**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**




**FORM 10-Q**




**QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**


**SECURITIES
      EXCHANGE ACT OF 1934**




**FOR
      THE QUARTERLY PERIOD ENDED JUNE 30, 2007**





**Commission
      File Number 000-50921**




**SOUTHERN
      HERITAGE BANCSHARES, INC.**


(Exact
      Name of Registrant As Specified in Its Charter)




**Tennessee**
            
            42-1627829(State
                or Other Jurisdiction of
            
            (IRS
                Employer Identification No.)Incorporation
                or Organization)


3020
      Keith Street, NW


Cleveland,
      Tennessee  37312


(Address
      of Principal Executive Offices and Zip Code)





(423)
      473-7980


(Registrant’s
      Telephone Number, Including Area Code)




**Not
      Applicable**


(Former
      name, former address and former fiscal year if changes since last
      report)




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 o




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
      (Check one):




Large
                Accelerated Filer o
            Accelerated
                Filer o
            Non-accelerated
                Filer x




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


Yes
o  
                       
   No x




As
      of
      July 31, 2007 there were 1,224,389 shares of common stock issued and
      outstanding.



















**Southern
      Heritage Bancshares, Inc.**




**Table
      of Contents**







**PART
                I:  FINANCIAL INFORMATION**
            3ITEM
                1:  FINANCIAL
                STATEMENTS
            3ITEM
                2:  MANAGEMENT’S
                DISCUSSION AND ANALYSIS OF FINANCIAL
              CONDITION
                AND RESULTS OF OPERATIONS
            12ITEM
                3:  QUANTITATIVE
                AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
            16ITEM
                4:  CONTROLS AND
                PROCEDURES
            18**PART
                II:  OTHER INFORMATION**
            19ITEM
                1:  LEGAL
                PROCEEDINGS
            19ITEM
                1A:  RISK
                FACTORS
            19ITEM
                2:  UNREGISTERED
                SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
            22ITEM
                3:  DEFAULTS UPON
                SENIOR SECURITIES
            22ITEM
                4:  SUBMISSION OF
                MATTERS TO A VOTE OF SECURITY HOLDERS
            22ITEM
                5:  OTHER
                INFORMATION
            23ITEM
                6:  EXHIBITS
            23SIGNATURES
            24


























2





**PART
      I – FINANCIAL INFORMATION**




**ITEM
      1. FINANCIAL STATEMENTS**




**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Consolidated
      Balance Sheets**


**June
      30, 2007**




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




**June
                30,**
              **2007**
            
            
            **December 31,**
              **2006*****Assets***Cash
                and due from banks
            
            $
            5,697
            
            
            
            5,165Federal
                funds sold
            
            
            10,992
            
            
            
            12,288***Cash
                and cash equivalents***
            
            
            16,689
            
            
            
            17,453Securities
                available-for-sale, at fair value
            
            
            40,575
            
            
            
            28,746Mortgage
                loans held for sale
            
            
            1,174
            
            
            
            2,538Loans
            
            
            154,022
            
            
            
            162,114Allowance
                for loan losses
            
            
            (4,307
            )
            
            
            (1,971
            )***Loans,
                net***
            
            
            149,715
            
            
            
            160,143Premises
                and equipment
            
            
            5,187
            
            
            
            5,177Restricted
                stock
            
            
            830
            
            
            
            830Accrued
                income receivable
            
            
            974
            
            
            
            1,043Other
                assets
            
            
            3,282
            
            
            
            2,254$
            218,426
            
            
            
            218,184***Liabilities
                and Shareholders’ Equity*****Liabilities:****Deposits:**Noninterest-bearing
            
            $
            30,486
            
            
            
            26,265Interest-bearing
            
            
            164,948
            
            
            
            164,758***Total
                deposits***
            
            
            195,434
            
            
            
            191,023Repurchase
                agreements
            
            
            537
            
            
            
            332FHLB
                advance
            
            
            0
            
            
            
            3,000Accrued
                interest payable
            
            
            1,519
            
            
            
            1,494Subordinated
                debentures
            
            
            5,155
            
            
            
            5,155Other
                liabilities
            
            
            320
            
            
            
            270***Total
                liabilities***
            
            
            202,965
            
            
            
            201,274**Shareholders’
                equity:**Preferred
                stock, no par value. Authorized 1,000,000 shares; none
                issued
            
            
            -
            
            
            
            —Common
                stock, $1 par value. Authorized 2,000,000 shares; 1,224,389 shares
                issued
                at
              June 30, 2007 and 1,164,996 at Dec 31, 2006
            
            
            1,224
            
            
            
            1,164Additional
                paid-in-capital
            
            
            15,403
            
            
            
            13,074Retained
                earnings (deficit)
            
            
            (163
            )
            
            
            2,885Accumulated
                other comprehensive loss
            
            
            (1,003
            )
            
            
            (213
            )***Total
                shareholders’ equity***
            
            
            15,461
            
            
            
            16,910$
            218,426
            
            
            
            218,184


See
      accompanying notes to consolidated
      financial statements.









3







**SOUTHERN
      HERITAGE BANCHARES, INC.**


**Consolidated
      Statements of Operations**


**Six
      Months Ended June 30**




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




Three
                Months Ended June 30
            
            
            Six
                Months Ended June 30**2007**
            
            
            2006
            
            
            **2007**
            
            
            2006**Interest
                income:**Loans,
                including fees
            
            **$**
            **2,952**
            
            
            
            2,839
            
            
            **$**
            **6,073**
            
            
            
            5,485Securities
            
            ****
            **407**
            
            
            
            273
            
            
            ****
            **747**
            
            
            
            515Federal
                funds sold
            
            ****
            **202**
            
            
            
            95
            
            
            ****
            **407**
            
            
            
            175***Total
                interest income***
            
            ****
            **3,561**
            
            
            
            3,207
            
            
            ****
            **7,227**
            
            
            
            6,175**Interest
                expense:**Deposits
            
            ****
            **1,821**
            
            
            
            1,274
            
            
            ****
            **3,606**
            
            
            
