**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**




**Washington,
      D.C. 20549**




**FORM
      10-QSB**






**(Mark
                One)****x**
            
            **QUARTERLY
                REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES**
              **EXCHANGE
                ACT OF 1934****For
                the Quarterly Period Ended: September 30, 2006****o**
            
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**






**Commission
      File No. 00050921**




**SOUTHERN
      HERITAGE BANCSHARES, INC.**


(Exact
      Name of Small Business Issuer as Specified in its Charter)








**Tennessee**
            
            **42-1627829**(State
                of Incorporation)
            
            (I.R.S.
                Employer Identification No.)**3020
                Keith Street, N.W.****Cleveland,
                Tennessee**
            
            **37312**(Address
                of Principal Executive Offices)
            
            (Zip
                Code)






**(423)
      473-7980**


(Issuer’s
      Telephone Number, Including Area Code)




**None**


(Former
      Name, Address and Fiscal Year, if Changed Since Last Report)




Check
      whether the issuer (1) filed all reports required to be filed by Section 13
      or
      15(d) of the Exchange Act during the past 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 o




Indicate
      by check mark whether the registrant is a shell company (as defined in Exchange
      Act Rule 12b-2).  Yes o No x




State
      the
      outstanding number of shares of the issuer’s common stock as of Oct 31,
      2006:  1,164,996




Transitional
      Small Business Disclosure Format (check one): Yes o No x

































**SOUTHERN
      HERITAGE BANCSHARES, INC.**




**FORM
      10-QSB**


**Quarter
      ended September 30, 2006**








**PART
                I.**
            
            **FINANCIAL
                INFORMATION****Item
                1.**
            Financial
                StatementsConsolidated
                Balance Sheets - September 30, 2006 (Unaudited) and December 31,
                2005Consolidated
                Statements of Operations -Three and Nine months ended September 30,
                2006
                and 2005 (Unaudited)Consolidated
                Statements of Cash Flows - Nine months ended September 30, 2006 and
                2005
                (Unaudited)Notes
                to Consolidated Financial Statements**Item
                2.**
            Managements
                Discussion And Analysis**Item
                3.**
            Controls
                And Procedures**PART
                II.**
            
            **OTHER
                INFORMATION****Item
                1.**
            Legal
                Proceedings**Item
                2.**
            Unregistered
                Sales of Equity Securities and Use of Proceeds**Item
                3.**
            Defaults
                Upon Senior Securities**Item
                4.**
            Submission
                of Matters to a Vote of Security Holders**Item
                5.**
            Other
                Information**Item
                6.**
            Exhibits**Signatures**


























2





**Item
      1. Financial Statements**




**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Consolidated
      Balance Sheets**


**September
      30, 2006**




($
      amounts in thousands except share and earnings per share)








**(Unaudited)****September 30,**
              **2006**
            
            **December 31,**
              **2005*****Assets***Cash
                and due from banks
            
            $
            5,447
            
            5,250Federal
                funds sold
            
            6,397
            
            1,828***Cash
                and cash equivalents***
            
            11,844
            
            7,078Securities
                available-for-sale, at fair value
            
            24,534
            
            24,736Mortgage
                loans held for sale
            
            1,965
            
            245Loans
            
            161,192
            
            151,131Allowance
                for loan losses
            
            (2,220)
            
            (2,036
            )***Loans,
                net***
            
            158,972
            
            149,095Premises
                and equipment
            
            5,268
            
            5,366Restricted
                stock
            
            539
            
            515Accrued
                income receivable
            
            958
            
            819Other
                assets
            
            1,920
            
            1,292$
            206,000
            
            189,146***Liabilities
                and Shareholders’ Equity*****Liabilities:****Deposits:**Noninterest-bearing
            
            $
            27,238
            
            26,788Interest-bearing
            
            151,966
            
            141,327***Total
                deposits***
            
            179,204
            
            168,115Repurchase
                agreements
            
            305
            
            300FHLB
                advance
            
            3,000
            
            0Accrued
                interest payable
            
            1,242
            
            904Subordinated
                debentures
            
            5,155
            
            5,155Other
                liabilities
            
            812
            
            501***Total
                liabilities***
            
            190,175
            
            174,975**Shareholders’
                equity:**Preferred
                stock, no par value. Authorized 1,000,000 shares; none
                issued
            
            -
            
            —Common
                stock, $1 par value. Authorized 2,000,000 shares; issued 1,164,996
                shares
              at Sept 30, 2006 and 1,082,675 at Dec 31, 2005
            
            1,165
            
            1,082Additional
                paid-in-capital
            
            12,876
            
            10,766Retained
                Earnings
            
            2,474
            
            2,696Accumulated
                other comprehensive income (loss)
            
            (233)
            
            (373
            )***Total
                shareholders’ equity***
            
            16,282
            
            14,171$
            206,000
            
            189,146






See
      accompanying notes to consolidated financial statements.












