11. INCOME TAXES

Before May 17, 2022, the ProFrac Predecessor entities were organized as limited liability companies or a limited partnership and were treated as either a disregarded entity or a partnership for U.S. federal income tax purposes, whereby the ordinary business income or loss and certain deductions were passed-through and reported on the members’ income tax returns. As such, we were not required to account for U.S. federal income taxes in our consolidated financial statements. Certain state income-based taxes are imposed on the Company which are reflected as income tax expense or benefit in historical periods. In connection with the IPO in May 2022, the Company reorganized and ProFrac LLC became partially owned by ProFrac Corp., a C-Corporation. ProFrac Corp. is a taxable entity and is required to account for income taxes under the asset and liability method for periods subsequent to May 17, 2022.

The Company’s effective tax rate will generally be lower than the federal corporate income tax rate of 21% because income allocated to our Class B shareholders will not be subject to tax on the Company’s tax returns.

As of December 31, 2022, the Company had approximately $2.3 billion of federal net operating loss ("NOL") carryforwards, of which $1.5 billion will expire on various dates between 2032 and 2037 with the remaining losses carried forward indefinitely. The Company's NOLs were acquired through its acquisition of FTSI and USWS during 2022. FTSI filed for bankruptcy protection on September 22, 2020 and upon emergence on November 19, 2020 elected Section 382(l)(5) with respect to its tax attributes, including NOLs. Section 382(l)(5) completely limits utilization of NOLs if a company making the election experiences a second "ownership change" under Section 382 within a two year period. FTSI experienced a second "ownership change" when it was acquired by the Company on March 2, 2022, within the two year period after it elected Section 382(l)(5). As such, $1.9 billion of federal NOLs are fully limited and unable to be utilized in the future. The Company's remaining $386.0 million federal NOLs are also subject to limitation under Section 382.

The Company also has $704.3 million of state NOLs, of which $600.8 million will expire on various dates between 2032 and 2042 with the remaining losses carried forward indefinitely. NOLs that are fully limited under Section 382(l)(5) were $510.0 million and the remaining $194.3 million are subject to limitation under Section 382.

We have established a valuation allowance on substantially all of the Company’s net deferred tax assets. As a result, we only recorded income tax expense for current year tax expense. Deferred tax assets related to our U.S. federal and state tax net operating losses are still available to us to offset future taxable income, subject to limitations in the event of a change of control under Section 382 of the Internal Revenue Code. At December 31, 2022, we had not incurred such an ownership change.

At each reporting date, we consider all available positive and negative evidence to evaluate whether our deferred tax assets are more likely than not to be realized. A significant piece of negative evidence that we consider is whether we have incurred cumulative losses (generally defined as losses before income taxes) in recent years. Such negative evidence weighs heavily against other more subjective positive evidence such as our projections for future taxable income. We noted that for the three years ended December 31, 2022, we recorded cumulative income before income taxes of $190.1 million as a result of income reported in 2022. Notwithstanding the shift to three-year cumulative income, we concluded that a valuation allowance was still required at December 31, 2022, because it is more likely than not that the deferred tax assets will not be realized. We based this conclusion on the positive and negative evidence discussed below.

The primary positive evidence we noted was:

The primary negative evidence we noted was:

If we continue to generate income before income taxes in future periods and if our forecasts become more accurate due to the cycles of the hydraulic fracturing industry becoming less significant, we may be able to recognize a portion of our net deferred tax assets in future periods. We will adjust the valuation allowance based on our evaluation of new information as it becomes available and new circumstances as they occur. A change in our assessment could cause a decrease to the valuation allowance, which could materially impact our results of operations. Due to the prevailing negative evidence cited above, we believe that the earliest period when we may adjust the valuation allowance is the fourth quarter of 2023.
 

At December 31, 2022, we had no liability for uncertain tax positions. We recognize accrued interest and penalties related to any uncertain tax positions as part of income tax expense. At December 31, 2022, we had no accrued interest expense associated with unrecognized tax benefits. Interest expense associated with unrecognized tax benefits was zero for all periods presented.

ProFrac LLC is obligated to make cash distributions to the redeemable noncontrolling interest holders to fund their respective income tax liabilities relating to their share of the income of ProFrac LLC. In the fourth quarter of 2022, the Company paid a distribution of $8.0 million to the redeemable noncontrolling interest holders. The revised estimate for the full year liability to these shareholders was $2.8 million. As of December 31, 2022, we have recorded the $5.2 million overpayment of the distribution in prepaid expenses and other current assets on our consolidated balance sheets. We will apply this overpayment against future distribution obligations.

ProFrac Holding Corp and its U.S. subsidiaries join in the filing of a U.S. federal consolidated income tax return. Our income tax returns, along with income tax returns for FTSI and USWS, are currently subject to examination in federal and state jurisdictions primarily for tax years from 2018-2021.