            2,390Other
                borrowed funds
            
            ****
            **103**
            
            
            
            96
            
            
            ****
            **215**
            
            
            
            183***Total
                interest expense***
            
            ****
            **1,924**
            
            
            
            1,370
            
            
            ****
            **3,821**
            
            
            
            2,573***Net
                interest income***
            
            ****
            **1,637**
            
            
            
            1,837
            
            
            ****
            **3,406**
            
            
            
            3,602**Provision
                for loan losses**
            
            ****
            **2,414**
            
            
            
            117
            
            
            ****
            **2,440**
            
            
            
            168***Net
                interest income/(expense) after provision***
              ***for loan losses***
            
            ****
            **(777**
            **)**
            
            
            1,720
            
            
            ****
            **966**
            
            
            
            3,434**Noninterest
                income:**Service
                charges on deposit accounts
            
            ****
            **232**
            
            
            
            275
            
            
            ****
            **435**
            
            
            
            554Mortgage
                banking activities
            
            ****
            **179**
            
            
            
            204
            
            
            ****
            **319**
            
            
            
            347Gain
                (loss) on sale of securities
            
            ****
            **(1**
            **)**
            
            
            3
            
            
            ****
            **3**
            
            
            
            13Other
                service charges, commissions and fees
            
            ****
            **129**
            
            
            
            76
            
            
            ****
            **235**
            
            
            
            156***Total
                noninterest income***
            
            ****
            **539**
            
            
            
            558
            
            
            ****
            **992**
            
            
            
            1,070**Noninterest
                expenses:**Salaries
                and employee benefits
            
            ****
            **786**
            
            
            
            768
            
            
            ****
            **1,603**
            
            
            
            1,484Occupancy
                expense
            
            ****
            **102**
            
            
            
            98
            
            
            ****
            **198**
            
            
            
            192Other
                operating expenses
            
            ****
            **799**
            
            
            
            581
            
            
            ****
            **1,479**
            
            
            
            1,123***Total
                noninterest expenses***
            
            ****
            **1,687**
            
            
            
            1,447
            
            
            ****
            **3,280**
            
            
            
            2,799***Income
                (loss)  before income taxes***
            
            ****
            **(1,925**
            **)**
            
            
            831
            
            
            ****
            **(1,322**
            **)**
            
            
            1,705**Income
                tax expense (benefit)**
            
            ****
            **(795**
            **)**
            
            
            283
            
            
            ****
            **(619**
            **)**
            
            
            581***Net
                income (loss)***
            
            ****
            **(1,130**
            **)**
            
            
            548
            
            
            ****
            **(703**
            **)**
            
            
            1,124**Other
                comprehensive income (loss):**Unrealized
                gains/losses on securities
            
            ****
            **(1,009**
            **)**
            
            
            (150
            )
            
            ****
            **(1,003**
            **)**
            
            
            (511
            )**Comprehensive
                income (loss)**
            
            ****
            **(2,139**
            **)**
            
            
            398
            
            
            ****
            **(1,706**
            **)**
            
            
            613Basic
                earnings (loss) per share
            
            **$**
            **(0.92**
            **)**
            
            $
            0.46
            
            
            **$**
            **(0.57**
            **)**
            
            $
            0.94Diluted
                earnings (loss) per share
            
            **$**
            **(0.92**
            **)**
            
            $
            0.43
            
            
            **$**
            **(0.57**
            **)**
            
            $
            0.87Shares
                used in computation of earnings per shareBasic
            
            ****
            **1,223,384**
            
            
            
            1,196,446
            
            
            ****
            **1,223,138**
            
            
            
            1,195,932Diluted
            
            ****
            **1,223,384**
            
            
            
            1,288,894
            
            
            ****
            **1,223,138**
            
            
            
            1,288,380


See
      accompanying notes to consolidated
      financial statements.








4









**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Consolidated
      Statements of Cash Flows**


**Six
      Months Ended June 30**




*($
      amounts in thousands)*




2007
              
              2006Cash
                  flows from operating activitiesNet
                  income (loss)
              $
              
              (703
              )    $
              
              1,124Adjustments
                  to reconcile net income to net cash from operating
                  activitiesProvision
                  for loan losses
              
              2,440
              
              168Depreciation
                  and amortization
              
              268
              
              199Investment
                  securities (gains) losses
              
              (3
              )
              (13
              )Mortgage
                  loans originated for sale
              
              (13,924
              )
              (15,651
              )Proceeds
                  from sale of mortgage loans
              
              15,607
              
              14,724Gains
                  on sales of mortgage loans
              
              (319
              )
              (347
              )Loss
                  on sale of other real estate
              
              45
              
              -Stock
                  compensation expense
              
              25
              
              24Tax
                  benefit from the exercise of stock options
              
              (13
              )Changes
                  in operating assets and liabilities:(Increase)
                  decrease in accrued interest receivable
              
              69
              
              55Increase
                  (decrease) in accrued interest payable
              
              25
              
              (120
              )Other,
                  net
              
              (730
              )
              (33
              )Net
                  cash provided by (used in) operating activities
              
              2,787
              
              130Cash
                  flows from investing activitiesProceeds
                  from maturities and redemptions of securities available for
                  sale
              
              601
              
              529Proceeds
                  from sales of securities available for sale
              
              1,126
              
              3,171Purchases
                  of securities available for sale
              
              (14,785
              )
              (5,294
              )Purchases
                  of restricted equity securities
              
              -
              
              (4
              )Net
                  decrease (increase) in loans
              
              7,367
              
              (4,922
              )Proceeds
                  from sale of other real estate
              
              748
              
              -Net
                  purchases of premises and equipment
              
              (243
              )
              (184
              )Net
                  cash (used in) provided by investing activities
              
              (5,186
              )
              (6,704
              )Cash
                  flows from financing activitiesIncrease
                  in repurchase agreements and federal funds purchased
              
              205
              
              46(Decrease)
                  increase in Federal Home Loan Bank Advances
              
              (3,000
              )
              3,000Proceeds
                  from exercise of stock options
              
              20
              
              29Tax
                  Benefit from the exercise of stock options
              
              13
              
              -Dividends
                  Paid
              
              (14
              )
              (9
              )Net
                  increase in deposits
              
              4,411
              
              7,075Net
                  cash provided by financing activities
              
              1,635
              
              10,141Net
                  increase (decrease) in cash and cash equivalents
              
              (764
              )
              3,567Cash
                  and cash equivalents at beginning of period
              
              17,453
              
              7,078Cash
                  and cash equivalents at end of period
              $
              16,689
              $
              10,645Supplemental
                disclosures of cash flow informationCash
                paid during period for:Interest
              $
              3,796
              $
              2,453Income
                  Taxes
              
              57
              
              697Loans
                transferred to other real estate acquired through foreclosure
              
              621
              
              -




See
      accompanying notes to consolidated
      financial statements.









