Taxmasters (TAXSQ) 10-Q 2010 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934   for the quarterly period ended September 30, 2010

OR

[   ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number  33-11986-LA

TAXMASTERS, INC.

(Exact name of registrant as specified in its charter)

NEVADA	91-2008803
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

900 Town & Country Lane, Suite 400, Houston, TX  77024

(Address of principal executive offices)

(281) 497-5937

(Registrant’s telephone number)

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes   [X] No [   ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes   [   ]                 No [  ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a small reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer                                         [   ]                                Accelerated filer                                                       [   ]

Non-accelerated filer                                          [   ]                                Smaller reporting company                                    [X]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes   [   ] No [X]

As of November 11, 2010, the registrant had 140,700,105 shares of common stock, $0.001 par value, outstanding and 1,000 shares of Control Series Preferred stock outstanding.

TAXMASTERS, INC.

QUARTERLY REPORT ON FORM 10-Q

QUARTER ENDED SEPTEMBER 30, 2010

TABLE OF CONTENTS

PART I.   FINANCIAL INFORMATION

Item 1  -  Financial Statements (unaudited)
Balance Sheets as of September 30, 2010 and December 31, 2009	1
Statements of Operations for the three and nine months ended September 30, 2010 and 2009	2
Statements of Cash Flows for the nine months ended September 30, 2010 and 2009	3
Notes to Financial Statements	4
Item 2   -  Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item 4  -  Controls and Procedures	25

PART II.  OTHER INFORMATION

Item 1              -         Legal Proceedings	25
Item 2              -         Unregistered Sales of Equity Securities and Use of Proceeds	26
Item 3              -         Defaults Upon Senior Securities	26
Item 4              -         Removed and Reserved	26
Item 5              -         Other Information	26
Item 6              -         Exhibits	26
SIGNATURES	27
CERTIFICATIONS

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

TaxMasters, Inc.  BALANCE SHEETS  (Unaudited)
	As of September 30,			As of December 31,
	2010			2009
ASSETS
CURRENT ASSETS
Cash and cash equivalents	$	279,115		$	2,892,895
Short-term investments		317,203			313,663
Accounts receivable trade, net of allowance of $34,231,236 and $23,171,452,      respectively		16,684,475			11,426,037
Deferred tax asset		2,696,965			1,654,130
Prepaid expenses		144,083			125,000
Total current assets		20,121,841			16,411,725
Property and equipment, net of accumulated depreciation of $962,009 and $396,486,      respectively		3,024,990			2,533,387
Note receivable		262,305			250,000
Investments		428,536			423,968
Deferred tax asset, net of current portion		3,170,630			3,709,430
Other assets		17,000			17,000
TOTAL ASSETS	$	27,025,302		$	23,345,510
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
Accounts payable	$	2,748,127		$	3,099,427
Accounts payable - related parties		69,273			117,673
Accrued liabilities		3,156,666			2,448,783
Deferred revenue		25,426,951			20,478,350
Capital lease obligation		542,748			568,562
Note payable - related party		4,502,392			4,582,718
Total current liabilities		36,446,157			31,295,513
LONG TERM DEBT
Capital lease obligations, net of current portion		1,409,280			1,708,588
Total liabilities		37,855,437			33,004,101
COMMITMENTS AND CONTIGENCIES
STOCKHOLDERS' DEFICIT
Preferred stock, $0.001 par value,
500,000,000 shares authorized, 1,000 shares issued
and outstanding		1			1
Common stock, $0.001 par value, 1,000,000,000 shares
authorized, 339,675,899 shares issued and 140,700,105 shares outstanding		340,700			339,676
Additional paid-in capital		930,744			199,768
Accumulated deficit		(12,101,580	)		(10,198,036	)
Total stockholders' deficit		(10,830,135	)		(9,658,591	)
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT	$	27,025,302		$	23,345,510

See accompanying notes to financial statements.

-1-

TaxMasters, Inc. STATEMENTS OF OPERATIONS (Unaudited)
	For the three months ended September 30,						For the nine months ended September 30,
	2010			2009			2010			2009
				Revised						Revised
REVENUES, net	$	10,439,002		$	10,822,536		$	32,847,123		$	26,970,767
OPERATING COSTS AND EXPENSES:
Selling, general and administrative expenses		5,844,298			3,724,780			19,018,797			12,013,109
Compensation		4,992,295			4,292,508			15,314,790			11,187,060
Depreciation		200,261			94,617			560,070			179,210
Total operating costs and expenses		11,036,854			8,111,905			34,893,657			23,379,379
INCOME (LOSS) FROM OPERATIONS		(597,852	)		2,710,631			(2,046,534	)		3,591,388
OTHER  INCOME (EXPENSE):
Interest income		7,430			10,558			28,059			31,893
Interest expense		(71,084	)		(31,153	)		(213,780	)		(65,980	)
Total other income (expense)		(63,654	)		(20,595	)		(185,721	)		(34,087	)
INCOME (LOSS) BEFORE INCOME TAXES		(661,506	)		2,690,036			(2,232,255	)		3,557,301
INCOME TAX BENEFIT, NET		57,400			(4,239,847	)		(328,711	)		(4,239,847	)
NET INCOME (LOSS)	$	(718,906	)	$	6,929,883		$	(1,903,544	)	$	7,797,148
EARNINGS (LOSS) PER SHARE
Basic and diluted	$	(0.01	)	$	0.02		$	(0.01	)	$	0.03
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic and diluted		140,687,377			324,411,448			273,082,698			308,889,572

See accompanying notes to financial statements.

-2-

TaxMasters, Inc. STATEMENTS OF CASH FLOWS (Unaudited)
	For the nine months ended September 30,
	2010			2009
				Revised
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)	$	(1,903,544	)	$	7,797,148
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:
Change in deferred tax asset		(504,035	)		(4,239,847	)
Depreciation and amortization		560,070			179,210
Deferred rent		479,014			137,737
Write-off of note receivable		-			400,000
Common stock issued for services		732,000			526,104
Changes in operating assets and liabilities:
Accounts receivable		(5,258,438	)		(6,915,417	)
Prepaid service		(19,083	)		-
Accounts payable and accrued liabilities		(122,431	)		(15,465	)
Accounts payable - related parties		(48,400	)		142,495
Deferred revenue		4,948,601			6,400,711
Net cash provided by (used in) operating activities		(1,136,246	)		4,412,676
CASH FLOWS FROM INVESTING ACTIVITIES:
Receipts (Purchase) of investments, net		(8,108	)		(15,920	)
Issuance and interest accrued on note receivable		(12,305	)		(400,000	)
Acquisition of property and equipment		(961,797	)		(26,445	)
Net cash used in investing activities		(982,210	)		(442,365	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of capital lease obligations		(414,998	)		(168,222	)
Repayment, net of accrued interest, of note payable to related party		(80,326	)		(523,290	)
Distributions to shareholders prior to conversion to C corp.		-			(2,326,094	)
Net cash used in financing activities		(495,324	)		(3,017,606	)
NET CHANGE IN CASH AND CASH  EQUIVALENTS		(2,613,780	)		952,705
CASH AND CASH EQUIVALENTS—Beginning of year		2,892,895			3,683,467
CASH AND CASH EQUIVALENTS—End of period	$	279,115		$	4,636,172
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid for interest	$	213,780		$	27,831
Cash paid for taxes		-			-
NON CASH INVESTING AND FINANCING ACTIVITIES
Purchase of property and equipment by seller financing		89,876			1,398,890
Issuance of note payable to related party due to conversion from S to C corp		-			6,296,816

See accompanying notes to financial statements.

-3-

TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

Note 1 - Basis of Presentation

The accompanying financial statements information reflects financial information of TaxMasters, Inc. (“Company”) and (“TaxMasters”).  

The Company primarily engages in resolution of complicated Internal Revenue Service tax problems for customers located in the USA and other parts of the world with USA operations.  The Company also assists customers with state and local tax problem resolution.  The Company headquarters is located in Houston, Texas.

The accompany unaudited interim financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America and the rules of the Securities and Exchange Commission (“SEC”) and should be read in conjunction with the audited financial statements of TaxMasters and related notes thereto contained in the Company’s Form 10-K for the year ended December 31, 2009 filed with the SEC on April 15, 2010.  Certain information and note disclosure normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules and regulations.  In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fai r presentation of financial position and the results of operations for the interim periods presented have been reflected herein.  The results of operations for interim periods are not necessarily indicative of the results to be expected for the full year.