3




**SOUTHERN
      HERITAGE BANCHARES, INC.**


**Consolidated
      Statements of Operations**


**Nine
      Months Ended September 30**


**(Unaudited)**




($
      amounts in thousands except share and earnings per share)








**Three Months Ended September 30**
            
            **Nine Months Ended September 30****2006**
            
            **2005**
            
            **2006**
            
            **2005****Interest
                income:**Loans,
                including fees
            
            $
            3,080
            
            2,332
            
            $
            8,565
            
            6,502Securities
            
            285
            
            221
            
            800
            
            589Federal
                funds sold
            
            137
            
            63
            
            312
            
            168***Total
                interest income***
            
            3,502
            
            2,616
            
            9,677
            
            7,259**Interest
                expense:**Deposits
            
            1,488
            
            902
            
            3,878
            
            2,368Other
                borrowed funds
            
            143
            
            72
            
            326
            
            199***Total
                interest expense***
            
            1,631
            
            974
            
            4,204
            
            2,567***Net
                interest income***
            
            1,871
            
            1,642
            
            5,473
            
            4,692**Provision
                for loan losses**
            
            267
            
            111
            
            435
            
            298***Net
                interest income after provision for loan
                losses***
            
            1,604
            
            1,531
            
            5,038
            
            4,394**Noninterest
                income:**Service
                charges on deposit accounts
            
            261
            
            329
            
            815
            
            987Mortgage
                banking activities
            
            165
            
            110
            
            512
            
            313Gain
                (loss) on sale of securities
            
            183
            
            (2
            )
            196
            
            (6
            )Other
                service charges, commissions and fees
            
            62
            
            59
            
            218
            
            202***Total
                noninterest income***
            
            671
            
            496
            
            1,741
            
            1,496**Noninterest
                expenses:**Salaries
                and employee benefits
            
            792
            
            661
            
            2,276
            
            1,916Occupancy
                expense
            
            102
            
            88
            
            294
            
            263Other
                operating expenses
            
            561
            
            531
            
            1,684
            
            1,600***Total
                noninterest expenses***
            
            1,455
            
            1,280
            
            4,254
            
            3,779***Income
                before income taxes***
            
            820
            
            747
            
            2,525
            
            2,111**Income
                taxes**
            
            265
            
            238
            
            846
            
            710***Net
                income***
            
            555
            
            509
            
            1,679
            
            1,401**Other
                comprehensive income (loss):**Change
                in unrealized gains/losses on securities
            
            278
            
            3
            
            140
            
            (80
            )**Comprehensive
                income (loss)**
            
            833
            
            512
            
            1,819
            
            1,321Basic
                earnings per share
            
            $
            0.48
            
            $
            0.45
            
            $
            1.49
            
            $
            1.29Diluted
                earnings per share
            
            $
            0.44
            
            $
            0.41
            
            $
            1.39
            
            $
            1.18Shares
                used in computation of earnings per shareBasic
            
            1,164,923
            
            1,131,628
            
            1,123,157
            
            1,084,080Diluted
            
            1,250,891
            
            1,231,076
            
            1,209,125
            
            1,183,528






See
      accompanying notes to consolidated financial statements.









4




**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Consolidated
      Statements of Cash Flows**


**Nine
      Months Ended September 30**


**(Unaudited)**




*($
      amounts in thousands)*




**2006**
            
            **2005****Cash
                flows from operating activities:****Net
                income**
            
            $
            1,679
            
            1,401Adjustments
                to reconcile net income to net cash provided (used) by operating
                activities:Depreciation
                and amortization
            
            303
            
            269Provision
                for loan losses
            
            435
            
            298(Gain)
                loss on sale of securities
            
            (196)
            
            6Gain
                on sale of mortgage loans
            
            (512)
            
            (313
            )Mortgage
                loans originated for sale
            
            (22,446)
            
            (19,406
            )Proceeds
                from sale of mortgage loans
            
            21,238
            
            19,249Decrease
                (increase) in accrued interest receivable
            
            (139)
            
            (177
            )Increase
                (decrease) in accrued interest payable
            
            338
            
            258Other,
                net
            
            (75)
            
            (51
            )***Net
                cash provided by operating activities***
            
            625
            
            1,534**Cash
                flows from investing activities:**Proceeds
                from maturities and redemptions of securities available for
                sale
            
            787
            
            1,044Proceeds
                from sales of securities available for sale
            
            6,384
            
            5,294Purchases
                of securities available for sale
            
            (6,777)
            
            (8,716
            )Purchases
                of restricted stock
            
            (24)
            
            (65
            )Net
                decrease (increase) in loans
            
            (10,415)
            
            (18,251
            )Purchases
                of premises and equipment
            
            (165)
            
            (147
            )***Net
                cash used by investing activities***
            
            (10,210)
            
            (20,841
            )**Cash
                flows from financing activities:**Increase
                (decrease) in repurchase agreements
            
            5
            
            (789
            )FHLB
                advance
            
            3,000
            
            -Proceeds
                from exercise of stock options
            
            266
            
            -Dividends
                paid
            
            (9)
            
            -Increase
                in deposits
            
            11,089
            
            28,089***Net
                cash provided by financing activities***
            
            14,351
            
            27,300***Net
                increase in cash***
            
            4,766
            
            7,993**Cash
                and cash equivalents, beginning of period**
            
            7,078
            
            5,093**Cash
                and cash equivalents, end of period**
            
            $
            11,844
            
            13,086**Cash
                payments for interest**
            
            $
            3,866
            
            2,309**Cash
                payments for income taxes**
            
            980
            
            852






See
      accompanying notes to consolidated financial statements.













5




**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2006**


**(Unaudited)**




*Basis
      of Presentation*




The
      accompanying financial statements have been prepared in accordance with
      generally accepted accounting principals for interim financial information
      and
      with the instructions to Form 10-QSB. Accordingly they do not include all
      information and footnotes required by generally accepted accounting principals
      for complete financial statements.




The
      consolidated financial statements include Southern Heritage
      Bancshares, Inc. and its wholly owned subsidiary, Southern Heritage Bank,
      together referred to as “the Company”. Intercompany transactions and balances
      are eliminated in consolidation.




Southern
      Heritage Bancshares, Inc. is a one bank holding company that owns 100% of
      Southern Heritage Bank (the Bank). Substantially all of the consolidated
      operations are that of the Bank.




