Note 4 - Income Taxes

During the years ended December 31, 2020 and 2019, we incurred financial net operating losses before income tax benefit of $15,414,807 and $3,960,592, respectively, and federal taxable losses of $2,648,248 and $1,401,806, respectively. We did not record any income tax benefit for the $1,345,002 and $1,205,811 ($370,111 and $331,809 tax effected, respectively) of general and administrative expenses treated as deferred start-up expenditures for tax purposes for the years ended December 31, 2020 and 2019, respectively. We also did not record any income tax benefit for the $8,743,517 ($2,405,997 tax effected) of purchased and expensed in-process research and development costs for the year ended December 31, 2020; nor did we record any income tax benefit for the $144,154 and $283,189 of federal orphan drug tax credits for the years ended December 31, 2020 and 2019, respectively. The 2017 net operating loss carry forwards are available for application against future taxable income for 20 years expiring in 2037. Tax losses incurred after December 31, 2017 have an indefinite carry forward period. We have recorded the benefit of our 2020 and 2019 net operating losses in our consolidated financial statements as a reduction in the deferred tax liability created by the future financial statement amortization of the intangible asset from the acquired CoNCERT license and Know-How. The benefit associated with the net operating loss carry forward will more-likely-than-not go unrealized unless future operations are successful except for their offset against the deferred tax liability created by the acquired CoNCERT license and Know-How.

A deferred tax liability was recorded on March 19, 2018 when Processa received CoNCERT’s license and Know-How in exchange for Processa stock that had been issued in an Internal Revenue Code Section 351 Transaction. The Section 351 Transaction treats the acquisition of the license and Know-How for stock as a tax-free exchange. As a result, under ASC 740-10-25-51 Income Taxes, Processa recorded a deferred tax liability of $3,037,147 for the acquired temporary difference between intangible assets for the financial reporting basis of $11,038,929 and the tax basis of $1,782. The deferred tax liability has been reduced for the effect of non-deductibility of the amortization of the intangible asset to $2,433,959 at December 31, 2020 and offset by deferred tax assets resulting from net operating tax losses.

For the years ended December 31, 2020 and 2019, we recorded a federal income tax benefit of $1,001,019 and $602,716, respectively, as a result of offsetting our deferred tax liability (related to the CoNCERT asset) by the deferred tax assets resulting from our net operating loss and the amortization of the intangible asset related to CoNCERT.

Our provision (benefit) for income taxes for the years ended December 31, 2020 and 2019 was as follows:

A reconciliation of our effective income tax rate and statutory income tax rate for the years ended December 31, 2020 and 2019 is as follows:

At December 31, 2020 and 2019, we had available federal and state net operating loss carryforwards of approximately $6.7 million and $4.1 million, respectively. The federal net operating loss generated in 2020 and 2019 of $2.6 million and $1.4 million, respectively, will carry forward indefinitely. Net operating losses generated prior to 2018 will expire 2037. We are evaluating our qualified research expenditures for the federal orphan drug credit and the federal and state credit for increasing research activities to offset potential future tax liabilities. The federal research and development tax credits have a 20-year carryforward period. We have not recognized any deferred tax assets related to research and development tax credits as of December 31, 2020 or 2019. All federal and state net operating loss and credit carryforwards listed above are reflected after the reduction for amounts effectively eliminated under Section 382.

We do not recognize other deferred income tax assets at this time because the realization of the assets is not more-likely-than-not that they will be realized. The benefit associated with the amortization of the deferred start-up expenditures, purchased in-process research and development expenditures and other deductible expenses will more-likely-than-not go unrealized unless future operations are successful. Since the success of future operations is indeterminable, the potential benefits resulting from these deferred tax assets have not been recorded in our consolidated financial statements.

We recorded a valuation allowance during the years ended December 31, 2020 and 2019 equal to the full recorded amount of our net deferred tax assets related to deferred start-up costs, federal orphan drug tax credit and certain other temporary differences since it is more-likely-than-not that such benefits will not be realized. The valuation allowance is reviewed quarterly and is maintained until sufficient positive evidence exists to support its reversal.

The significant components of our deferred tax assets and liabilities for Federal and state income taxes consisted of the following:

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 the scheduled reversal of deferred tax liabilities, the projected future taxable income and tax planning strategies in making this assessment. Based on management’s analysis, a reserve has been established against the deferred tax assets related to deferred start-up expenditures and certain other deductible expenses. The change in the valuation allowance in 2020 and 2019 was $2,974,703 and $668,584, respectively.

Our total deferred tax asset as of December 31, 2020 and 2019 primarily include $4,256,064 and $2,909,715 ($1,171,162 and $800,681 tax effected, respectively) of general and administrative expenses treated as deferred start-up expenditures for tax purposes, respectively, $6,714,504 and $4,067,602 ($1,847,664 and $1,119,302 tax effected, respectively) of tax losses resulting in tax loss carryforwards as of the same periods; $8,743,517 of purchased in-process research and development ($2,405,997 tax effected) as of December 31, 2020; and $427,343 and $283,189 of federal orphan drug tax credits as of December 31, 2020 and 2019. We have had no revenues and recognized cumulative loses since inception. Due to the uncertainty regarding future profitability and recognition of taxable income to utilize the amortization of deferred start-up expenditures, purchased in-process research and development, federal orphan drug tax credits and the tax loss carryforwards, except for their offset against the deferred tax liability created by our acquisition of the CoNCERT license, a valuation allowance against the deferred tax assets has been recognized for the years ended December 31, 2020 and 2019.

We recognize potential liabilities for uncertain tax positions using a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon settlement. We have not recorded any uncertain tax positions.

We file U.S. Federal income and California and Maryland state tax returns. There are currently no income tax examinations underway for these jurisdictions. However, tax years from and including 2016 remain open for examination by federal and state income tax authorities.