NOTE 4. INCOME TAXES

The Company files income tax returns in the U.S. federal jurisdiction and the Commonwealth of Pennsylvania. The Bank also files an income tax return in the State of Maryland. The Company is generally no longer subject to U.S. federal, state or local income tax examination by tax authorities for years before 2010.

Included in the balance sheet at June 30, 2014 and December 31, 2013, are tax positions related to loan charge-offs for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility. Because of the impact of deferred tax accounting, other than interest and penalties, the disallowance of the shorter deductibility period would not affect the annual effective tax rate but would accelerate the payment of cash to the tax authority to an earlier period.

The components of income tax expense for the three and six months ended June 30, 2014 and 2013 are summarized as follows:


	Three months ended June 30,						Six months ended June 30,
(Dollars in thousands)	2014			2013			2014			2013
Current year provision:
Federal	$	0		$	30		$	0		$	60
State		0			0			0			0
Deferred tax expense		583			719			838			788
Valuation allowance on deferred taxes		(583	)		(719	)		(838	)		(788	)

Net income tax expense	$	0		$	30		$	0		$	60

The provision for income taxes includes $211,000 and $0 of applicable income tax expense related to net security gains for the three months ended June 30, 2014 and 2013. The provision for income taxes includes $420,000 and $43,000 of applicable income tax expense related to net securities gains for the six months ended June 30, 2014 and 2013.

The components of the net deferred tax asset, included in other assets, are as follows:


	June 30,			December 31,
(Dollars in thousands)	2014			2013
Deferred tax assets:
Allowance for loan losses	$	7,625		$	7,776
Deferred compensation		518			510
Retirement plans and salary continuation		1,640			1,585
Stock compensation		194			191
Off balance sheet reserves		219			204
Nonaccrual loan interest		199			341
Net unrealized losses on securities available for sale		0			2,592
Goodwill		169			184
Low income housing credit carryforward		1,259			1,022
Alternative minimum tax credit carryforward		664			664
Charitable contribution carry forward		351			333
Net operating loss carryforward		7,181			8,169
Other		181			178

Total deferred tax assets		20,200			23,749
Valuation allowance		(18,126	)		(18,964	)

		2,074			4,785

Deferred tax liabilities:
Depreciation		1,024			1,116
Net unrealized gains on securities available for sale		692			0
Purchase accounting adjustments		457			495
Other		593			582

Total deferred tax liabilities		2,766			2,193

Net deferred tax asset (liability)	$	(692	)	$	2,592

As of June 30, 2014, the Company has charitable contribution, low-income housing, and net operating loss carryforwards that expire through 2019, 2034 and 2032, respectively.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers taxes paid in prior years, projected future taxable income and available tax planning strategies, and other factors in making this assessment. Based upon the level of historical taxable income, projections for future taxable income over the periods and other available evidence, management believed it was not more likely than not that the net deferred tax asset would be realized at June 30, 2014 and December 31, 2013.

Accordingly, a full valuation allowance for the net amount of the deferred tax assets, which represented future deductible temporary differences on our tax returns, was established at June 30, 2014 and December 31, 2013. Primary factors contributing to this determination included:

•

The Company has exhausted all of its carryback availability to 2010 – 2011, as we had recognized current federal income tax receivable which fully offset 2010 and 2011’s taxable income.

•

While improvement is evident, as of June 30, 2014 and December 31, 2013, the Company was in a three-year cumulative loss position, representing significant negative evidence against the realizability of the deferred tax asset.

Although improvement is recognized, given the uncertainty of the economy and in the event economic and real estate conditions decline, additional losses may result in our loan portfolio above those already provided for. As a result, we have placed less weight on our current forecast of earnings until the point where we demonstrate sustainable additional earnings for the realization of the deferred tax asset.