5









**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Notes
      to Consolidated Financial Statements**


**June
      30, 2007**




*Basis
      of Presentation*




The
      accompanying financial statements have been prepared in accordance with
      generally accepted accounting principles for interim financial information
      and
      with the instructions to Form 10-Q. Accordingly they do not include all
      information and footnotes required by generally accepted accounting principles
      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 June
      30,
      2007, the results of operations for the six months ended June 30, 2007, and
      cash
      flows for the six months ended June 30, 2007. The interim financial statements
      should be read in conjunction with the notes to the financial statements
      presented in the Bank’s December 31, 2006, 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:




**Six Months**
              **Ended**
              **June
                30, 2007**
            
            
            **Six Months**
              **Ended**
              **June
                30, 2006****(In Thousands)**
            
            
            **(In Thousands)**Balance
                January 1
            
            $
            1,971
            
            
            $
            2,036Add
                (deduct):Losses
                charged to allowance
            
            
            (131
            )
            
            
            (259
            )Recoveries
                credited to allowance
            
            
            27
            
            
            
            17Provision
                for loan losses
            
            
            2,440
            
            
            
            168Balance
                June 30
            
            $
            4,307
            
            
            $
            1,962


























6







**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Notes
      to Consolidated Financial Statements**


**June
      30, 2007**






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****June
                30,**
              **2007**
            
            
            **December 31,**
              **2006**Domestic:
            
            **($ in thousands)**Commercial,
                financial and agricultural
            
            $
            51,262
            
            
            $
            53,953Real
                estate - construction
            
            
            27,092
            
            
            
            28,464Real
                estate - family residential
            
            
            24,120
            
            
            
            24,835Real
                estate - commercial
            
            
            46,199
            
            
            
            49,996Consumer
            
            
            5,349
            
            
            
            4,866Total
                loans
            
            
            154,022
            
            
            
            162,114Allowance
                for loan losses
            
            
            (4,307
            )
            
            
            (1,971
            )Total
                (net of allowance)
            
            $
            149,715
            
            
            $
            160,143










The
      following table presents information regarding nonaccrual, past due,
      restructured loans and internally classified substandard or doubtful loans
      at
      the dates indicated:




**As of****June
                30,**
              **2007**
            
            **December 31,**
              **2006****($ in thousands)**Loans
                accounted for on a non-accrual basis:Number
            
            8
            
            3Amount
            
            $
            4,793
            
            
            250Accruing
                loans (including consumer loans) which are contractually past due
                90 days
                or
              more as to principal and interest payments:Number
            
            0
            
            6Amount
            
            $
            0
            
            293Loans
                internally classified as substandard or doubtfulNumber
            
            
            27
            
            25Amount
            
            $
            11,736
            
            6,376






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.  The increase in the allowance for loan losses relates solely
      to a group of loans to borrowers controlled by one guarantor that totaled
      approximately $6.7 million in the aggregate.  An extensive review and
      analysis of the loans and their collateral in order to determine their level
      of
      impairment and possible loss was performed.  Based on this review the
      Company increased its allowance for loan losses through an additional
      provision of approximately $2.5 million.









7






As
      of
      June 30, 2007, there are no loans classified for regulatory purposes as doubtful
      or substandard that have not been disclosed in the above table, which (i)
      represent or result from trends or uncertainties which management reasonably
      expects will materially impact future operating results, liquidity, or capital
      resources, or (ii) represent material credits about which management is aware
      of
      any information which causes management to have serious doubts as to the ability
      of such borrowers to comply with the loan repayment terms.




*Stock
      Dividend*




The
      Company declared a stock dividend of one share for each 20 shares owned for
      shareholders of record as of May 17, 2007.  The effect of this stock
      dividend has been reflected in earnings per share and shares used in the
      computation of earnings per share for all periods presented.




*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 2007.






































8









**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Notes
      to Consolidated Financial Statements**


**June
      30, 2007**






A
      summary
      of option activity under the Plan as of June 30, 2007, and changes during the
      six 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, 2007
            
            131,813
            
            $
            11.33Granted
            
            -
            
            -Exercised
            
            1,500
            
            13.45Forfeited
            
            -
            
            -Outstanding
                at June 30, 2007
            
            130,313
            
            $
            11.31
            
            4.83
            
            $
            2,265Exercisable
                at June 30, 2007
            
            42,932
            
            $
            10.06
            
            3.46
            
            $
            853














































9









**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Notes
      to Consolidated Financial Statements**


**June
      30, 2007**








As
      of
      June 30, 2007, there was $218,270 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
      no
      shares have vested in 2007. However, the compensation cost is recorded on a
      prorata basis over the entire vesting period resulting in total compensation
      cost of $25,000 for the six months ended June 30, 2007 and $24,000 for the
      same
      period ended June 30, 2006, based on the fair value of the options.




There
      were 1,500 options exercised during the six months ended June 30,
      2007.