Certain reclassification of prior period amounts has been made to conform to the current presentation.  The reclassification had no impact on stockholders’ deficit and net income.

Note 2 -  Revision of Prior Period Amounts

In preparing the Company’s financial statements for the quarter ended September 30, 2010, the Company discovered and corrected an error related to accounting for shares granted to a consultant in May 2010.  These shares to be issued (shares were actually issued on July 8, 2010) were not recorded and resulted in a $720,000 understatement in selling, general and administrative expenses and an understatement in income tax benefit and deferred tax asset of $244,800 in the second quarter of 2010.  In accordance with SEC Staff Accounting Bulletin Nos. 99 and 108 (“SAB 99 and SAB 108”), the Company evaluated these errors and, based on an analysis of quantitative and qualitative factors, determined that they were immaterial to each of the reporting periods affected and, therefore, amendment of previou sly filed reports with the Securities and Exchange Commission was not required. However, if the adjustments to correct the cumulative effect of the aforementioned errors had been recorded in the quarter ended September 30, 2010, the Company believes the impact would have been significant to the third quarter of 2010 and would impact comparisons to prior periods. Therefore, as permitted by SAB 108, the Company revised in the current filing previously reported quarterly results for the second quarter of 2010.

The adjustment did not result to any changes in total stockholders’ equity reported in the balance sheet at June 30, 2010.  Likewise, the adjustment to the statement of cash flows for the six months ended June 30, 2010 did not result to any changes to amounts previously reported for net cash from operating activities, investing activities or financing activities.

The revisions of prior period amounts are as follows:

-4-

TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

Statement of Operations– Six Months Ended June 30, 2010

	For the six months ended June 30, 2010
	As previously reported			Adjustment			Revised
REVENUES, net		22,408,121			-			22,408,121
OPERATING COSTS AND EXPENSES:
Selling, general and administrative expenses		12,454,499			720,000			13,174,499
Compensation		10,322,495			-			10,322,495
Depreciation		359,809			-			359,809
Total operating costs and expenses		23,136,803			720,000			23,856,803
NET INCOME (LOSS) FROM OPERATIONS		(728,682	)		(720,000	)		(1,448,682	)
OTHER  INCOME (EXPENSE):
Interest income		20,629			-			20,629
Interest expense		(142,696	)		-			(142,696	)
Total other income (expense)		(122,067	)		-			(122,067	)
NET  INCOME (LOSS) BEFORE INCOME TAXES		(850,749	)		(720,000	)		(1,570,749	)
INCOME TAX BENEFIT, NET		(386,111	)					(386,111	)
NET INCOME (LOSS)	$	(464,638	)	$	(720,000	)	$	(1,184,638	)
Earnings per share - Basic and diluted	$	(0.00	)				$	(0.00	)
Weighted average shares outstanding - Basis and diluted		339,675,899			232,044			339,907,943

Statement of Operations– Three Months Ended June 30, 2010

	For the three months ended June 30, 2010
	As previously reported			Adjustments			Revised
REVENUES, net	$	11,061,594			-			11,061,594
OPERATING COSTS AND EXPENSES:
Selling, general and administrative expenses		7,583,426			720,000			8,303,426
Compensation		5,524,775			-			5,524,775
Depreciation		167,057			-			167,057
Total operating costs and expenses		13,275,258			720,000			13,995,258
NET INCOME (LOSS) FROM OPERATIONS		(2,213,664	)		(720,000	)		(2,933,664	)

-5-

TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

OTHER  INCOME (EXPENSE):
Interest income		7,941						7,941
Interest expense		(71,333	)		-			(71,333	)
Total other income (expense)		(63,392	)		-			(63,392	)
NET  INCOME (LOSS) BEFORE INCOME TAXES		(2,277,056	)		(720,000	)		(2,997,056	)
INCOME TAX BENEFIT, NET		(872,971	)					(872,971	)
NET INCOME (LOSS)	$	(1,404,085	)	$	(720,000	)	$	(2,124,085	)
Earnings per share - Basic and diluted	$	(0.00	)				$	(0.01	)
Weighted average shares outstanding - Basis and diluted		339,675,899			461,538			340,137,437

Also, the Company identified errors in the previously issued unaudited financial statements as of and for the three and nine months ended September 30, 2009.  In accordance with SEC Staff Accounting Bulletin Nos. 99 and 108 (“SAB 99 and SAB 108”), the Company evaluated these errors and, based on an analysis of quantitative and qualitative factors, determined that they were immaterial to each of the reporting periods affected.  Therefore, as permitted by SAB 108, the Company revised in the current filing previously reported quarterly results for the third quarter of 2009.

The Company made adjustments to correct an understatement of revenues for the three months ended September 30, 2009 caused by an overstatement of revenues for the six months ended June 30, 2009, correct an overstatement of certain operating expenses, record the write-off of a note receivable, correct an overstatement in stock compensation expense and to record distributions made to shareholders that were not previously recognized.

The following table reflects the impact of the above adjustments to the statement of operations and cash flows for the three and nine months ended September 30, 2009:

Statement of Operations– Nine Months Ended September 30, 2009

	For the nine months ended September 30, 2009
	As previously reported		Adjustments				Reclassification			Revised
REVENUES, net		26,970,767		-				-		26,970,767
OPERATING COSTS AND EXPENSES:
Selling, general and administrative expenses		13,831,942		(698,837	)	a		(1,119,996	) b	12,013,109
Compensation		11,119,290		(1,052,226	)	c		1,119,996	b	11,187,060
Depreciation		94,617		84,593		d				179,210
Total operating costs and expenses		25,045,849		(1,666,470	)			-		23,379,379
NET INCOME FROM OPERATIONS		1,924,918		1,666,470				-		3,591,388
							��

-6-

TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

OTHER  INCOME (EXPENSE):
Interest income		31,893			-						31,893
Interest expense		(31,153	)		(34,827	)	e				(65,980	)
Total other income (expense)		740			(34,827	)			-		(34,087	)
NET  INCOME  BEFORE INCOME TAXES		1,925,658			1,631,643				-		3,557,301
INCOME TAX BENEFIT, NET		(4,239,847	)								(4,239,847	)
NET INCOME	$	6,165,505		$	1,631,643			$	-	$	7,797,148
Earnings per share -  Basic and diluted	$	0.02								$	0.03
Weighted average shares outstanding     Basic and diluted		308,889,572									308,889,572

The following is a summary explanation of the adjustments and reclassifications to our previously issued statement of operations :

a - Selling, general and administrative expenses were reduced due the following;

1.To correct distributions to shareholders of $981,968 that were erroneously recorded as selling, general and administrative expenses (SG&A).

2.  To write-off a note receivable of $400,000 which was deemed not collectible as of June 30, 2009.

3.  To correct an overstatement of $116,869 in equipment rental expense which should have been capitalized.

b - To reclassify payroll taxes, employee healthcare insurance and outside labor from SG&A to compensation.

c - To correct an overstatement in stock compensation expense due to an error in the share price used.

d - To correct understatement in depreciation expense as result of the correction to equipment rental expense.

e - To correct understatement in interest expense due to an error in the calculation.

Statement of Operations – Three Months Ended September 30, 2009

	For the three months ended September 30, 2009
	As previously reported			Adjustments				Reclassifications			Revised
REVENUES, net		8,212,414			2,610,122		a	-			10,822,536
OPERATING COSTS AND EXPENSES:
Selling, general and administrative expenses		6,097,665			(1,688,808	)	b	(684,077	)	c	3,724,780
Compensation		4,660,630			(1,052,226	)	d	684,104		c	4,292,508
Depreciation		57,387			37,230		e				94,617
Total operating costs and expenses		10,815,682			(2,703,804	)		27			8,111,905
NET INCOME (LOSS) FROM OPERATIONS		(2,603,268	)		5,313,926			(27	)		2,710,631

-7-

TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

OTHER  INCOME (EXPENSE):
Interest income		10,531			-				27	c		10,558
Interest expense		(11,775	)		(19,378	)	f		-			(31,153	)
Total other income (expense)		(1,244	)		(19,378	)			27			(20,595	)
NET  INCOME (LOSS) BEFORE INCOME TAXES		(2,604,512	)		5,294,548				-			2,690,036
INCOME TAX BENEFIT, NET		(4,239,847	)		-				-			(4,239,847	)
NET INCOME	$	1,635,335		$	5,294,548			$	-		$	6,929,883
Earnings per share -  Basic and diluted	$	0.01									$	0.02
Weighted average shares outstanding     Basic and diluted		324,411,448										324,411,448

The following is a summary explanation of the adjustments and reclassifications to our previously issued statement of operations:

a - To correct understatement in reported revenues as a result of the restatement in June 30, 2009 amounts.

b - Selling, general and administrative expenses were reduced due the following;

1. To correct distributions to shareholders of $981,968 that were erroneously recorded as selling, general and administrative expenses (SG&A).