In
      the
      opinion of management, the financial statements contain all adjustments
      necessary to summarize fairly the financial position of the Bank as of September
      30, 2006, the results of operations for the three and nine months ended
      September 30, 2006, and cash flows for the nine months ended September 30,
      2006.
      The interim financial statements should be read in conjunction with the notes
      to
      the financial statements presented in the Bank’s December 31, 2005,
      financial statements. The results for the interim periods are not necessary
      indicative of the results to be expected for the complete year.




*Allowance
      for Loan Losses*




Transactions
      in the allowance for loan losses were as follows:




**Nine Months**
              **Ended**
              **September
                30, 2006**
            
            **Nine Months**
              **Ended**
              **September 30,
                2005****(In Thousands)**
            
            **(In Thousands)**Balance
                January 1
            
            $
            2,036
            
            $
            1,723Add
                (deduct):Losses
                charged to allowance
            
            (271)
            
            (70
            )Recoveries
                credited to allowance
            
            20
            
            18Provision
                for loan losses
            
            435
            
            298Balance
                September 30
            
            $
            2,220
            
            $
            1,969






The
      following table presents various categories of loans contained in the Company’s
      loan portfolio for the periods indicated and the total amount of all loans
      for
      such period:




**As of****September
                30, 2006**
            
            **December 31,**
              **2005**Domestic:
            
            **($ in thousands)**Commercial,
                financial and agricultural
            
            $
            52,883
            
            $
            43,499Real
                estate - construction
            
            30,033
            
            27,212Real
                estate - family residential
            
            25,175
            
            25,692Real
                estate - commercial
            
            48,189
            
            46,614Consumer
            
            4,912
            
            8,114Total
                loans
            
            161,192
            
            151,131Allowance
                for loan losses
            
            (2,220)
            
            (2,036
            )Total
                (net of allowance)
            
            $
            158,972
            
            $
            149,095











6




**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2006**


**(Unaudited)**








The
      following table presents information regarding nonaccrual, past due and
      restructured loans at the dates indicated:




**As of****September
                30, 2006**
            
            **December 31,**
              **2005****($ in thousands)**Loans
                accounted for on a non-accrual basis:Number
            
            6
            
            2Amount
            
            $
            797
            
            $
            27Accruing
                loans (including consumer loans) which are contractually past due
                90
              days or more as to principal and interest payments:Number
            
            2
            
            -Amount
            
            $
            17
            
            -






Management’s
      determination of the appropriate level of the provision for loan losses and
      the
      adequacy of the allowance for loan losses is based, in part on an evaluation
      of
      specific loans, as well as other factors considered by management, including
      the
      composition of the loan portfolio, current economic conditions, and the
      creditworthiness of the Bank’s borrowers and other related factors.




At
      September 30, 2006, the Bank had six loans totaling $797,000 in nonaccrual
      status; one customer accounts for five loans totaling $788,000. This compares
      with December 31, 2005, where there were two loans for $27,000 in
      nonaccrual. The Bank had two loans for a total of $17,000 that was more than
      90
      days delinquent on September 30, 2006 compared to no loans that were delinquent
      as of December 31, 2005. In the first nine months of 2006, loans totaling
      $271,000 were charged off (one loan represents $192,000 of the total) and
      $20,000 was recovered on loans previously charged off. Based on historical
      low
      chargeoff levels (five year average is .07%) the level of allowance relative
      to
      total loans is warranted and is reflected in the allowance for September 30,
      2006 and the provision for the nine months then ended.




*Stock
      Dividend*




The
      Company declared a stock dividend of one share for each 20 shares owned for
      shareholders of record as of May 18, 2006. The effect of this stock
      dividend have been reflected in earnings per share and shares used in the
      computation of earnings per share for all periods presented as well as the
      share
      data presented in the summary of option activity table.




*Stock
      Compensation*




The
      Company established an Incentive Stock Option Plan (ISO) for officers and
      employees and a Non-Employee Directors’ Non-Qualified Stock Option Plan (NQO),
      which was shareholder approved, effective August 8, 2000, allowing for the
      granting of share options and shares to its employees and directors up to
      153,543 shares of common stock. The Company believes that such awards better
      align the interests of its employees and directors with those of its
      shareholders. Option awards are generally granted with an exercise price equal
      to the market price of the Company’s stock at the date of grant; those option
      awards generally vest 20% every two years based on 10 years of continuous
      service. Certain option and share awards provide for accelerated vesting if
      there is a change in control (as defined in the Plan).




The
      fair
      value of each option grant is estimated on the date of grant using the
      Black-Scholes option-pricing model. Expected volatilities are based on
      historical exercise patterns, employee terminations and historical stock prices.
      The expected life of options granted represents the period of time that options
      granted are expected to be outstanding. The U.S. Treasury 10 year constant
      maturity rate in effect at the date of the grant is used to derive the risk-free
      interest rate for the contractual period of the options.There were no options
      granted in 2006.









7




**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2006**


**(Unaudited)**








A
      summary
      of option activity under the Plan as of September 30, 2006, and changes during
      the nine months then ended is presented below:








**Options**
            
            **Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Weighted**
              **Average**
              **Remaining**
              **Contractual**
              **Term**
            
            **Weighted**
              **Average**
              **Intrinsic**
              **Value****(In thousands)**Outstanding
                at January 1, 2006
            
            157,457
            
            $
            11.57Granted
            
            -
            
            -Exercised
            
            (28,352
            )
            9.37Forfeited
            
            (2,425
            )
            14.35Outstanding
                at September 30, 2006
            
            126,680
            
            $
            12.00
            
            5.07
            
            $
            3,294Exercisable
                at September 30, 2006
            
            41,617
            
            $
            10.68
            
            3.92
            
            $
            1,137






The
      total
      intrinsic value of options exercised during the nine months ended September
      30,
      2006 was $811,718.