2007
            
            2006Intrinsic
                value of options exercised
            
            $
            39,821
            
            $
            58,817Cash
                received from option exercises
            
            20,179
            
            29,300Tax
                benefit realized from option exercises
            
            13,539
            
            -Weighted
                average fair value of options granted
            
            -
            
            -































10









**SOUTHERN
      HERITAGE BANCSHARES, INC.**


**Notes
      to Consolidated Financial Statements**


**June
      30, 2007**








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. Due to the loss for the three
      months and six months ended June 30, 2007 diluted earnings per share is not
      relevant. The effect of these options on earnings per common share was to
      increase average shares outstanding by 92,448 in 2006 and to decrease earnings
      per share by  $.07 for the six months ended June 30, 2006. No shares
      were antidilutive at June 30, 2006.




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 adopted the provisions of FASB Interpretation No. 48, Accounting for
      Uncertainty in Income Taxes (“FIN 48”), on January 1, 2007, and determined there
      was no need to make an adjustment to retained earnings due to adoption of this
      Interpretation.  The Company has no unrecognized tax benefits and does
      not anticipate any increase in unrecognized benefits during 2007 relative to
      any
      tax positions taken prior to January 1, 2007.  Should the accrual of
      any interest or penalties relative to unrecognized tax benefits be necessary,
      it
      is the Company’s policy to record such accruals in its income taxes accounts; no
      such accruals exist as of January 1, 2007.  The Company and its
      subsidiary file a consolidated U.S. federal income tax return and a combined
      unitary return in the state of Tennessee.  These returns are subject
      to examination by taxing authorities for all years after 2002.




In
      September 2006, the FASB issued Statement No. 157, Fair Value
      Measurements.  This statement defines fair value, establishes a
      framework for measuring fair value and expands disclosures about fair value
      measurements.  This Statement establishes a fair value hierarchy about
      the assumptions used to measure fair value and clarifies assumptions about
      risk
      and the effect of a restriction on the sale or use of an asset.  The
      standard is effective for fiscal years beginning after November 15,
      2007.  The Company has not completed its evaluation of the impact of
      the adoption of this standard.





In
      February 2007 the FASB issued Statement of Financial Accounting Standard(“SFAS”)
      No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.”
SFAS No. 159 permits entities to choose to measure many financial instruments
      and certain other items at fair value with an objective of improving financial
      reporting by providing entities with the opportunity to mitigate volatility
      in
      reported earnings caused by measuring related assets and liabilities differently
      without having to apply complex hedge accounting provisions.  The
      provisions of SFAS No. 159 are effective as of the beginnings of an entity’s
      first fiscal year that begins after November 15, 2007.





In
      addition, recently issued accounting standards that revise the accounting for
      derivatives embedded in other financial instruments and revise the recognitions
      and accounting for servicing of financial assets are effective for 2007 but
      did
      not have a material effect on the financial statements as of and for the six
      months ended June 30, 2007.











11




**ITEM
      2:  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
      RESULTS OFOPERATIONS**




**FORWARD-LOOKING
      STATEMENTS**




Management’s
      discussion about us and management’s analysis of our operations and prospects,
      and other matters, may include forward-looking statements within the meaning
      of
      the Private Securities Litigation Reform Act of 1995 and other provisions of
      federal and state securities laws.  Although we believe that the
      assumptions underlying such forward-looking statements contained in this report
      are reasonable, any of the assumptions could be inaccurate and, accordingly,
      there can be no assurance that the forward-looking statements included herein
      will prove to be accurate.  The use of such words as expect, anticipate,
      forecast, and comparable terms should be understood by the reader to indicate
      that the statement is “forward-looking” and thus subject to change in a manner
      that can be unpredictable.  Factors that could cause actual results to
      differ materially from the results anticipated, but not guaranteed, in this
      report, include (without limitation) economic and social conditions, competition
      for loans, mortgages, and other financial services and products, changes in
      interest rates, unforeseen changes in liquidity, results of operations, and
      financial conditions affecting our customers, as well as other risks that cannot
      be accurately quantified or completely identified.  Many factors affecting
      our financial condition and profitability, including changes in economic
      conditions, the volatility of interest rates, political events and competition
      from other providers of financial services simply cannot be predicted. 
Because these factors are unpredictable and beyond our control, earnings may
      fluctuate from period to period.  The purpose of this type of information
      is to provide readers with information relevant to understanding and assessing
      our financial condition and results of operations, and not to predict the future
      or to guarantee results.  We are unable to predict the types of
      circumstances, conditions, and factors that can cause anticipated results to
      change.  We undertake no obligation to publish revised forward-looking
      statements to reflect the occurrence of changes or unanticipated events,
      circumstances, or results.







**FINANCIAL
      CONDITION**




Total
      assets as of June 30, 2007 increased 0.11%, or $242,000 to $218,426,000 compared
      with $218,184,000 at December 31, 2006.  Cash and cash equivalents
      decreased $764,000 to $16,689,000 at June 30, 2007 from $17,453,000 at December
      31, 2006. Securities increased $11,829,000 to $40,575,000 at June 30, 2007
      compared to $28,746,000 at December 31, 2006.  The decrease
      in loans is primarily a result of pay downs in commercial loans and a slowdown
      in loan demand.  The increase in deposits of, $4,411,000 was used
      primarily to increase the securities portfolio and improve the Company’s
      liquidity position, through increases in cash and federal funds
      sold.




Loans
      are
      the principal component of the Company’s assets and the primary source of
      income. Total loans at June 30, 2007, were $154,022,000 compared to $162,114,000
      at December 31, 2006, a decrease of $8,092,000. The decrease in loans in the
      first six months of 2007 was as follows: construction real estate loans
      decreased $1,372,000, commercial loans secured by real estate decreased
      $3,797,000, commercial loans which decreased $2,691,000 consumer loans increased
      $483,000, and loans secured by family residential real estate decreased
      $715,000.  As of June 30, 2007, $46,199,000 or 30.0% of total loans were
      commercial loans secured by real estate. Commercial loans were $51,262,000
      or
      33.28% of total loans. Loans secured by family residential real estate were
      $24,120,000 or 15.66% of total loans. Construction loans secured by real estate
      were $27,092,000 or 17.59% of total loans. Consumer loans were $5,349,000 or
      3.47% of total loans.  Of the total loans, $97,887,000 or 63.6% mature
      or reprice within 12 months. Only $56,135,000 or 36.4% mature or reprice over
      five years.  Net charge-offs for the first six months of 2007 were
      $104,000 compared to $242,000 for the same period in 2006.  This
      compares to net charge-offs of $847,000 and $83,000 for the years ended December
      31, 2006 and 2005.  At June 30, 2007, the company had eight loans
      totaling $4,793,000 in nonaccrual status.  This compares with December
      31, 2006, where there were three loans totaling $250,000 in
      nonaccrual.  There were 27 loans totaling $11.7million internally
      classified as substandard of doubtful loans at June 30, 2007 compared to 25
      loans totaling $6.3million at June 30, 2007.  At June 30, 2007, the
      ratio of allowance for loan losses to total loans was 2.80% compared to 1.22%
      at
      December 31, 2006.