2. To correct overstatement in reported SG&A amount of $589,971 as a result of the restatement in June 30, 2009 amounts.

3. To correct an overstatement of $116,869 in equipment rental expense which should have been capitalized.

c - To reclassify payroll taxes, employee healthcare insurance and outside labor from SG&A to compensation and to reclassify interest of $27 from SG&A to interest income.

d - To correct an overstatement in stock compensation expense due to an error in the share price used.

e – To correct understatement in depreciation expense as result of the correction to equipment rental expense

f – To correct understatement in interest expense due to an error in the calculation

Statement of Cash Flows – Nine Months Ended September 30, 2009

	For the nine months ended September 30, 2009
	As previously reported			Adjustments			Revised
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	6,165,505			1,631,643			7,797,148
Adjustments to reconcile net income to net cash provided by
operating activities:
Change in deferred tax asset		(4,239,847	)		-			(4,239,847	)
Depreciation and amortization		94,617			84,593			179,210
Deferred rent		137,737			-			137,737
Write off of note receivable		-			400,000			400,000
Common stock issued to employees for services		1,578,330			(1,052,226	)		526,104
Changes in operating assets and liabilities:								-
Accounts receivable		(6,915,417	)		-			(6,915,417	)
Accounts payable and accrued liabilities		(15,465	)		-			(15,465	)
Accounts payable - related parties		142,495			-			142,495
Deferred revenue		6,400,711			-			6,400,711
Net cash provided by operating activities		3,348,666			1,064,010			4,412,676

-8-

TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of investments, net		(15,920	)	-			(15,920	)
Issuance of note receivable		(400,000	)	-			(400,000	)
Acquisition of property and equipment		(26,445	)	-			(26,445	)
Net cash used in investing activities		(442,365	)	-			(442,365	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of capital lease obligations		(86,180	)	(82,042	)		(168,222	)
Repayment, net of accrued interest, of note payable to related party		(523,290	)	-			(523,290	)
Distributions to shareholders prior to conversion to C corp		(1,344,126	)	(981,968	)		(2,326,094	)
Net cash used in financing activities		(1,953,596	)	(1,064,010	)		(3,017,606	)
NET CHANGE IN CASH AND CASH  EQUIVALENTS		952,705		-			952,705
CASH AND CASH EQUIVALENTS—Beginning of year		3,683,467					3,683,467
CASH AND CASH EQUIVALENTS—End of period	$	4,636,172				$	4,636,172

Note 3 – Summary of Significant Accounting Policies

Revenue Recognition

The Company’s revenue is generated from the sale of our proprietary tax resolution products and services.  TaxMasters uses the proportionate completion method for revenue recognition.  With this method, we determine our revenue by gathering the completion points of six major services rendered by the company.  These services are Consultations, Tax Returns, Automated Collection Service (ACS), Revenue Officer Case (ROC), Collection Due Process (CDP), and Settlement Analysis. Revenue is recognized when it is earned, typically when our services have been rendered. Upon execution of an agreement, if services have not been provided then the amount to be paid under such agreement is recorded as deferred revenue on the balance sheet and is reclassified as revenue on the statement of operations after services have been provided and such revenue has been earned.

Fair Value Measurements

The Company adopted Statement of ASC No. 820, “Fair Value Measurements and Disclosures” (“ASC 820”).  ASC 820 clarifies that fair value is an estimate of the exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (i.e., the exit price at the measurement date).  Under ASC 820, fair value measurements are not adjusted for transaction cost.  ASC 820 provides for use of a fair value hierarchy that prioritizes inputs to valuation techniques used to measure fair value into three levels:

Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities

-9-

TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

Level 2: Input other than quoted market prices that are observable, either directly or indirectly, and reasonably available.  Observable inputs reflect the assumptions market participants would use in pricing the asset or liability and are developed based on market data obtained from sources independent of the Company.

Level 3:  Unobservable inputs.  Unobservable inputs reflect the assumptions that the Company develops based on available information about what market participants would use in valuing the asset or liability.

An asset or liability’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.  Availability of observable inputs can vary and is affected by a variety of factors.

The Company uses judgment in determining fair value of assets and liabilities and Level 3 assets and liabilities involve greater judgment than Level 1 and Level 2 assets or liabilities.  See note 4, “Fair value of Financial Instruments”, for additional information regarding the Company’s financial assets and liabilities measured at fair value on a recurring basis.

Cash and Cash Equivalents

The Company considers all bank deposits and highly liquid investments with original maturities of three months or less to be cash and cash equivalents.  Cash in financial institutions exceeded the Federal Deposit Insurance Corporation (FDIC) coverage.  Management does not consider such deposits over the FDIC insured limits to be a significant risk.  We use quoted market prices where available and industry standard valuation models using market-based inputs when quoted prices are unavailable.

Short-term investments

Short-term investments consist of investments with original maturities greater than three months and less than one year.  The Company invests excess funds in Certificates of Deposits (“CDs”) issued by domestic banks and, at times, may exceed federally insured limits The Company had Bank CD’s valued at approximately $317,203 and $313,663 as of September 30, 2010 and December 31, 2009, respectively and mature on January 09, 2011 and July 9, 2010, respectively.  The interest rates were approximately 1.15% and 1.00% for the 2010 and 2009 CDs respectively (see note 4 below for level hierarchy presentation). We use quoted market prices where available and industry standard valuation models using market-based inputs when quoted prices are unavailable.

Long-Term Investments

Long-term investments consist of investments with original maturities greater than one year.  The Company invests excess funds in Certificates of Deposits (“CDs”) issued by domestic banks and, at times, may exceed federally insured limits.  The Company had Bank CD’s valued at approximately $428,536 and 423,968 as of September 30, 2010 and December 31, 2009, respectively, and mature on July 9, 2012 and January 9, 2011, respectively.  The interest rates were approximately 1.15% for both the 2010 and 2009 CDs (see note 4 below for level hierarchy presentation). We use quoted market prices where available and industry standard valuation models using market-based inputs when quoted prices are unavailable.

Earnings (Loss) Per Share

Basic earnings (loss) per share (“EPS”) are computed using the weighted-average number of common shares outstanding. Diluted earnings per share include additional dilution from common stock equivalents, such as stock issuable pursuant to the exercise of stock options and warrants. Common stock equivalents are not included in the computation of diluted earnings per share when the Company reports a loss because to do so would be anti-dilutive for the periods presented. Contingently issuable shares where the shares are not certain to be issued are also be excluded from the EPS calculation. As of September 30, 2010, the Company has 200,000,000 contingently issuable shares that were not deemed as outstanding and were excluded from the calculation of both basic and diluted EPS (see note 9 below for details).

Advertising Expenses

The Company expenses the costs of advertising as incurred.  For the three month period ended September 30, 2010 and 2009, advertising expenses were approximately  $4.0 million and $2.6 million, respectively and for the nine months ended September 30, 2010 and 2009, advertising expenses were approximately $11.8 million and $8.7 million, respectively.

-10-

TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

Recently Adopted Accounting Pronouncements

In October 2009, the FASB issued ASU 2009-13, Multiple-Deliverable Revenue Arrangements, (amendments to FASB ASC Topic 605, Revenue Recognition) (“ASU 2009-13”). ASU 2009-13 requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The amendments eliminate the residual method of revenue allocation and require revenue to be allocated using the relative selling price method. ASU 2009-13 should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted.  The Company is currently assessing the impact of the standard on its results of operations or financial condition.

January 2010, the FASB issued ASU 2010-06, Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends ASC 820 to require a number of additional disclosures regarding fair value measurements. The amended guidance requires entities to disclose the amounts of significant transfers between Level 1 and Level 2 of the fair value hierarchy and the reasons for these transfers, the reasons for any transfers in or out of Level 3, and information in the reconciliation of recurring Level 3 measurements about purchases, sales, issuances and settlements on a gross basis. The ASU also clarifies the requirements for entities to disclose information about both the valuation techniques and inputs used in estimating Level 2 and Level 3 fair value measurements. The amended guidance is e ffective for interim and annual financial periods beginning after December 15, 2009.  The adoption of ASU 2010-06 did not impact the Company’s operating results, financial position or cash flows, but did impact the Company’s disclosures on fair value measurements.  See note 4 “Fair Value Measurement of Financial Instruments”.