8




**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2006**


**(Unaudited)**








As
      of
      September 30, 2006, there was $277,000 of total unrecognized compensation cost
      related to nonvested share-based compensation arrangements granted under the
      Plan. That cost is expected to be recognized over a weighted-average period
      of
      approximately 5 years. The options under the Plan vest every other year and
      14,782 shares have vested in 2006. However, the compensation cost is recorded
      on
      a prorata basis over the entire vesting period resulting total compensation
      cost
      of $36,000 for the nine months ended September 30, 2006, based on the fair
      value
      of the options.




Cash
      received from options exercised for the nine months ended September 30, 2006
      was
      $265,729. All of these options were ISO’s, resulting in no tax benefit for the
      Company. The Company’s policy is to issue new shares to satisfy option
      exercises.




Effective
      January 1, 2006, the Company adopted SFAS No. 123 (Revised 2004), Accounting
      for
      Stock-Based Compensation, which requires the Company to compute the fair value
      of options at the date of grant and to recognize such costs as compensation
      expense ratably over the vesting period of the options. The Company adopted
      SFAS
      No. 123 (R) under the modified prospective transition method. In 2005 and prior,
      employee compensation expense under stock options was reported using the
      intrinsic value method. No stock-based compensation cost was reflected in net
      income; as all options granted had an exercise price equal to or greater than
      the market price of the underlying common stock at date of grant. The following
      table illustrates the effect on net income and earnings per share if expense
      was
      measured using the fair value recognition provisions of FASB Statement
      No. 123, Accounting for Stock-Based Compensation.






**Three Months**
              **Ended**
              **September 30, 2005**
            
            **Nine Months**
              **Ended**
              **September 30, 2005**Net
                income as reported
            
            $
            509
            
            $
            1,401Deduct:
                Stock-based compensation expense determined under fair value based
                method
            
            
            12
            
            
            36Pro
                Forma net income
            
            $
            497
            
            $
            1,365Basic
                earnings per share as reported
            
            $
            .45
            
            $
            1.29Pro
                Forma basic earnings per share
            
            
            .44
            
            
            1.26Diluted
                earnings per share as reported
            
            
            .41
            
            
            1.18Pro
                Forma diluted earnings per share
            
            
            .40
            
            
            1.15









9





**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2006**


**(Unaudited)**








Earnings
      Per Share Amounts : 
      Basic earnings per share is computed using the weighted average number of common
      shares outstanding during the period and excludes any dilutive effects of
      options. Diluted earnings per share is computed using the weighted average
      number of common and common stock equivalent shares outstanding during the
      period; common stock equivalent shares are excluded from the computation if
      their effect is antidilutive. The effect of these options on earnings per common
      share was to increase average shares outstanding by 85,968 and 99,448 in 2006
      and 2005 and decrease earnings per share by $.10 and $.11. No shares were
      antidilutive at September 30, 2006 and 2005.




Recently
      Issued Accounting Standards on the Financial Statements :
      In July
      2006, the FASB released Interpretation No. 48, "Accounting for Uncertainty
      in
      Income Taxes." This Interpretation revises the recognition tests for tax
      positions taken in tax returns such that a tax benefit is recorded only when
      it
      is more likely than not that the tax position will be allowed upon examination
      by taxing authorities. The amount of such a tax benefit to record is the largest
      amount that is more likely than not to be allowed. Any reduction in deferred
      tax
      assets or increase in tax liabilities upon adoption will correspondingly reduce
      retained earnings. The Company has not yet determined the effect of adopting
      this Interpretation, which is effective for it on January 1, 2007.





In
      September 2006, the SEC staff issued SEC Staff Accounting Bulletin (SAB) Topic
      1N, “Financial Statements — Considering the Effects of Prior Year Misstatements
      When Quantifying Misstatements in Current Year Financial Statements” SAB
      108. SAB 108
      permits the Company to adjust for the cumulative effect of immaterial errors
      relating to prior years in the carrying amount of assets and liabilities as
      of
      the beginning of the current fiscal year, with an offsetting adjustment to
      the opening balance of retained earnings in the year of adoption. SAB 108
      also requires the adjustment of any prior quarterly financial statements within
      the fiscal year of adoption for the effects of such errors on the quarters
      when
      the information is next presented. Such adjustments do not require previously
      filed reports with the SEC to be amended. The Company has not yet determined
      the
      effect of adopting this standard, which is effective for it as of December
      31,
      2006. Any cumulative adjustments for prior year immaterial errors will be
      effective as of January 1, 2006.













10


**Item
      2. Management’s Discussion and Analysis**




**OVERVIEW**




The
      following discussion compares the financial condition of Southern Heritage
      Bancshares, Inc. (the “Company”) at September 30, 2006, to December 31, 2005,
      and the results of operations for the nine months ended September 30, 2006
      and 2005.  Reasons for changes in the quarterly results are primarily the
      same as those for the year to date results.  The Company is a one bank
      holding company that owns 100% of Southern Heritage Bank (the “Bank”).
      Substantially all of the consolidated operations are that of the Bank. This
      discussion should be read in conjunction with the interim financial statements
      and footnotes included herein.