There
      was
      $1,174,000 in mortgage loans held for sale at June 30, 2007, compared with
      $2,538,000 at December 31, 2006. The decrease in mortgage loans held for sale
      was primarily due to timing issues related to secondary market investor
      funding.













12




Management
      anticipates that loan demand will be moderate in the near future. Excluding
      mortgage loans held for sale; the loan-to-deposit ratio as of June 30, 2007,
      was
      78.8%, compared to 84.9% at December 31, 2006, and the loan-to-assets ratio
      was
      70.5% at June 30, 2007, compared to 74.3% at December 31, 2006. Management
      expects that the loan-to-deposit ratio for the remainder of 2007 will remain
      in
      the range of approximately 75% - 85% and the loans-to-assets ratio will be
      between 70% - 75%.




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 June
      30, 2007, the Company owned $40,575,000 of securities available-for-sale, an
      increase of $11,829,000 or 41.2% compared to $28,746,000 at December 31,
      2006.




Deposits
      which are the Company’s primary source of funds, totaled $195,434,000 at June
      30, 2007, for an increase of $4,411,000, or 2.3%, compared to $191,023,000
      at
      December 31, 2006. Deposits at June 30, 2007 consisted of $30,486,000 or 15.6%
      in non-interest bearing demand deposits, $39,834,000 or 20.4% in
      interest-bearing demand deposits, $117,870,000 or 60.3% in time certificates
      of
      deposit and $7,244,000 or 3.7% in savings accounts. There was $6,445,000 in
      brokered CDs at June 30, 2007 compared to $21,526,000 at December 31, 2006.
      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 $319,000 in the
      first six months of 2007. At June 30, 2007, the weighted average rate on CDs
      was
      5.07% compared to 4.05% for the six months ended June 30, 2006. The Company
      has
      time deposits maturing within one year of $108,524,000 or 92.0% of total time
      deposits. Time deposits maturing greater than one year were $9,346,000 or 8.0%
      of total time deposits. Interest-bearing accounts, other than CDs, decreased
      $57,000 in the first six months of 2007. Noninterest bearing deposits increased
      $4,221,000 for the six months ended June 30, 2007. The weighted average cost
      of
      all deposit accounts during the first six months of 2007 was 3.82% compared
      to
      2.92% for the same period in 2006.




Total
      shareholders’ equity decreased $1,449,000, to $15,461,000 at June 30, 2007, from
      $16,910,000 at December 31, 2006. This decrease was due to the Company’s net
      loss of $703,000 for the first six months of 2007 along with a net increase
      in
      unrealized losses on securities available for sale of $790,000 net of
      tax.  There was $25,000 in additional paid in capital related to stock
      option compensation according to FASB 123R.  Stock options totaling
      $20,000 were exercised during the year and the tax benefit of $13,000 was
      recognized.  The 5% stock dividend declared on May 17, 2007 resulted
      in $14,000 paid for fractional shares.




As
      of
      June 30, 2007 the Bank is categorized as well capitalized under the regulatory
      framework for prompt corrective action. The total capital to risk-weighted
      assets ratio was 12.65%. Tier-1 to risk-weighted assets ratio was 11.39% and
      Tier-1 to average asset ratio was 9.10%.







































13




**RESULTS
      OF OPERATIONS**




For
      the
      first six months of 2007, the Company’s net loss after tax was $703,000,
      compared to net income of $1,124,000 for the same period in 2006. The decrease
      in earnings over the previous year was a result of a substantial increase in
      the
      provision for loan losses, $2,440,000 at June 30, 2007 compared to $168,000
      at
      June 30, 2006 along with a lower loan-to-deposit ratio, 78.8% at June 30, 2007
      compared to 89.1% at June 30, 2006, decrease in interest margin, and an increase
      in personnel and other operating expenses.  Net interest income before
      the provision for loan losses for the first six months of 2007 was $3,406,000,
      a
      decrease of $196,000 from $3,602,000 for the first six months of 2006. The
      net
      interest margin for June 30, 2007 was 3.46%, compared to 3.99% at June 30,
      2006.




Interest
      and fee income on loans for the first six months of 2007 was $6,073,000, an
      increase of $588,000 or 10.72% from $5,485,000 for the six months ended June
      30,
      2006. The increase in interest and fee income on loans is primarily due to
      the
      increased rates. The yield on all loans increased 40 basis points to 7.76%
      for
      the six months ended June 30, 2007 compared to 7.36% for the six months ended
      June 30, 2006. Total loans outstanding at June 30, 2007 were $154,022,000
      compared to $162,114,000 at June 30, 2006.




Interest
      income from securities and short-term funds totaled $1,154,000 for the first
      six
      months of 2007, an increase of $464,000 over the same period of 2006. The
      increase in 2007 was due to an increase in the average dollar amount of
      securities and short-term funds outstanding; $51,567,000 at June 30, 2007
      compared to $41,034,000 at June 30, 2006 and the increase in short term rates.
      The yield on securities and short-term funds increased to 5.23% at June 30,
      2007
      compared to 4.53% at June 30, 2006.




Interest
      expense totaled $3,821,000 in the first six months of 2007, compared to
      $2,573,000 for the same period of 2006. The increase in interest expense in
      2006
      was due to the growth of deposits and an increase in short term rates. The
      Company’s cost of funds increased to 4.29% at June 30, 2007 compared to 3.33% at
      June 30, 2006. Total deposits outstanding at June 30, 2007 were $195,434,000
      compared to $171,023,000 at June 30, 2006.