In February 2010, FASB issued ASU No. 2010-09, Amendments to Certain Recognition and Disclosure Requirements (ASU 2010-09). This update amends Subtopic 855-10 and gives a definition to SEC filer, and requires SEC filers to assess for subsequent events through the issuance date of the financial statements. This amendment states that an SEC filer is not required to disclose the date through which subsequent events have been evaluated for a reporting period. ASU 2010-09 becomes effective upon issuance of the final update. The Company adopted the provisions of ASU 2010-09 for the period ended March 31, 2010.

Note 4 - Fair Value of Financial Instruments

ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The Company utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable. The Company classifies fair value balances based on the observability of those inputs.

The following tables set forth by level within the fair value hierarchy the Company’s financial assets and liabilities that were accounted for at fair value as of September 30, 2010 and December 31, 2009. As required by ASC 820, a financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. There were no transfers between fair value hierarchy levels for the nine months ended September 30, 2010.

Balance at September 30, 2010	Level 1		Level 2		Level 3		Total
Assets
Investments- short-term	$	317,203		-		-	$	317,203
Investments- long-term		428,536						428,536
Total Assets	$	745,739		-		-	$	745,739
Liabilities – N/A		-		-		-		-

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TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

Balance at December 31, 2009	Level 1		Level 2		Level 3		Total
Assets
Investments- short-term	$	313,663		-		-	$	313,663
Investments- long-term		423,968						423,968
Total Assets	$	737,631		-		-	$	737,631
Liabilities – N/A		-		-		-		-

All company investments were in bank CD’s at September 30, 2010 and December 31, 2009, and have a maturity range from three to twelve months (see note 3 above).

Some of the Company's financial instruments are not measured at fair value on a recurring basis but are recorded at amounts that approximate fair value due to their liquid or short-term nature, such as cash and cash equivalents, receivables and payables.

Note 5 – Capital Lease Obligations

The Company acquired equipment under long-term leases with two to five year terms, generally bearing interest rates from 2% to 26%.  For financial reporting purposes, the present value of the minimum lease payments have been capitalized.

		September 30	December 31
Year		2010	2009
2006	The Company entered into various capital leases for computer equipment.  The terms range from 36 to 48 months and the monthly lease payments are approximately $2,427 including interest, with maturity dates ranging from January 2009 to January 2010.	$                      -	$               651
2007	The Company entered into various capital leases for computer equipment and office equipment.  The terms are for 36 months and the monthly lease payments are approximately $4,560 including interest, with maturity dates ranging from January 2010 to August 2010.	-	20,967
2008	The Company entered into various capital leases for computer equipment and office equipment.  The terms range from 24 to 48 months and the monthly lease payments are approximately $10,159 including interest, with maturity dates ranging from January 2011 to March 2012.	70,411	138,112
2009	The Company entered into various capital leases for computer equipment, office equipment and phone system equipment.  The terms range from 24 to 60 months and the monthly lease payments are approximately $41,702, with maturity dates ranging from February 2011 to December 2014	1,803,252	2,117,420
2010	The Company entered into various capital leases for computer equipment, office equipment and phone system equipment.  The terms of 36 months and the monthly lease payments are approximately $3,343, with a maturity date of May 2013.	78,365	-
	Total  lease obligation	1,952,028	2,277,150
	Less:  current portion	542,748	568,562
	Capital lease obligation, net of current portion	$     1,409,280	$       1,708,588

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TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

Future payments under these capital lease arrangements are as follows:

2010	$	161,801
2011		584,217
2012		505,769
2013		416,874
2014		405,840
2015 & beyond		10,727
Total future payments	$	2,085,228
Less: amount representing interest		133,200
Present value of net minimum lease payments	$	1,952,028

Note 6 - Note Payable – Related Party

In August 2009, the Chief Executive Officer loaned the Company $5,314,848, at an interest rate of prime plus 1%.  The note is unsecured and is due on demand, with covenants that limit demand rights. The covenants limited demand rights to $1 million annually as long as the Company is achieving certain financial targets and the Company has the cash for repayment.  For the nine months ended September 30, 2010 the Company repaid $231,753, inclusive of $142,421 of interest.  The balance of this note payable at September 30, 2010 is $4,502,392.

Note 7 – Income Taxes

As part of the process of preparing the financial statements, the Company is required to estimate its income taxes. The process incorporates an assessment of the current tax exposure together with temporary differences resulting from different treatment of transactions for tax and financial statement purposes. Such differences may result in deferred tax assets and/or liabilities, which are included within the balance sheet. Prior to the reverse merger of August 4, 2009, the Company was taxed as a Sub-S corporation and was not subject to corporate taxes which created a deferred tax asset when the Sub-S corporation was converted to a C corporation and converted from cash basis to accrual basis for tax purposes. The conversion from cash to accrual is recognized in year of conversion as the IRC sec 481(a) adjustment is favorable. The resul t is favorable given the liabilities exceeded the assets therefore the benefit can be recorded in the current year. The revenue classified as deferred for financial statement purposes was previously taxed to the Sub-S owner.

Our provision (benefit) for income taxes for the nine months ended September 30, 2010 and 2009 consisted of the following:

	2010			2009
Current:
Federal	$	-		$	178,380
State		175,324			-
Deferred:
Federal		(504,305	)		(4,418,227	)
State		-			-
Total tax provision (benefit)	$	(328,711	)	$	(4,239,847	)

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TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

The U.S. federal statutory income tax rate is reconciled to the effective rate at September 30, 2010 and 2009 as follows:

	2010			2009
Income tax expenses at U.S. federal statutory rate		34.0	%		34.0	%
Valuation allowance		67.4	%		-
Permanent differences		-11.4	%		27.9	%
NOL deduction		-67.4	%		-
Other		-7.8	%		-
481(a) adjustment		-			-229.5	%
Income taxed as S-Corp.		-			-52.6	%
Effective tax rate		14.8	%		-220.2	%

The components of the net deferred tax assets (liabilities) at September 30, 2010 and December 31, 2009 are as follows:

	2010		2009
Deferred tax asset
Net operating loss	$	1,140,210	$	2,890,047
Allowance for bad debt s		2,277,722		1,159,023
Deferred revenue		2,360,911		1,109,257
Deferred rent		320,703		157,839
Deferred bonus		342,833		342,833
Customer refundable balance		44,271		127,840
Other		30,610		22,903
Charitable contributions		1,530		1,530
Total deferred tax assets		6,518,790		5,811,272
Deferred tax liability
Property and equipment (depreciation)		651,195		447,712
Net deferred tax asset (liability)	$	5,867,595	$	5,363,560

The Company periodically assesses the likelihood that it will be able to recover its deferred tax assets and determines if a valuation allowance is necessary. As a result of this analysis the Company concluded that it is more likely than not that its deferred tax assets will ultimately be recovered and, accordingly, no valuation allowance was recorded as of September 30, 2010 and December 31, 2009.

Note 8 – Related Party Transactions

The Company incurs certain business development and entertainment expenses related to brand image development, employee retention, necessary entertainment, and certain expenses related to its community relations activities that are paid to companies owned by one or more of the corporate executives.  It is believed that these costs are reasonable and approximate the costs of similar activities with unrelated parties.

The Company is affiliated, through common ownership, with another company that provides the Company with advertising.  The affiliated company charged $825,313 and $671,530 for the nine months ended September 30, 2010 and 2009, respectively, for advertising costs incurred.  In addition, the Company had an outstanding balance due to the affiliated company as of September 30, 2010 of $69,273.  The outstanding balance as of December 31, 2009 to this related party was $117,673.

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TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

The Company also has marketing services provided by a related entity that is owned by the Company’s management.  Marketing expenses were $142,000 and $427,280 for the nine months ended September 30, 2010 and 2009, respectively.  There were no outstanding balances due to this related entity as of September 30, 2010 and December 31, 2009.

Note 9– Equity

Shares issued for services

During the three months ended September 30, 2010, the Company issued a total of 1,024,000 fully vested, non-forfeitable common shares to non-employees for services rendered. The Company recorded an expense of $732,000 to Selling, general and administrative expenses.  The value of the related services was determined to be the price of the stock on the performance commitment date.