Certain
      statements contained in this report that are not historical facts are forward
      looking statements that are subject to certain risks and uncertainties. When
      used herein, the terms “anticipates,” “plans,” “expects,” “believes,” and
      similar expressions as they relate to the Company or its management are intended
      to identify such forward looking statements. The Company’s actual results,
      performance or achievements may materially differ from those expressed or
      implied in the forward-looking statements. Risks and uncertainties that could
      cause or contribute to such material differences include, but are not limited
      to, general economic conditions, the interest rate environment, competitive
      conditions in the financial services industry, changes in law, governmental
      policies and regulations, and rapidly changing technology affecting financial
      services.




**FINANCIAL
      CONDITION**




Total
      assets as of September 30, 2006 increased 8.9%, or $16,854,000 to $206,000,000
      compared with $189,146,000 at December 31, 2005. The increase in total assets
      was funded primarily by an increase in total deposits of $11,089,000 and a
      FHLB
      CMA Advance of $3,000,000. Cash and cash equivalents increased $4,766,000 to
      $11,844,000 at September 30, 2006 from $7,078,000 at December 31, 2005.
      Securities decreased $202,000 to $24,534,000 at September 30, 2006 compared
      to
      $24,736,000 at December 31, 2005.




Loans
      are
      the principal component of the Company’s assets and the primary source of
      income. Total loans at September 30, 2006, were $161,192,000 compared to
      $151,131,000 at December 31, 2005, an increase of $10,061,000. The increase
      in
      loans in the first nine months of 2006 was as follows: construction real estate
      loans increased $2,821,000, commercial loans secured by real estate increased
      $1,575,000, commercial loans which increased $9,384,000; and consumer loans
      decreased $3,202,000, and loans secured by family residential real estate
      decreased $517,000.  As of September 30, 2006, $48,189,000 or 29.9% of
      total loans were commercial loans secured by real estate. Commercial loans
      were
      $52,883,000 or 32.8% of total loans. Loans secured by family residential real
      estate were $25,175,000 or 15.6% of total loans. Construction loans secured
      by
      real estate were $30,033,000 or 18.6% of total loans. Consumer loans were
      $3,979,000 or 2.5% of total loans. Other loans were $933,000 or .6% of total
      loans. Of the total loans, $109,929,000 or 68.2% mature or reprice within 12
      months. Only $3,472,000 or 2.2% mature or reprice over five years.




There
      was
      $1,965,000 in mortgage loans held for sale at September 30, 2006, compared
      with
      $245,000 at December 31, 2005. The increase in mortgage loans held for sale
      was
      primarily due to timing issues related to secondary market investor
      funding.









11





Management
      anticipates that loan demand will be moderate in the near future. The
      loan-to-deposit ratio as of September 30, 2006, was 89.7%, compared to 89.9%
      at
      December 31, 2005, and the loan-to-assets ratio was 78.1% at September 30,
      2006,
      compared to 79.9% at December 31, 2005. Management expects that the
      loan-to-deposit ratio for the remainder of 2006 will remain in the range of
      approximately 85% - 90% and the loans-to-assets ratio will be between 75% -
      80%.




The
      securities portfolio provides a balance to interest rate and credit risk while
      providing a vehicle for investing available funds, furnishing liquidity, and
      supplying securities to pledge as required for certain deposits and borrowed
      funds. All securities are classified as “available for sale”. We have no plans
      to liquidate a significant amount of the securities portfolio.  As of
      September 30, 2006, the Company owned $24,534,000 of securities
      available-for-sale, an decrease of $798,000 or .8%.




Deposits
      which are the Company’s primary source of funds, totaled $179,204,000 at
      September 30, 2006, for an increase of $11,089,000, or 6.6%, compared to
      $168,115,000 at December 31, 2005. Deposits at September 30, 2006 consisted
      of
      $27,238,000 or 15.2% in non-interest bearing demand deposits, $34,831,000 or
      19.4% in interest-bearing demand deposits, $110,131,000 or 61.4% in time
      certificates of deposit and $7,004,000 or 4.0% in savings accounts. There was
      $21,028,000 in brokered CDs at September 30, 2006 compared to $19,263,000 at
      December 31, 2005. The Company has targeted local consumers, professionals,
      and
      small businesses as its central clientele. These customers are being offered
      various deposit instruments such as demand deposits, savings accounts, money
      market accounts, certificates of deposit and IRAs. Rates paid on such
      instruments are set based on various factors such as liquidity needs and market
      conditions. The Company believes it has a competitive advantage by being a
      locally owned financial institution which will contribute to increased market
      share. However, no assurance of market growth can be given.




The
      majority of the deposits continue to be CDs, which increased $14,171,000 in
      the
      first nine months of 2006. At September 30, 2006, the weighted average rate
      on
      CDs was 4.22% compared to 3.23% for the nine months ended September 30, 2005.
      The Company has time deposits maturing within one year of $83,453,000 or 75.8%
      of total time deposits. Time deposits maturing greater than one year is
      $26,678,000 or 24.2% of total time deposits. Interest-bearing accounts, other
      than CDs, decreased $3,523,000 in the first nine months of 2006. Noninterest
      bearing deposits increased $907,000 for the nine months ended September 30,
      2006. The weighted average cost of all deposit accounts during the first nine
      months of 2006 was 3.10% compared to 2.18% for the same period in
      2005.




Total
      shareholders’ equity increased $2,111,000, to $16,282,000 at September 30, 2006,
      from $14,171,000 at December 31, 2005. This increase was due to the Company’s
      net income of $1,679,000 for the first nine months of 2006 along with a net
      decrease in unrealized losses on securities available for sale of $139,000
      net
      of tax. Stock options totaling $266,000 were exercised during the year. There
      was a $36,000 increase in additional paid in capital related to stock option
      compensation according to FASB 123R.  The 5% stock dividend declared on
      May 18, 2006 resulted in $9,000 paid for fractional
      shares.