The
      Company’s yield on earning assets has increased to 7.13%, for the first six
      months of 2007 compared to 6.83% for the same period of 2006. The cost of
      interest-bearing funds has followed the same trend, increasing to 4.39% for
      the
      first six months of 2007, up from 3.45% for the six months ended June 30,
      2006.  The Company’s net interest margin for the first six months of
      2007 was 3.46% as compared to June 30, 2006 at 3.99%.  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 estimates the allowance balance required using
      past loan loss experience, the nature and volume of the portfolio, information
      about specific borrower situations and estimated collateral values, economic
      conditions, and other factors.   The Company provided $2,440,000
      for loan losses in the six months ended June 30, 2007, compared to $168,000
      for
      the same period of 2006.  The substantial increase in the loan loss
      provision for the second quarter and six months ended June 30, 2007 relates
      solely to a group of loans to borrowers controlled by one guarantor that totaled
      approximately $6.7 million in the aggregate.  An extensive review and
      analysis of the loans and their collateral in order to determine their level
      of
      impairment and possible loss was performed.  Based on this review, the
      Company increased its allowance for loan losses through an additional
      provision of approximately $2.5 million. The increase to the provision was
      partially offset by changes in the historical loss factors used in the
      calculation of the overall allowance for loan loss. Although the Company has
      exercised extreme diligence in estimating the impairment on this credit the
      variables involved in the analysis make it difficult to achieve a high level
      of
      precision.  Therefore, the ultimate loss on this credit could be
      significantly different from what the impairment analysis
      indicates.  The increase to the provision was partially offset by
      changes in the historical loss factors used in the calculation of the overall
      allowance for loan loss. The net charge-offs for the first six months of 2007
      were $104,000 compared to $242,000 for the same period in 2006. This compares
      to
      net charge offs of $847,000 and $83,000 for the years ended December 31, 2006
      and 2005.  At June 30, 2007, the Company had eight loans totaling
      $4,793,000 in nonaccrual status.  This compares with December 31, 2006,
      where there were three loans totaling $250,000 in nonaccrual.  There
      were 27 loans totaling $11.7million internally classified as substandard or
      doubtful loans at June 30, 2007 compared to 25 loans totaling $6.3 million
      at
      June 30, 2006.  At June 30, 2007, the ratio of allowance for loan
      losses to total loans was 2.80% compared to 1.22% at
      December 31, 2006.









14




Total
      noninterest income for the first six months of 2007 was $992,000 compared to
      $1,070,000 for the same period in 2006. The largest single source of noninterest
      income is service charges on deposit accounts. Service charges on deposits
      totaled $435,000 in 2007 compared to $554,000 in 2006. Of the $119,000 decrease;
      $107,000 is due primarily to lower NSF and overdraft protection fee
      income.  The remaining $12,000 decrease is due to competitive pressure
      to offer lower fee accounts.   Mortgage banking income was
      $319,000 for the six months ended June 30, 2007 compared to $347,000 for the
      same period in 2006. For the six months ended June 30, 2007, the Company
      originated for subsequent sale, 98 loans for $13,924,000 compared to 99 loans
      for $15,651,000 for the same period in 2006. The average loan closed decreased
      $16,000 to $142,000 from $158,000 in the previous year due to increased activity
      in our specialized government underwriting program.  Net securities
      gains or losses reflected a gain of $3,000 in 2007 compared to a gain of $13,000
      in 2006. Other service charges, commissions and fees were $235,000 as of June
      30, 2007 as compared to $156,000 for the same period in 2006. This includes
      safe
      deposit box rent, ATM interchange and surcharges, credit card interchange
      income, and the sale of checks to depositors.




Noninterest
      expenses were $3,280,000 for the first six months of 2007 compared with
      $2,799,000 for the same period of 2006; an increase of $481,000 or 17.2%. The
      increase in noninterest expenses in the first six months of 2007 is attributable
      primarily to the increase in salaries and benefits expense; an increase of
      $119,000 or 8.0% compared to 2006.  This increase primarily resulted
      from the hiring of additional personnel.  As of June 30, 2007, the
      Company had 55 full-time equivalent employees compared to 50 for the same period
      of 2006. The employee incentive bonus accrual of $37,500 reflected in the first
      quarter was eliminated in the second quarter as a result of the Company’s loss
      for the year.  For the six months ended June 30, 2006, the Company
      accrued $103,000 for incentive bonus compared to nothing in the current
      year.




Other
      operating expenses had an increase of $356,000 in the first six months of 2007
      as compared to the same period in 2006.  With the growth of the Company
      there were increases in some areas such marketing $73,000, data processing
      $60,000, loss recognized on retirement of the Company’s phone system $44,000,
      outside services related to legal audit and accounting $42,000, loan expense
      $33,000, loss on sale of ORE $31,000, ATM expense $21,000, FF&E expense
      $15,000, and supplies $12,000.




The
      Company recorded federal and state income tax benefit of $795,000 and $619,000
      for the three and six months ended June 30, 2007 compared to $283,000 and
      $581,000 expense for the same periods in 2006.  The effective tax rate
      for the three and six months ended 2007 was 47% and 41% compared to 34% and
      34%
      for the same periods ended 2006.  The increased effective tax rate for
      2007 is due to recognition of future state income tax benefit and a carryback
      for federal tax purposes as a result of the loss incurred for the three months
      and six months ended June 30, 2007.  The Company’s average tax free
      securities at June 30, 2007 were $24,749,000 or 68.5% of the portfolio compared
      to $15,377,000 or 62.4% in the prior year.  Tax free income for the
      year was $469,000 compared to $293,000 in the prior year.




The
      above
      discussion compares the financial condition of Southern Heritage Bancshares,
      Inc. (the “Company”) at June 30, 2007, to December 31, 2006, and the results of
      operations for the three and six months ended June 30, 2007 and
      2006.  Reasons for changes except as discussed above are primarily the
      same as those for the year to date results.






