax positions		0.8			(2.3	)		(0.2	)
Tax credits		(3.6	)		(4.3	)		(0.9	)
Other		(0.3	)		(0.1	)		(0.6	)
		53.20	%		37.60	%		39.00	%

Our effective tax rate increased from 37.6% for 2013 to 53.2% in 2014, primarily due to non-deductible stock-based compensation and the revaluation of deferred taxes resulting from regulatory state tax law changes. The Company recognized $2.6 million, $0.3 million and $0.4 million of tax expense related to the revaluation of deferred taxes for the periods ended December 31, 2014, 2013 and 2012, respectively.

The Company records a valuation allowance to reduce reported deferred tax assets if, based on the weight of available evidence, both positive and negative, for each respective tax jurisdiction, it is more likely than not that some or all of the deferred tax assets will not be realized. The Company recorded a valuation allowance of $1.9 million and $2.0 million as of December 31, 2014 and 2013, respectively, related to certain federal and state net operating loss carryforwards that may not be utilized prior to expiration. The Company has federal and multiple state net operating loss carryforwards of approximately $8.6 million and $58.6 million as of December 31, 2014, respectively. The federal net operating loss carryforward will begin expiring in 2030 and the state net operating loss carryforward will begin expiring in 2015.The Internal Revenue Code of 1986, as amended, imposes substantial restrictions on the utilization of net operating losses in the event of an “ownership change” of a corporation. Accordingly, a company’s ability to use net operating losses may be limited as prescribed under Internal Revenue Code Section 382 (“IRC Section 382”). Events which may cause limitations in the amount of the net operating losses that the Company may use in any one year include, but are not limited to, a cumulative ownership change of more than 50% over a three-year period. Due to the effects of historical equity issuances, the Company has determined that the future utilization of a portion of its net operating losses is limited annually pursuant to IRC Section 382. As of December 31, 2014, the Company has determined that a portion of its federal and state net operating losses in the amount of $3.8 million and $2.7 million, respectively, will expire because of the annual limitation.

The Company has excluded excess windfall tax benefits resulting from stock option exercises as components of the Company’s gross deferred tax assets, as tax attributes related to such windfall tax benefits should not be recognized until they result in a reduction of taxes payable. The gross amount of unrealized net operating loss carryforwards for federal and state resulting from stock option exercises was $4.6 million and $19.3 million, respectively at December 31, 2014. When realized, excess windfall tax benefits are credited to additional paid-in capital. The December 31, 2014 current tax benefit of $26.3 million is net of $9.7 million excess tax benefit resulting from stock option exercises and net operating loss carryforward utilization. The Company follows tax law ordering method to determine when such net operating loss carryforwards have been realized.

The Company has multiple federal tax credit carryforwards of approximately $3.9 million, of which $1.8 million will begin expiring in 2031. The Company recorded a valuation allowance of $0.1 million and $0.1 million as of December 31, 2014 and 2013, respectively, related to certain federal tax credit carryforwards that may not be utilized prior to the expiration. Additionally, the Company has $6.5 million (net of federal benefit) state tax credit carryforwards available that will begin expiring in 2021, which are partially offset by a valuation allowance of $5.0 million. The December 31, 2014 current tax benefit of $26.3 million is net of $24.3 million tax benefit from operating loss carry forwards. The valuation allowance increased by $1.8 million, $3.7 million and $1.1 million as of December 31, 2014, 2013 and 2012, respectively.

The Company is subject to tax in U.S. federal and various state and local jurisdictions, as well as Canada. The Company is not subject to any material income tax examinations in federal or state jurisdictions for tax years beginning prior to January 1, 2010. However, there are outstanding Notices of Proposed Assessment disallowing employment tax credits totaling $10.5 million in connection with the IRS examination of Gevity HR, Inc. and Subsidiaries, which was acquired by TriNet on June 1, 2009. While Appeals has denied the credits, and the Company plans to exhaust all administrative efforts to resolve this issue, it is likely that the matter will ultimately be resolved through litigation. With regard to these employment tax credits, the Company believes it is more likely than not that the Company will prevail. Therefore, no reserve has been recognized related to this matter.

As of December 31, 2014 and 2013, the total unrecognized tax benefits related to uncertain income tax positions, which would affect the effective tax rate if recognized, were $3.2 million and $2.9 million, respectively. It is reasonably possible that $2.6 million of the total unrecognized tax benefits as of December 31, 2014 will settle within the next year; thus, the gross unrecognized tax benefit at December 31, 2014 (including interest of $0.8 million) could significantly decrease within 2015. Unrecognized tax benefits that may settle within the next year represent federal employment tax credits, which are more fully described above.

A reconciliation of the beginning and ending amount of unrecognized tax benefits (excluding interest and penalties) is as follows (in thousands):

	December 31,
	2014			2013			2012
Unrecognized tax benefits at January 1	$	2,300		$	2,710		$	2,516
Additions for tax positions of prior periods		25			–			110
Additions for tax positions of current period		182			286			49
Additions due to acquisitions		–			–			509
Reductions for tax positions of prior period:
Settlements with taxing authorities		–			(406	)		–
Lapse of applicable statute of limitations		–			(290	)		(330	)
Adjustments to tax positions		(36	)		–			(144	)
Unrecognized tax benefits at December 31	$	2,471		$	2,300		$	2,710

The Company includes interest and penalties related to unrecognized tax benefits within the provision for income taxes. As of December 31, 2014 and December 31, 2013, the total amount of gross interest and penalties accrued was $0.8 million and $0.7 million, respectively, which is classified as current liabilities in the Consolidated Balance Sheets. In connection with tax matters, the Company recognized interest and penalty expense related to its uncertain tax positions as a component of income tax expense in the accompanying consolidated statements of operations of $0.1 million, de minimis and $0.2 million for the years ended December 31, 2014, 2013 and 2012, respectively.

The Company has not provided for U.S. federal income and foreign withholding taxes on its Canadian subsidiary’s undistributed earnings of $1.9 million as of December 31, 2014, because the Company intends to reinvest such earnings indefinitely. Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to U.S. income taxes (subject to an adjustment for foreign tax credits). Determining the unrecognized deferred tax liability related to investment in the Canadian subsidiary that are indefinitely reinvested is not practicable. We currently intend to indefinitely reinvest those earnings and other basis differences in operations outside the U.S.