As
      of
      September 30, 2006 the Bank is categorized as well capitalized under the
      regulatory framework for prompt corrective action. The total capital to
      risk-weighted assets ratio was 13.15%. Tier-1 to risk-weighted assets ratio
      was
      11.92% and Tier-1 to average asset ratio was 10.19%.









12


**RESULTS
      OF OPERATIONS**




For
      the
      first nine months of 2006, net income after tax was $1,679,000, compared to
      $1,401,000 for the same period in 2005, an increase of 19.8%. The increase
      in
      earnings over the previous year was primarily a result of the increase in net
      interest income as a result of the overall growth of the Company. Net interest
      income before the provision for loan losses for the first nine months of 2006
      was $5,473,000, an increase of $781,000 or 16.6% from $4,692,000 for the first
      nine months of 2005. The net interest margin for September 30, 2006 was 3.93%,
      compared to September 30, 2005 at 3.88%.




Interest
      and fee income on loans for the first nine months of 2006 was $8,565,000, an
      increase of $2,063,000 or 31.7% from $6,502,000 for the nine months ended
      September 30, 2005. The increase in interest and fee income on loans is
      primarily due to increased volume in commercial loans as well as construction
      and commercial real estate loans along with the increase in rates following
      the
      Federal Reserve’s efforts to increase short term rates. The yield on all loans
      increased 100 basis points to 7.48% at September 30, 2006 compared to 6.48%
      at
      September 30, 2005. Total loans outstanding at September 30, 2006 were
      $161,192,000 compared to $151,131,000 at September 30, 2005.




Interest
      income from securities and short-term funds totaled $1,112,000 for the first
      nine months of 2006, an increase of $355,000 over the same period of 2005.
      The
      increase in 2006 was due to an increase in the average dollar amount of
      securities and short-term funds outstanding; $33,814,000 at September 30, 2006
      compared to $27,536,000 at September 30, 2005 and the increase in short term
      rates. The yield on securities and short-term funds increased to 4.37% at
      September 30, 2006 compared to 3.65% at September 30, 2005.




Interest
      expense totaled $4,204,000 in the first nine months of 2006, compared to
      $2,567,000 for the same period of 2005. The increase in interest expense in
      2006
      was due to the significant growth of deposits and an increase in short term
      rates. The Company’s cost of funds increased to 3.10% at September 30, 2006
      compared to 2.18% at September 30, 2005. Total deposits outstanding at September
      30, 2006 were $179,204,000 compared to $165,448,000 at September 30,
      2005.




The
      Company’s yield on earning assets has increased to 6.92%, for the first nine
      months of 2006 compared to 6.0% for the same period of 2005. The cost of
      interest-bearing funds has followed the same trend, increasing to 3.62% for
      the
      first nine months of 2006, up from 2.60% for the nine months ended September
      30,
      2005. The Company’s net interest margin for the first nine months of 2006 was
      3.93% as compared to September 30, 2005 at 3.88%. See interest rate
      sensitivity for further discussion.




The
      allowance for loan losses is maintained by management at a level considered
      adequate to cover probable incurred losses in the Company’s loan portfolio.
      Management’s determination of the appropriate level of the provision for loan
      losses and the adequacy of the allowance for loan losses is based, in part,
      on
      the consideration of loss histories of other similar community financial
      institutions which management believes are representative of the probable
      expected loss experience of the Company. Other factors considered by management
      include the composition of the loan portfolio, current economic conditions,
      the
      creditworthiness of the Company’s borrowers and other related factors. For the
      nine months ended September 30, 2006, the Company provided $435,000 for loan
      losses compared to $298,000 for the same period of 2005. The net charge-offs
      for
      the first nine months of 2006 were $251,000 compared to $52,000 for the same
      period in 2005. This compares to net chargeoffs of $61,000 and $101,000 for
      the
      years ended December 31, 2005 and 2004.  The $251,000 net chargeoffs for
      2006 includes one loan for $192,000.  Management believes that the level of
      net chargeoffs for the nine months ended September 30, 2006 will not be
      sustained for the entire year. At September 30, 2006, the Company had six loans
      totaling $797,000 in nonaccrual status.  The $797,000 primarily consists of
      one customer totaling $788,000.  This compares with December 31, 2005,
      where there were two loans totaling $27,000 in nonaccrual. At September 30,
      2006
      two loans totaling $17,000 are more than 90 days delinquent. At September 30,
      2006, the allowance for loan losses was 1.38% compared to 1.35% at
      December 31, 2005.  Based on historical low chargeoff levels
      (five year average is .07%) the level of allowance relative to total loans
      is
      warranted and is reflected in the allowance for September 30, 2006 and the
      provision for the nine months then ended.





13




Total
      noninterest income for the first nine months of 2006 was $1,741,000 compared
      to
      $1,496,000 for the same period in 2005. The largest single source of noninterest
      income is service charges on deposit accounts. Service charges on deposits
      totaled $815,000 in 2006 compared to $987,000 in 2005. The decrease is due
      primarily to lower NSF and overdraft protection fee income realized during
      the
      period. Mortgage banking income was $512,000 for the nine months ended September
      30, 2006 compared to $313,000 for the same period in 2005. For the nine months
      ended September 30, 2006, the Company originated for subsequent sale, 146 loans
      for $22,446,000 compared to 138 loans for $19,406,000 for the same period in
      2005. The average loan closed increased $13,000 to $154,000 from $141,000 in
      the
      previous year. Net securities gains or losses reflected a gain of $196,000
      in
      2006 compared to a loss of $6,000 in 2005. Other service charges, commissions
      and fees were $218,000 as of September 30, 2006 as compared to $202,000 for
      the
      same period in 2005. This includes safe deposit box rent, ATM interchange and
      surcharges, credit card interchange income, and the sale of checks to
      depositors.