**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 six months of 2007, 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 may also meet liquidity needs with
      brokered deposits.  The Company currently has $6,445,000 in brokered
      certificates of deposit, compared to $21,526,000 at December 31,
      2006.







15




At
      June
      30, 2007 and December 31, 2006, 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:




**June
                30, 2007**
            
            **Dec. 31, 2006**
            
            **Well-capitalized**Tier
                1 capital to risk-weighted assets
            
            11.39
            %
            12.26
            %
            6.0
            %Total
                capital to risk-weighted assets
            
            12.65
            %
            13.35
            %
            10.0
            %Tier
                1 leverage ratio
            
            9.10
            %
            10.82
            %
            5.0
            %






As
      discussed above, total shareholders’ equity decreased $1,449,000, to $15,461,000
      at June 30, 2007 from $16,910,000 at December 31, 2006. This decrease was due
      to
      the Company’s net loss of $703,000 for the first six months of 2007 along with a
      net increase in unrealized losses on securities available for sale of $790,000,
      net of tax.  There was $25,000 in additional paid in capital related
      to stock option compensation according to FASB 123R.  Stock options
      totaling $20,000 were exercised during the year and a tax benefit of $13,000
      was
      recognized.  There was $25,000 allocated to additional paid in capital
      related to stock option compensation according to FASB 123R.




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 Tennessee Department of Financial Institutions. 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.  The bank is also subject to state regulations
      restricting the amount of dividends that can be paid.  At June 30,
      2007, the bank could pay approximately $3,200 in dividends under these
      regulations.




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.






**ITEM
      3:  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**







Like
      all
      financial institutions, we are subject to market risk from changes in interest
      rates. Interest rate risk is inherent in the balance sheet due to the mismatch
      between the maturities of rate sensitive assets and rate sensitive liabilities.
      If rates are rising, and the level of rate sensitive liabilities exceeds the
      level of rate sensitive assets, the net interest margin will be negatively
      impacted. Conversely, if rates are falling, and the level of rate sensitive
      liabilities is greater than the level of rate sensitive assets, the impact
      on
      the net interest margin will be favorable. Managing interest rate risk is
      further complicated by the fact that all rates do not change at the same pace,
      in other words, short term rates may be rising while longer term rates remain
      stable. In addition, different types of rate sensitive assets and rate sensitive
      liabilities react differently to changes in rates.












16




To
      manage
      interest rate risk, we must take a position on the expected future trend of
      interest rates. Rates may rise, fall, or remain the same. Our asset liability
      committee develops its view of future rate trends and strives to manage rate
      risk within a targeted range by monitoring economic indicators, examining the
      views of economists and other experts, and understanding the current status
      of
      our balance sheet. Our annual budget reflects the anticipated rate environment
      for the next twelve months. The asset liability committee conducts a quarterly
      analysis of the rate sensitivity position and reports its results to our board
      of directors.




The
      asset
      liability committee uses a computer model to analyze the maturities of rate
      sensitive assets and liabilities. The model measures the “gap” which is defined
      as the difference between the dollar amount of rate sensitive assets repricing
      during a period and the volume of rate sensitive liabilities repricing during
      the same period. Gap is also expressed as the ratio of rate sensitive assets
      divided by rate sensitive liabilities. If the ratio is greater than “one”, the
      dollar value of assets exceeds the dollar value of liabilities, and the balance
      sheet is “asset sensitive”. Conversely, if the value of liabilities exceeds the
      value of assets, the ratio is less than one and the balance sheet is “liability
      sensitive”. Our internal policy requires management to maintain the total gap
      within a range of 0.60 to 1.40 monitored on a one year basis.  At June
      30, 2007 we are “liability sensitive” with a ratio of .69.




The
      model
      measures scheduled maturities in periods of three months, four to twelve months,
      one to five years and over five years. The chart below illustrates our rate
      sensitive position at June 30, 2007. Management uses the one year gap as the
      appropriate time period for setting strategy.






**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 June 30, 2007 the
      cumulative one-year gap was a negative .69%, (or liability sensitive)
      $50,737,000, or 24.5% of total earning assets compared to a negative gap .83%,
      $25,298,000 or 12.3% of total earning assets at December 31, 2006.




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
      six
      months of 2007 rates remained constant compared to four rate increases in the
      first six months of 2006. Management believes that interest rates will possibly
      decline within the next two years. The Company’s strategy of being in a negative
      one year gap position should result in a stable or improving net interest margin
      as rates decline. The Company maintained a negative position during the fourth
      quarter of 2006. This negative position through the second quarter of 2007
      has
      contributed to the net interest margin declining from 3.90% to 3.46% at June
      30,
      2007. 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.









17





**Interest
      Rate Gap Analysis**




**Reprice’s
                or Maturing Within****(Dollars
                in Thousands)****0-3**
              **Months**
            
            **3-12**
              **Months**
            
            **Total**
              **1
                Year**
            
            **1-5**
              **Years**
            
            **Over**
              **5
                Years**
            
            **Total**ASSETSSecurities
                available for sale, at fair value
            
            $
            504
            
            $
            —
            
            $
            504
            
            $
            3,612
            
            $
            36,459
            
            $
            40,575Federal  funds
                sold
            
            10,992
            
            —
            
            10,992
            
            —
            
            —
            
            10,992Mortgage
                loans held for sale
            
            1,174
            
            
            
            1,174
            
            
            
            
            
            1,174Loans
            
            69,969
            
            27,918
            
            97,887
            
            51,787
            
            4,348
            
            154,022Total
                Earning Assets
            
            $
            82,639
            
            $
            27,918
            
            110,557
            
            $
            55,399
            
            $
            40,807
            
            206,763LIABILITIESInterest-bearing
                deposits
            
            $
            79,379
            
            $
            76,223
            
            155,602
            
            $
            9,346
            
            $
            —
            
            164,948Subordinated
                debentures
            
            5,155
            
            
            
            5,155
            
            
            
            
            
            5,155Other
                borrowings
            
            537
            
            —
            
            537
            
            —
            
            —
            
            537Total
                interest-bearing liabilities
            
            $
            85,071
            
            $
            76,223
            
            161,294
            
            $
            9,346
            
            $
            —
            
            170,640Asset
                (liability) GAP
            
            (2,432
            )
            (48,305
            )
            (50,737
            )
            46,053
            
            40,807
            
            36,123Cumulative
                asset (liability) GAP
            
            (2,432
            )
            (50,737
            )
            (50,737
            )
            (4,684
            )
            36,123
            
            36,123Cumulative
                as a percentage of interest-earning assets
            
            (1.2)
            %
            (24.5)
            %
            (24.5)
            %
            (2.3)
            %
            17.5
            %
            17.5
            %





**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 June 30,
      2007, we had unfunded loan commitments outstanding of $39.9 million and standby
      letters of credit of $2.8 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 we do 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 $14 million.