Contingently Issuable Shares

On July 1, 2010, the Company entered into a voluntary Financial Reorganization Agreement with Patrick R. Cox, the Company’s Chief Executive Officer and majority and controlling shareholder, and Olde Monmouth Stock Transfer Co., Inc., the Registrant’s transfer agent (“Olde Monmouth”).

Pursuant to the Financial Reorganization Agreement, Mr. Cox transferred 200 million common shares owned by him to Olde Monmouth, which shall hold such shares in escrow until June 30, 2015.  Such escrowed shares were originally issued to Mr. Cox in a “B” reorganization under the Internal Revenue Code of 1986.  While the escrowed shares are held by Olde Monmouth in escrow, Mr. Cox shall not have the right to vote such escrowed shares nor receive any dividend or other distributions in respect of such escrowed shares.  After each of the Company’s fiscal years, completed prior to June 30, 2015, Mr. Cox shall be entitled to claw back the number of such escrowed shares based upon a formula tied to the financial performance of the Company for such fiscal year.  If the formula calculatio n is negative, no shares shall be released and under no circumstances shall Mr. Cox be required to turn back any of the 101 million shares which he is retaining.  If the calculation would require the release of more shares than those that remain in escrow, only the remaining shares shall be released, the Company is not required to issue any additional shares to Mr. Cox.  At June 30, 2015, any escrowed shares not released to Mr. Cox pursuant to the Financial Reorganization Agreement shall be cancelled.

The 200,000,000 shares are considered contingently issuable shares since they have been placed in escrow to be issued only when certain performance conditions have been met and as such, are reported as issued but not outstanding in the Balance Sheets at September 30, 2010 and were not included in the computation of earnings (loss) per share for the three and nine months ended September 30, 2010.

Note 10 – Commitments and Contingencies

Deferred Rent

The Company recognizes rent, including rent holidays, and escalating rent provisions, on a straight-line basis over the terms of the lease.  The difference between the cash paid to the landlord and the amount recognized as rent expense on a straight-line basis is included in deferred rent. The current portion of deferred rent is included in accrued expenses.  Cash reimbursements received from landlords for leasehold improvements and other incentives are also recorded as deferred rent and amortized on a straight-line basis over the lease term as an offset to rent expense.  The amount at September 30, 2010 and December 31, 2009 is $943,245 and $464,231, respectively and is included in accrued expenses on the Balance Sheets.

Legal Proceedings

On May 13, 2010, the Texas Attorney General’s (AG) office filed a suit against the Company and its Chief Executive Officer in state district court for Travis County, Texas.  In the suit, styled as The State of Texas v. TaxMasters, Inc., TMIRS Enterprises, Ltd., GP Services, LLC, d/b/a TaxMasters, and Patrick R. Cox, the AG  alleges, the Company violated certain provisions of the Texas Deceptive Trade Practices Act (“DTPA”) and the Texas Debt Collection Act and is seeking (i) injunctions against the Company from further violations of the applicable Texas statutes, (ii) restitution, and (iii) civil penalties of up to $20,000 per violation for each violation of the DTPA. The Company denies the allegations and is vigorously defending the AG’s claims.

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TaxMasters, Inc.

NOTES TO THE FINANCIAL STATEMENTS

 (unaudited)

On May 25, 2010, as part of the same proceeding, the court granted and agreed temporary injunction which requires the Company to more clearly and conspicuously disclose to potential customers prior to their purchase of tax resolution services from the Company that (i) the Company’s contract provides that the Company is entitled to its full fee regardless of the Company’s success or failure in resolving the customer’s tax issues, (ii) the Company’s contract provides that the Company is not obligated to perform services for the customer until the Company’s fee has been paid in full, (iii) if the customer is paying in installments, the Company may not be working on the customer’s tax issues until the Company has received its entire fee and (iv) the Company’s contract provides that any and all fees paid to the Company for its services are non-refundable.  

Management believes that the Company has complied with all the requests from the Texas Attorney General’s office and has made appropriate changes to its current business model.  The Company is vigorously defending itself against these allegations but the Company also recognizes that it is probable it will incur some civil penalties and have to make restitution.  Company’s management has determined that the amount of penalties and restitution cannot be reasonably estimated and any estimate would be so uncertain as to impair the integrity of these financial statements.  Per FASB ASC 450-20-25; recognition of a contingency loss may only be made if the event is (1) probable and (2) the amount of the loss can be reasonably estimated. Since the amount cannot be reasonably estimated, no accrual for th is contingent loss has been made to these financial statements.

Also from time to time, the Company is involved in other various legal proceedings in the ordinary course of business.  Management believes that these pending legal proceedings will not have a material adverse effect on the financial condition, results of operations or cash flows of the Company.

Assessment from U.S. Department of Labor

During the three months ended June 30, 2010 the U.S. Department of Labor (DOL) performed an audit of wages paid by the Company from July 2007 to June 2010.  As a result, the DOL alleges the Company incorrectly determined overtime wage payments for some employees.  To resolve the DOL’s claims, the Company has accrued an expense of $512,000 for the nine months ended September 30, 2010.

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ITEM 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the financial statements and the related notes thereto included in this document.

Forward Looking Statements

The following discussion of the financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes thereto. The words or phrases "would be," "will allow," "expect to", "intends to," "will likely result," "are expected to," "will continue," "is anticipated," "estimate," "project," or similar expressions are intended to identify "forward-looking statements". Such statements include those concerning our expected financial performance, our corporate strategy and operational plans. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of risks and uncertainties, including:  (a) our ability to retain and add qualified personnel with the proper tax and IRS experience and business acumen, (b) our ability to execute our business plan, (c) our ability to successfully compete against numerous competitors, some of whom are larger and better financed than us, (d) the amount and timing of operating costs and capital expenditures relating to the expansion of our business, (e) the implementation of our marketing programs and (f) general economic conditions specific to our industry.

Unless otherwise required by applicable law, the Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences, developments, unanticipated events or circumstances after the date of such statement.

The following discussion should be read in conjunction with our consolidated financial statements and related notes included as part of this report.

Overview

History

We are TaxMasters, Inc., a Nevada corporation formerly known as Crown Partners, Inc. (the “Company” or “we”, “our” or “us”).  On August 4, 2009, the Company acquired all of the outstanding shares of common stock of TaxMasters, Inc., (the "Target"), a Nevada corporation, in an exchange of shares of its common stock and certain preferred stock for all of the issued and outstanding shares of the Target under Section 368(a)(1)(B) of the Internal Revenue Code (the “Share Exchange”).  As a result of the Share Exchange the sole stockholder of the Target acquired control of the Company through the receipt of approximately 99.1% of the Company’s 303,712,899 then-issued and outstanding shares of common stock.  As a result of the Share Exchange, the Targ et became a wholly-owned subsidiary of the Company.

Our Company

We are a tax resolution company engaged in the business of assisting taxpayers with matters at the Internal Revenue Service (“IRS”), especially the resolution of disputes and assessments and the settlement of tax liabilities.  We are a firm of experienced tax professionals that help our clients solve their Federal tax problems, ranging from filing delinquent tax returns to settling tax debts.  Our tax professionals include tax attorneys, Certified Public Accountants, Former IRS agents, Licensed Tax Preparers and other tax professionals who are authorized to practice before the IRS.  Our tax professionals are experienced in analyzing and providing solutions to even the most complicated tax problems and guiding clients through the bureaucracy of the IRS.

Our tax professionals have the skill and knowledge to reduce our client’s tax liabilities and solve their IRS tax problems.  We use the rules established by the Internal Revenue Code and IRS regulations to help our clients resolve matters at the IRS.  Our tax professionals help our clients reduce taxes, eliminate penalties and get representation before the IRS.  We help our clients understand how they developed their tax problems they have and help them fix the entire problem that caused their tax debt.  We can often reduce the tax our clients owe even before attempting to develop a tax strategies with the IRS.

-17-

Through our tax professionals, we offer the following services:

· ·	Get our clients into compliance with their obligation to file income tax returns and pay back taxes due;
· ·	reduce taxes by reducing penalties and interest on tax debts;
· ·	Settle our client’s tax debt for the lowest amount possible under the law;
· ·	Stop IRS wage garnishments;
· ·	Stop IRS property seizure;
· ·	Defend our client in an IRS audit or IRS criminal investigation;
· ·	Recover seized funds; and
· ·	Remove an IRS levy or lien.