Noninterest
      expenses were $4,254,000 for the first nine months of 2006 compared with
      $3,779,000 for the same period of 2005; an increase of $475,000 or 12.6%. The
      increase in noninterest expenses in the first nine months of 2006 is
      attributable primarily to the increase in salaries and benefits expense; an
      increase of $360,000 or 18.8% compared to 2005, and occupancy expense which
      increased $31,000 or 11.8%.




As
      of
      September 30, 2006, the Company had 56 full-time equivalent employees compared
      to 43 for the same period of 2005.  Mortgage commissions total $110,000 for
      2006 as compared to $91,000 for 2005. There was an additional $36,000 charge
      for
      stock option compensation as required by FASB 123R in 2006 compared to no charge
      in 2005.  The increased staff includes two highly compensated positions
      that were added during 2005; senior commercial lender (May) and human resources
      director (August) accounts for $74,000 of the increase.  Employee incentive
      programs increased $42,000 at September 30, 2006 over the prior
      year.




The
      increase in occupancy expense was due to increases in property taxes of $9,900,
      utilities $8,100, janitorial $9,900, and grounds maintenance
      $3,100.




Other
      operating expenses had a slight increase of $84,000 in the first nine months
      of
      2006 as compared to the same period in 2005.  With the growth of the
      Company there were increases in some areas such as marketing $57,000, ATM
      $34,000, supplies $8,000, telephone $3,000, dues/subscriptions $12,000, data
      processing $18,000, and human resources $11,000. The increases were offset
      with
      decreases in other areas such as accounting, audit and consulting fees totaling
      $59,000.




The
      Company recorded income tax expense of $846,000 for the period ended September
      30, 2006 compared to $710,000 for the same period in 2005. The effective tax
      rate for the nine months ended September 30, 2006 is 33.5% compared to 33.6%
      for
      the same period ended 2005.




**LIQUIDITY
      AND CAPITAL RESOURCES**




Liquidity
      refers to the Company’s ability to fund loan demand, meet deposit customers’
withdrawal needs and provide for operating expenses. As summarized in the
      Statement of Cash Flows, the Company’s main source of cash flow is from
      receiving deposits from its customers, and to a lesser extent, repayment of
      loan
      principal and interest income on loans and investments. The primary uses of
      cash
      are lending to the Company’s borrowers, and investing in securities and
      short-term interest-earning assets.




In
      the
      first nine months of 2006, deposit growth has exceeded loan growth; however,
      this is more of a timing issue and is not expected to continue. Other potential
      sources of liquidity include the sale of available-for-sale securities from
      the
      Company’s portfolio, the sale of loans, the purchase of federal funds, or
      repurchase agreements. The Company currently has $21,028,000 in brokered
      certificates of deposit, compared to $19,263,000 at December 31,
      2005.







14




At
      September 30, 2006 and December 31, 2005, the Bank’s risk-based capital ratios
      and the minimums to be considered well-capitalized under the Federal Reserve
      Board’s prompt corrective action guidelines were as follows:








**September
                30, 2006**
            
            **Dec. 31, 2005**
            
            **Well-**
              **capitalized**Tier
                1 capital to risk-weighted assets
            
            11.92
            %
            11.80
            %
            6.0
            %Total
                capital to risk-weighted assets
            
            13.15
            %
            13.04
            %
            10.0
            %Tier
                1 leverage ratio
            
            10.19
            %
            10.38
            %
            5.0
            %






As
      discussed above, total shareholders’ equity increased $2,111,000, to $16,282,000
      at September 30, 2006 from $14,171,000 at December 31, 2005. This increase
      was
      due to the Company’s net income of $1,679,000 for the first nine months of 2006
      along with a net decrease in unrealized losses on securities available for
      sale
      of $139,000, net of tax. Stock options totaling $266,000 were exercised during
      the year. There was a $36,000 increase in additional paid in capital related
      to
      stock option compensation according to FASB 123R.  The 5% stock dividend
      declared on May 18, 2006 resulted in $9,000 paid for fractional
      share.




The
      payment of dividends by the Company depends to a great extent on the ability
      of
      the Bank to pay dividends to the Company. The Company is subject to the
      Tennessee Banking Act, which provides that the Bank may not declare dividends
      in
      any calendar year that exceeds the total of its net income of that year combined
      with its retained net income of the preceding two years without the approval
      of
      the TDFI. Thereafter, 10% of net profits must be transferred to capital surplus
      prior to payment of dividends until capital surplus equals capital stock. The
      Bank is also subject to the minimum capital requirements of the FDIC which
      impact the Bank’s ability to pay dividends. If the Bank fails to meet these
      standards, it may not be able to pay dividends or to accept additional deposits
      because of regulatory requirements.




If,
      in
      the opinion of the applicable federal bank regulatory authority, a depository
      institution is engaged in or is about to engage in an unsafe or unsound practice
      (which, depending on the financial condition of the depository institution,
      could include the payment of dividends), such authority may require that such
      institution cease and desist from such practice. The federal banking agencies
      have indicated that paying dividends that deplete a depository institution’s
      capital base to an inadequate level would be such an unsafe and unsound banking
      practice. Moreover, the Federal Reserve Board, the Comptroller of the Currency
      and the FDIC have issued policy statements which provide that bank holding
      companies and insured depository institutions generally should only pay
      dividends out of current earnings.




