NOTE 13. INCOME TAXES

The Predecessors 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, the Predecessors were not required to account for U.S. federal income taxes in the unaudited condensed consolidated financial statements.

In connection with our initial public offering in May 2022, we 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 its income taxes under the asset and liability method for periods subsequent to May 17, 2022.

We record income taxes for interim periods based on an estimated annual effective tax rate. The estimated annual effective rate is recomputed on a quarterly basis and may fluctuate due to changes in forecasted annual operating income, positive or negative changes to the valuation allowance for net deferred tax assets and changes to actual or forecasted permanent book to tax differences. Our effective tax rate for the nine months ended September 30, 2023 was 20.5%, compared with 5.2% in the same period in 2022. The difference between our effective tax rate and the federal statutory rate in 2022 related to the income that was earned within the financial statement consolidated group that is not subject to tax within the financial statement consolidated group.

The conversion of our Class B common stock to Class A common stock (see Note 8) resulted in a shift from a net deferred tax asset position before the conversion to a net deferred tax liability position after the conversion. As of September 30, 2023, $74.4 million of our net deferred tax liability was associated with the conversion. The recognition of this net deferred tax liability was recorded as an equity transaction because the holders of Class B common stock and their affiliates control us through their Class A common stock holdings.

Tax Receivable Agreement

In connection with our initial public offering, ProFrac Corp. entered into a tax receivable agreement (the “TRA”) with certain holders of limited liability company interests in ProFrac LLC (the “TRA Holders”). The TRA generally provides for payment by ProFrac Corp. to the TRA Holders of 85% of the net cash savings, if any, in U.S. federal, state and local income tax and franchise tax that ProFrac Corp. actually realizes (or is deemed to realize in certain circumstances) as a result of (i) certain increases in tax basis that occur as a result of ProFrac Corp.'s acquisition (or deemed acquisition for U.S. federal income tax purposes) of all or a portion of such TRA Holder’s ProFrac LLC units in connection with the initial public offering or the exercise of the Redemption Right (as defined in the TRA) or the Call Right (as defined in the TRA), and (ii) imputed interest deemed to be paid by ProFrac Corp. as a result of, and additional tax basis arising from, any payments ProFrac Corp. makes under the TRA.

Payments will generally be made under the TRA as ProFrac Corp. realizes actual cash tax savings from the tax benefits covered by the TRA. As a result of the conversion of all our Class B common stock to Class A common stock (see Note 8) and the tax effect of this transaction, we recorded a $58.9 million noncurrent TRA liability. The recognition of the TRA liability was recorded as an equity transaction because the holders of Class B common stock and their affiliates control us through their Class A common stock holdings. As of September 30, 2023, the current liability for our TRA obligation was an additional $3.3 million.