Description of Revenues

We offer our clients a no-charge initial consultation regarding their tax problems.  The free initial consultation enables our tax consultants to get information from the potential client about his or her tax problem and understand the nature of the problem.  From the initial consultation, we can determine what services and forms the client will need and we can present a cost estimate for the client.

We charge our clients a fee based on the type of tax problem we are addressing and the service we are providing:  (i) an IRS collection matter, (ii) preparing or amending tax returns (including schedules), (iii) negotiated settlements and/or (iv) audits.  In addition, some of our rates will vary depending on whether our client is an individual or a business.  Built into all of our fees are the initial consultation we have with the IRS to determine all of the client’s problems and the preparation by us of a findings letter outlining the tax problems.  In addition to the fee, certain services will require our tax consultants to interact with the IRS, such as a settlement negotiation or an audit, for which we charge our clients additional consulting fees.  We may provide our services o n a “pay-as-you-go” basis and an installment plan.

The Company’s revenue is generated from the sale of our proprietary tax resolution products and services.  TaxMasters uses the proportionate completion method for revenue recognition.  With this method, we determine our revenue by gathering the completion points of six major services rendered by the company.  Our six major services products are as follows:

Consultations- (a) Transcript Consultant involves preparing power of attorney form 2848 or equivalent, contacting the IRS by phone, obtaining from the IRS the IRS income and withholding information, obtaining tax filing status and tax debt information and informing the client of the results of information obtained from the IRS.  (b) Report Consultation is obtaining from client tax data information, conducting analysis of the case, contacting the IRS if necessary and preparing recommendations to the client for suggested appropriate action to be taken.  (c) Other consulting services as agreed to in a written agreement.

Tax Return Preparation – Preparing and, when ready, filing of tax returns with the IRS.

Automated Collection Services and Revenue Officer Case - Discussions and meetings with client and IRS regarding the client’s case.   Providing analysis of open items due to the IRS, such as, preparation of unfiled tax returns.  Negotiating with the IRS on behalf of the client to establish payment plans, and or other alternatives to payment settlements.

Collection Due Process - Attending and setting up with the client a hearing with the IRS in an effort to relieve a client’s tax liabilities.  This service includes preparing the hearing request and submitting it to the IRS, attending the hearing and negotiating with the hearing officer on behalf of the client for whatever relief may be available and advising the client of the hearing results.

Settlement Analysis - Analyzing a client’s financial data, preparing drafts of IRS forms 433-A or 433-B, making recommendations to the client based upon the Company’s professional judgment as to what would be the client’s best alternative for various IRS programs, including, but not limited to, an offer-in compromise, partial payment installment agreements and uncollectible status.
 

-18-

The Company also earns small amounts of revenue for rendering other tax-related services such as, bookkeeping services, Tax Court services, innocent spouse relief, and IRS audits or appeals.  These revenue services are accounted for as other revenue.

Our clients can engage the Company for one or more services. Each service can be completed over various periods of time. The Company uses the Proportional Performance method to recognize revenue.

The Proportional Performance model is used when (1) the seller completes the performance obligation, and (2) the customer receives value over a period of time.  The Company fulfills a portion of its obligations and the customer receives value as each service of a multi-service contract is completed. As a result, a portion of contract revenue is earned as each service is performed/completed.

Upon execution of an agreement, if services have not been provided then the amount to be paid under such agreement is recorded as deferred revenue on the balance sheet and is reclassified as revenue on the statement of operations after services have been provided and such revenue earned.

Refund Policy

Full or partial refunds are granted to customers for the following:

(a)   when all services are completed and it is discovered that the customer will not require a service anticipated in the engagement agreement(s) – the refund is determined after the fee for services provided are deducted from the amounts paid by the customer;

(b)   an overpayment by customer when services are completed;

(c)   if the third party verification is found to be incomplete, a refund is given for any services not performed in whole or in part by the date of the refund request;

(d)   if all company required disclosures are not made during the initial sales process and the customer does not sign a written contract, the customer is given a refund for any services not performed in whole or in part on request of the customer;

(e)   on written contracts, no refund is made for services contracted by engagement agreements.

The company reserves the right to take a reasonable amount of time, not to exceed 90 days, to review the documents and case files in determining the amount, if any, of the refund.  Any refund due will normally be made only after company confirms the funds received from customer are good and collected funds.

Description of Expenses

Our expenses include the following: (i) Costs of services, which consists primarily of salaries and benefits to our tax consultants, customer service consultants, outside services and professional fees used to provide our tax services, including associated marketing expenses; (ii) Marketing costs (a significant portion of which consists of our advertising expense); and (iii) General administrative costs, which consists of overhead expenses, such as rent, utilities and telecommunications.

We currently have no material research and development expenses.

Results of Operations

Results for the three months ended September 30, 2010 versus the three months ended September 30, 2009.

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The following table sets forth selected statement of operations data as a percentage of total revenues for the periods indicated

	For three months ended September 30,
Statement of Operations Data:	2010					2009
Total revenue	$	10,439,000		100.0	%	$	10,823,000		100.0	%
Operating costs and expenses:
Selling, general and administrative		5,844,000		56.0	%		3,725,000		34.4	%
Compensation		4,993,000		47.8	%		4,292,000		39.7	%
Depreciation		200,000		1.9	%		95,000		0.9	%
Total operating expenses		11,037,000		105.7	%		8,112,000		75.0	%
Net income (loss) from operation		(598,000	)	5.7	%		2,711,000		25.0	%
Other income (expense), net		(64,000	)	0.6	%		(21,000	)	0.2	%
Net income (loss) before taxes		(662,000	)	6.3	%		2,690,000		24.9	%
Income tax benefit		57,000		0.6	%		(4,240,000	)	39.2	%
Net income (loss)	$	(719,000	)	6.9	%	$	6,930,000		64.0	%

Revenues.  Revenues decreased by approximately $400,000, or 4%, to approximately $10.4 million for the three months ended September 30, 2010 as compared to approximately $10.8 million for the same three month period in 2009.  The decrease in sales revenue was mainly due to lower volume in all service areas.  The Company significantly increased advertising campaign on major cable networks, the internet and radio.

Sales change for three month July 1 to September 30 versus prior year by area is as follows:

Services	9/30/2010			9/30/2009			Change			% chg
Collection Due Process	$	515,000		$	862,000		$	(347,000	)		-40.3	%
Automated Collection Service		1,053,000			1,112,000			(59,000	)		-05.3	%
Consultation		1,589,000			2,041,000			(452,000	)		-22.1	%
Revenue Officer Case		307,000			431,000			(124,000	)		-28.8	%
Settlement Analysis		4,749,000			3,562,000			1,187,000			33.3	%
Tax Returns		1,958,000			1,972,000			14,000			-0.7	%
Other		628,000			977,000			(349,000	)		-35.7	%
Total Sales all Services		10,799,000			10,957,000			(158,000	)		-1.4%
Less:  Sales Returns & Allowances		(360,000	)		(134,000	)		226,000			168.7	%
Total Revenue	$	10,439,000		$	10,823,000		$	(384,000	)		-3.5%

Compensation expense.  Compensation expense, which is comprised of salaries, health insurance, payroll taxes, and outside contract labor for the three months ended September 30, 2010 was approximately $5.0 million, which was an increase of approximately $700,000 or an increase of 16.3%, from the compensation expense of approximately $4.3 million for three months ended September 30, 2009.  The increase in compensation expense was mainly due to (i) an increase in the number of tax consultant personnel hired to support our increase in the number of clients (and, therefore, sales volume).  Salaries and payroll taxes alone increased approximately $1.2 million for the three months ended September 30, 2010. Contract labor paid to our tax experts was flat fo r the three months ended September 30, 2010 versus the same three month period in 2009. The increase in salaries in 2010 versus prior year was offset by a reduction in equity-based compensation which occurred in 2009, for the three month period end September 310, 2009 the Company recorded a charge of approximately $0.5 million for equity-based compensation but for the same three month period ended September 30, 2010, the Company had no equity-based compensation.