**INTEREST
      RATE SENSITIVITY**




Financial
      institutions are subject to interest rate risk to the degree that their
      interest-bearing liabilities (consisting principally of customer deposits)
      mature or reprice more or less frequently than their interest-earning assets
      (generally consisting of loans and investment securities). The match between
      the
      scheduled repricing and maturities of earning assets and liabilities within
      defined time periods is referred to as “gap” analysis. At September 30, 2006 the
      cumulative one-year gap was a negative (or liability sensitive) $14,798 or
      7.7%
      of earning assets compared to an evenly matched or slightly negative gap of
      $71,000 or .1% of earning assets at December 31, 2005.




One
      of
      management’s objectives in managing the Company’s balance sheet for interest
      rate sensitivity is to reduce volatility in the net interest margin by matching,
      as closely as possible, the timing of the repricing of its interest rate
      sensitive assets with interest rate sensitive liabilities. During the first
      nine
      monts of 2006 the Company experienced four rate increases after eight such
      increases during 2005. Management believes that interest rates will level off
      and possibly decline within the next two years. The Company’s strategy of being
      in a slight negative one year gap position should result in stable net interest
      margin as rates level off or decline. The Company had maintained a positive
      gap
      for most of 2005 and moved to a balanced or slightly negative position during
      the fourth quarter of 2005. This position into the third quarter of 2006 was
      significant in improving the net interest margin to 3.93% compared to 3.89%
      at
      December 31, 2005. Many of the Company’s loans are commercial real estate loans
      with rates that are tied to New York Prime or that are fixed for up to three
      years, and this strategy allows the Company to match longer-term funding with
      these loans, thus minimizing volatility in the net interest margin.




**OFF-BALANCE
      SHEET ARRANGEMENTS**




We
      are a
      party to financial instruments with off-balance sheet risk in the normal course
      of business to meet the financing needs of its consumers.  At September 30,
      2006, we had unfunded loan commitments outstanding of $34.5 million and standby
      letters of credit of $2.6 million.  These financial instruments include
      commitments to extend credit and standby letters of credit.  Those
      instruments involve, to varying degrees, elements of credit risk in excess
      of
      the amount recognized in the balance sheet.  The contract or notional
      amounts of those instruments reflect the extent of our involvement in those
      particular financial instruments.  We use the same credit policies in
      making commitments and conditional obligations as it does for on-balance sheet
      instruments.




Because
      these commitments generally have fixed expiration dates and many will expire
      without being drawn upon, the total commitment level does not necessarily
      represent future cash requirements.  If needed, we can liquidate Federal
      funds sold or securities available for sale or borrow and purchase Federal
      funds
      from other financial institutions where we have available federal funds lines
      totaling $10.9 million.









15





**Item
      3. Controls and Procedures**




As
      of
      September 30, 2006, an evaluation was carried out under the supervision and
      with
      the participation of the registrant’s management, including our President and
      Chief Financial Officer, of the effectiveness of our disclosure controls and
      procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
      Exchange Act of 1934 (the “Exchange Act”)). Based on their evaluation, our
      President and Chief Financial Officer have concluded that the registrant’s
      disclosure controls and procedures are effective to ensure that information
      required to be disclosed by the registrant in reports that it files or submits
      under the Exchange Act is recorded, processed, summarized and reported within
      the time periods specified in Securities and Exchange Commission rules and
      forms.




There
      have been no changes in the registrant’s internal controls over financial
      reporting or in other factors that has materially affected, or is reasonably
      likely to materially affect, the registrant’s internal control over financial
      reporting.









16




**PART
      II - OTHER INFORMATION**




**Item
      1. Legal Proceedings**




None




**Item
      2. Unregistered Sales of Equity Securities and Use of
      Proceeds**




(a)  Shares
      of
      the Company’s common stock were issued to Employees pursuant to the Company’s
      Stock Option Plan as follows:








**Date of Sale**
            
            **Number of Shares of**
              **Common Stock Sold**
            
            **Price Per Share**September
                16, 2006
            
            25,671
            
            $
            9.07September
                16, 2006
            
            220
            
            $
            16.33






The
      aggregate proceeds of the shares sold were $236,429.




There
      were no underwriters and no underwriting discounts or commissions. All sales
      were for cash.




The
      Company believes that an exemption from registration of these shares was
      available to the Company in that the issuance thereof did not constitute a
      public offering of securities within the meaning of the Securities Act of 1933,
      as amended. The Company relied on the exemption provided by Section 4(2) of
      the
      Securities Act of 1933.




The
      common stock is not convertible or exchangeable into other equity
      securities.




The
      proceeds of the sales are being used by the Company for general corporate
      purposes.




(b)  Not
      applicable.




(c)  No
      repurchases for our securities were made during the quarter ended September
      30,
      2006.









17









**Item
      3. Default Upon Senior Securities**




None




**Item
      4. Submission of Matters to a Vote of Security Holders**




None






**Item
      5. Other Information**




None




**Item
      6. Exhibits**




31.1  Rule
      13a-14(a)/15d-15(e) Certification of the President.


31.2  Rule
      13a-14(a)/15d-15(e) Certification of the Chief Financial Officer.




32.1  Section
      1350 Certification of the President.


32.2  Section
      1350 Certification of the Chief Financial Officer.











18









**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**FORM
      10-QSB**




Quarter
      ended September 30, 2006




**SIGNATURES**




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








Southern
                Heritage Bancshares, Inc.(Registrant)Nov
                10, 2006
            
            /s/
                J. Lee Stewart(Date)
            
            J.
                Lee StewartPresidentNov
                10, 2006
            
            /s/
                Steven W. Ledbetter(Date)
            
            Steven
                W. Ledbetter,Chief
                Financial Officer


































19