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Selling, general and administrative costs (“SG&A”).  Selling, general and administrative costs increased by approximately $2.1 million or 56.9%, from approximately $3.7 million for the three months ended September 30, 2009 to approximately $5.8 million for the same period in 2010.  Selling expenses, which consists mainly of advertising expenses and cost of customer service personnel.  Advertising expense for the three months ended September 30, 2010 was approximately $4.0 million, an increase of approximately $1.3 million or 47.7%.  Outside service and professional fees for the three months ended September 30, 2010 was approximately 600,000, an increase of approximately $422,000 from the 2009 costs for the same three month pe riod.  Legal fees increased approximately $116,000 due to current legal issues and costs incurred in connection with being a public company. The other significant increases in general and administrative costs consisted of overhead expenses, such as utilities, customer telecommunication expenses and repair & maintenance costs, which increased approximately $183,000 to approximately $401,000 for the three months ended September 30, 2010.  Rent increased approximately $193,000, or  92%, from approximately $210,000 for the same three month period in 2009, due to the additional office space in 2010.  Other general and administrative expenses that also had a significant change was banking fees and credit card fees which increased by approximately $210,000, to $252,000 from the same three month period  versus prior year. 

Total Operating Expenses.  Total operating expenses for the three months end September 30, 2010 were approximately $11.0 million, an increase of approximately $2.9million, or 36.1%, from total operating expenses of $8.1 million for the same three month period in 2009.  Total operating expenses for third quarter 2010 increased due to increases in salary compensation for new hires of $1.2 million, a reduction of $0.5 million in equity-based compensation expense, an increase in advertising expenses of $1.3 million, an increase in professional and consulting fees of approximately $0.7 million an increase other SG&A expenses of $0.2 million as described above and an increase in depreciation expense of approximately $0.1 million.

Total Other Income and  Expenses.  Total other income and other expenses consist of interest income and interest expense.  Interest expense for the three months ended September 30, 2010 was approximately $71,000, an increase of approximately $40,000 from the same three month period in 2009.  This increase is mainly due to the interest expense from the note payable to related party and the use of capital leases to purchase equipment.  Interest income for the three months ended September 30, 2010 was approximately $7,000, a small decline of approximately $3,000 for the same three month period in 2009.

Income taxes.   Total income taxes provision for the three months ended September 30, 2010 was a tax expense  of approximately $57,000 mainly for the Texas margin tax.  Prior to the reverse merger of August 4, 2009, the Company’s operating subsidiary, TaxMasters, was taxed as a limited partnership, then changed to a Subchapter S corporation and was not subject to corporate taxes which has created a deferred tax asset.  The Company recognized a deferred tax benefit of approximately $4.2 million for the three months ended September 30, 2009.   The total deferred tax asset as of September 30, 2010 is $5.8 million.

            Net Loss / Income.  The net loss for the three months ended September 30, 2010 was approximately $719,000 as compared to a net income of approximately $6.9 million for the same three month period in 2009, a decrease in the net income of approximately $7.6 million mainly due to the increase in operating expenses and the tax benefit recognized in 2009.   Operating loss for the three months ended September 30, 2010 was approximately $0.6 million as compared to operating profit of approximately $2.7 million for 2009.  Sales revenues were slightly down versus the same three month period, a decrease of approximately $0.4 million but operating expenses in 2010 were $2.9 million high er compared to the same three month period ended in 2009.  Since the Company was still a Sub-S corporation for the first six months of 2009, the Company recorded a $4.2 income tax benefit for the three months ended September 30, 2009.

 Results for the nine months ended September 30, 2010 versus the nine months ended September 30, 2009

The following table sets forth selected statement of operations data as a percentage of total revenues for the periods indicated.

	For nine months ended September 30,
Statement of Operations Data:	2010					2009
Total revenue	$	32,847,000		100.0%		$	26,970,000			100.0%
Operating costs and expenses:
Selling, general and Administrative		19,019,000		57.9	%		12,013,000			44.5	%
Compensation		15,315,000		46.6	%		11,187,000			41.5	%
Depreciation		560,000		1.7%			179,000			0.7%
Total operating expenses		34,894,000		106.2%			23,379,000			86.7%
Net income (loss) from operations		(2,047,000	)	6.2%			3,591,000			13.3%
Other income (expense), net		(186,000	)	0.6%			(34,000	)		0.1%
Net income (loss)  before taxes		(2,232,000	)	6.8%			3,557,000		$	13.2
Income tax benefit		(329,000	)	1.0%			(4,240,000	)	$	15.7
Net income (loss)	$	(1,903,000	)	5.8%		$	7,797,000		$	28.9

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Revenues.  Revenues increased by approximately $5.9 million or 21.8%, to approximately $32.8 million for the nine months ended September 30, 2010 as compared to approximately $26.9 million for the same nine month period in 2009.  The increase in sales revenue was mainly attributable to an increase in our advertising expense.  The Company significantly increased advertising campaign on major cable networks, the internet and radio.

Sales change versus prior year for the nine months ended September 30, 2010 by area is as follows:

Services	9/30/2010			9/30/2009			Change			% chg
Collection Due Process	$	1,633,000		$	1,973,000		$	(340,000	)		-17.2	%
Automated Collection Service		3,085,000			2,310,000			775,000			33.5	%
Consultation		5,276,000			4,667,000			609,000			13.0	%
Revenue Officer Case		948,000			918,000			30,000			3.3	%
Settlement Analysis		15,138,000			10,912,000			4,226,000			38.7	%
Tax Returns		5,628,000			4,482,000			1,146,000			25.6	%
Other		2,614,000			2,195,000			419,000			19.1	%
Total Sales all Services		34,322,000			27,457,000			6,865,000			25.0	%
Less:  Sales Returns & Allowances		(1,475,000	)		(487,000	)		988,000			202.9	%
Total Revenue	$	32,847,000		$	26,970,000		$	5,877,000			21.8	%

Compensation expense.  Compensation expense, which is comprised of salaries, health insurance, payroll taxes, and outside contract labor for the nine months ended September 30, 2010 was approximately $15.3 million, which was an increase of approximately $4.1 million, or an increase of 36.9%, from the compensation expense of approximately $11.2 million for the nine months ended September 30, 2009.  The increase in compensation expense was mainly due to (i) an increase in the number of tax consultant personnel hired to support our increase in the number of clients (and, therefore, sales volume).  Salaries and payroll taxes alone increased approximately $4.4 million for the nine months ended September 30, 2010. Contract labor paid to our tax experts als o increased approximately $148,000 for the nine months ended September 6 30, 2010 versus the same nine month period in 2009.  The increase in salaries in 2010 versus prior year was partially offset by a reduction in equity-based compensation which occurred in 2009, for the nine month period end September 310, 2009,  the Company recorded a charge of approximately $0.6 million for equity-based compensation but for the same nine month period ended September 30, 2010, the Company had no equity-based compensation.

Selling, general and administrative costs (“SG&A”).  Selling, general and administrative costs increased by approximately $7.0 million or 58.3%, from approximately $12.0 million for the nine months ended September 30, 2009 to approximately $19.0 million for the same period in 2010.  Selling expenses, which consists mainly of advertising expenses and cost of customer service personnel, increased approximately 33%.  Advertising expense for the nine months ended September 30, 2010 was approximately $11.8 million, an increase of approximately $3.0 million or 33.3%.  Outside services and professional fees for the nine months ended September 30, 2010 was approximately $1.8 million an increase of approximately $1.1 million from the 2009 costs for the same nine month period, mainly due to shares issued to consultants.   Legal fees increased approximately $308,000 due to current legal issues and related costs incurred in connection with being a public company.  The Company accrued an expense of $512,000 for the nine months ended September 30, 2010 for a potential assessment from the Department of Labor for unpaid wages. The other significant increases in general and administrative costs consisted of overhead expenses, such as utilities, customer telecommunication expenses and insurance costs, which increased approximately $326,000 to approximately $685,000 for the nine months ended September 30, 2010.  Rent increased approximately $653,000, or 169%, from approximately $387,000 for the same nine month period in 2009, due to the additional office space in 2010.  Expenses associated with community & public relations increased approximately $500,000 versus the same nine months period a year ago Ot her general and administrative was also impacted by approximately $0.4 million, primarily an increase in general insurance and increased expenses associated with increase in employee headcount versus prior year. 

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 Total Operating Expenses.  Total operating expenses for the nine months ended September 30, 2010 were approximately $34.9 million, an increase of approximately $11.5 million, or 49.3%, from total operating expenses of $23.3 million for the same nine month period in 2009.  The nine month period ended increases in 2010 versus 2009 can be attributed mainly to:  an increase in compensation costs of $4.1 million, an increase in equity-based compensation of $0.1 million; an increase in advertising expenses of $3.0 million; an increase in community & public relations of approximately $0.5 million;  professional fees, including legal fees increasing approximately $1.4 million; fee for the assessment expense from the Department of Labor of $0.5 million and other SG&A expenses of $2.5 million as described above.

Total Other Income and  Expenses.  Total other income and other expenses consist of interest income and interest expense.  Interest expense for the nine months ended September 30, 2010 was approximately $214,000, an increase of approximately $148,000 or 224% increase from the same nine month period in 2009, this increase is mainly due to the interest expense from the note payable to related party and the use of capital leases to purchase equipment.  Interest income for the nine months ended September 30, 2010 was approximately $28,000, a decrease of approximately $4,000 for the same nine month period in 2009.

Income taxes.   Total income taxes provision for the nine months ended September 30, 2010 was a tax benefit of approximately $0.5 million for federal income taxes.  The Company also incurred approximately $175,000 for Texas margin tax.  Prior to the reverse merger of August 4, 2009, the Company’s operating subsidiary, TaxMasters, was taxed as a limited partnership, then changed to a Subchapter S corporation and was not subject to corporate taxes which has created a deferred tax asset.  The total deferred tax asset as of September 30, 2010 is $5.8 million.

Net income (loss).  The net loss for the nine months ended September 30, 2010 was approximately $1.9 million as compared to a net income of approximately $7.8 million for the same nine month period in 2009, a decrease of approximately $9.7 million.  The decrease in net income for the nine months ended September 30, 2010, can be attributed to increases in revenues of approximately $5.9 million, offset by increases in operating expenses of approximately $11.5 million which consist of compensation costs ($4.4 million), advertising expenses ($3.0 million) and, various other expenses discussed above in operating expenses. Also for the nine months ended September 30, 2010 the Company had a decrease in deferred tax benefits of approximately $3.9 million.  T he loss before income taxes of approximately $2.2 million for the nine months ended September 30, 2010 was partially offset by a net income tax benefit of approximately $0.3 million.  The net income before income taxes of $3.5 million for the nine months ended September 30, 2009, also created a tax benefit of approximately $4.2 million because the Company was still a Sub-S corporation in 2009 and as such, no tax benefit was recorded as of June 30, 2009.

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Liquidity and Capital Resources

At September 30, 2010, the Company had total current assets of approximately $20.1 million and total current liabilities of approximately $36.4 million, resulting in negative working capital of approximately $16.3 million.  At September 30, 2010, the Company's current assets consisted of approximately $0.6 million in cash and  short-term investments and approximately $16.6 million in net accounts receivable.

Operating Activities

Net cash used in operating activities was approximately $1.1 million for the nine months ended September 30, 2010 as compared to net cash provided by operating activities of  approximately $4.4 million for the nine months ended September 30, 2009, a decrease of approximately $5.5 million. The decrease is attributed to a decrease in the net income of approximately $9.7 million for the nine months ended September 30, 2010, $1.9 million net loss in 2010versus a net income of $7.8 million for same period in 2009.  This decrease of approximately $5.5 million in cash used from operations is mainly attributed to increase in cash paid for operating expenses of approximately $2.1 million versus the same nine month period a year ago, we increased the cash used to pay our accounts payable, and prepaid items in the amount of a pproximately $300,000 and an increase in accounts receivable and decrease deferred revenue due to slower collections in the amount of approximately $3.1 million.

Investing Activities

Net cash used in investing activities was approximately $982,000  for the nine months ended September 30, 2010 compared to approximately $442,000 for the nine months ended September 30, 2009, an increase of approximately $540,000.  This increase is mainly due to purchase of property and equipment needed to expand the capacity within the IT department for operational efficiency.  Purchase of equipment increased approximately $936,000.  In 2009 the company paid $400,000 for possible business venture which was subsequently expensed as  this was deemed not collectible in 2009.

Financing Activities

Net cash used in financing activities was approximately $500,000  for the nine months ended September 30, 2010 compared to approximately $3.0 million for the nine months ended September 30, 2009, a decrease of approximately $2.5 million.  This decrease can be primarily attributed to the distribution of $2.3 million to the shareholder in 2009.  This decline was offset by the repayment of approximately $80,000 of  a note payable from a related party within the Company.  The Chief Executive Officer of the Company loaned the Company $5.3 million at an interest rate of prime plus 1% (the “CEO Note”).  The CEO Note is unsecured and is due on demand, with covenants that limit demand rights.  The covenants in the CEO Note limit demand rights to $1 million annual ly so long as the Company is achieving certain financial targets and has the cash for repayment.

Commitments and Contingencies

We currently have two separate lease agreements for our office space under an operating lease through May 2014.  Our monthly lease payment under these agreements amounts to approximately $25,162 and $67,431. Total obligation through 2014 under these agreements is approximately $6,135,000.

We currently plan to utilize both lease office spaces through 2010 and will evaluate office space needs in 2011 to determine if a sublet option or termination of a lease is appropriate.

On July 31, 2009, we entered into a lease agreement for approximately 107,890 square feet of office space, which we expect to occupy in late first quarter or early second quarter of 2011.  This lease has a term of 66 months and expires in late first quarter or early second quarter of 2015, depending on the date we occupy the space.  Under this lease, upon the commencement date we will not pay any rent for the first six months.  We will pay a monthly rent of $67,431 for months 7 to 26, which will then increase to $74,422 for the next 20 months and then to $85,413 for the remaining 20 months.  The Company has the right to extend the term of the lease for one additional term of five years.

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We also lease certain computer equipment under capital leases.  Our obligation under these leases continues until July 2014. Our total obligation under these leases is approximately $2,085,000.

These obligations are summarized in the table below:

Contractual Obligations

The following table presents future contractual obligations due by fiscal period as of June 30, 2010:

	2010			2011-2012		2013-2014	2014 and Thereafter		Total
Operating lease commitments	$	299,000	$	2,522,000	$	2,478,000	$	833,000	$	6,132,000
Capital & Equipment leases		162,000		1,090,000		823,000		10,000		2,085,000
Total	$	461,000	$	3,612,000	$	3,301,000	$	843,000	$	8,217,000

Off-Balance Sheet Arrangements

We currently have no off-balance sheet arrangements

ITEM 4. CONTROLS AND PROCEDURES

(a)    Disclosure Controls and Procedures.    Our management, with the participation of our principal executive officer (chief executive officer) and principal financial officer (chief financial officer), conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of March 31, 2010 (the “Evaluation Date”).  Based on this evaluation, and due to the material weaknesses in our internal control over financial reporting (as described below in the “Report of Management on TaxMasters, I nc.’s Internal Control Over Financial Reporting”), our chief executive officer and chief financial officer concluded that as of the Evaluation Date, our disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

The material weakness relates to the lack of segregation of duties in financial reporting, as our financial reporting and some of our accounting functions are performed by external consultants with no oversight by a professional with accounting expertise.  Our CFO does not possess accounting expertise and our company does not have an accounting staff with public company audit experience.  This weakness is due to the fact that TaxMasters, Inc., which we acquired on August 4, 2009, was a privately held company and its staff, overall, had minimal experience in public company matters, including public company accounting.  To help remedy this material weakness, in January 2010, we hired an assistant controller, who is a CPA with both external and internal audit experience, to assist with financial reporting.

(b)    Internal Controls Over Financial Reporting.    There was no change in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.

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PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

None.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

In July 2010, the Company issued 1,000,000 shares of common stock to a consultant in payment for public relations services.  In August 2010, the Company issued to AGS Capital Group, LLC (“AGS”) 24,000 shares of common stock as a due diligence fee paid to AGS pursuant to a term sheet for financing entered into by the Company and AGS.

No underwriter or underwriting discount or commission was involved in any of the transactions set forth above.

The offer and sale of the Company’s shares of common stock summarized above were made to accredited investors (as defined in Rule 501 of Regulation D promulgated under the Securities Act of 1933, as amended (the “Securities Act”)) and were made without any publicity or advertising, and thus subject to an exemption from registration under Section 4(2) of the Securities Act as a transaction by the issuer not involving a public offering.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. REMOVED AND RESERVED

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

Number	Description
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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SIGNATURE PAGE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	TAXMASTERS, INC.
Dated: November 15, 2010
	By: /s/ CHRISTOPHER J. KOSCINSKI
	Chief Financial Officer
	(Principal Financial and Accounting Officer and Duly Authorized Officer)

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