**ITEM
      4:  CONTROLS AND PROCEDURES**




**DISCLOSURE
      CONTROLS**




The
      Company maintains disclosure controls and procedures, as defined in Rule
      13a-15(a) promulgated under the Securities Exchange Act of 1934 (the “Exchange
      Act”), that are designed to ensure that information required to be disclosed by
      the Company in the reports that it files or submits under the Exchange Act
      is
      recorded, processed, summarized and reported within the time period specified
      in
      the SEC’s rules and forms and that such information is accumulated and
      communicated to the management of the Company, including its Chief Executive
      Officer and Chief Financial Officer (“Management”), as appropriate, to allow
      timely decisions regarding required disclosure.





Under
      the
      supervision and with the participation of Management, the Company evaluated
      the
      effectiveness of the design and operation of its disclosure controls and
      procedures as of the end of the period covered by this report. Based on the
      evaluation of these disclosure controls and procedures, the Chief Executive
      Officer and Chief Financial Officer concluded that the Company’s disclosure
      controls and procedures were effective, subject to the effectiveness of the
      Company's internal control over financial reporting.





**INTERNAL
      CONTROLS**




Management
      is responsible for establishing and maintaining adequate internal control over
      financial reporting.  The Company’s internal control system was
      designed to provide reasonable assurance to Management and the board of
      directors regarding the fair and reliable preparation and presentation of the
      consolidated financial statements.





Crowe
      Chizek and Company LLC (“Crowe”) is the independent registered public accounting
      firm responsible for auditing the Company’s consolidated financial
      statements.  In connection with Crowe's audit of the Company's 2006
      consolidated financial statements, Crowe submitted a draft report to Management
      and the Audit Committee on April 12, 2007 stating that a combination of control
      deficiencies and financial reporting errors amounted to a material weakness
      in
      internal controls over financial reporting.  Crowe submitted its final
      report on April 20, 2007 (the “Report”).  Management has thoroughly
      reviewed the draft and final reports and its findings and does not concur that
      a
      material weakness exists.  Nonetheless, Management reviewed the
      matters presented by Crowe in the Report and is responding to the deficiencies
      raised in the Report.




18





**PART
      II - OTHER INFORMATION**




**ITEM
      1. LEGAL PROCEEDINGS**




There
      are
      no material pending legal proceedings to which the Company is a party of which
      any of their property is the subject.







**ITEM
      1A. RISK FACTORS**




Investing
      in our common stock involves various risks which are particular to us, our
      bank,
      our industry and our market area. Several risk factors regarding investing
      in
      our common stock are discussed below. This listing should not be considered
      as
      all-inclusive. If any of the following risks were to occur, we may not be able
      to conduct our business as currently planned and our financial condition or
      operating results could be negatively impacted. These matters could cause the
      trading price of our common stock to decline in future periods.




*We
      are geographically concentrated in the Cleveland, Tennessee, and changes in
      local economic conditions impact our profitability.*




We
      operate primarily in Cleveland, Tennessee, and substantially all of our loan
      customers and most of our deposit and other customers live or have operations
      in
      Cleveland. Accordingly, our success significantly depends upon the growth in
      population, income levels, deposits and housing starts in Cleveland, along
      with
      the continued attraction of business ventures to the area. Our profitability
      is
      impacted by the changes in general economic conditions in this market.
      Additionally, unfavorable local or national economic conditions could reduce
      our
      growth rate, affect the ability of our customers to repay their loans to us
      and
      generally affect our financial condition and results of operations.




We
      are
      less able than a larger institution to spread the risks of unfavorable local
      economic conditions across a large number of diversified economies. Moreover,
      we
      cannot give any assurance that we will benefit from any market growth or
      favorable economic conditions in our primary market areas if they do
      occur.




Our
      continued growth may require the need for additional capital and further
      regulatory approvals which, if not obtained, could adversely impact our
      profitability and implementation of our current business plan.




To
      continue to grow, we will need to provide sufficient capital to the Company
      through earnings generation, additional equity offerings or borrowed funds
      or
      any combination of these sources of funds. Should we incur indebtedness, we
      are
      required to obtain certain regulatory approvals beforehand. Should our growth
      exceed our expectations, we may need to raise additional capital over our
      projected capital needs. However, our ability to raise additional capital,
      if
      needed, will depend on conditions in the capital markets at that time, which
      are
      outside our control, and on our financial performance. Accordingly, we cannot
      assure our ability to raise additional capital if needed on terms acceptable
      to
      us. If we cannot raise additional capital when needed, our ability to further
      expand and grow our operations could be materially impaired. Additionally,
      our
      current plan involves increasing our branch network, which will require capital
      expenditures. Our expansion efforts may also require certain regulatory
      approvals. Should we not be able to obtain such approvals or otherwise not
      be
      able to grow our asset base, our ability to attain our long-term profitability
      goals will be more difficult.




*If
      our allowance for loan losses is not sufficient to cover actual loan losses,
      our
      earnings will decrease.*




If
      loan
      customers with significant loan balances fail to repay their loans according
      to
      the terms of these loans, our earnings would suffer. We make various assumptions
      and judgments about the collectibility of our loan portfolio, including the
      creditworthiness of our borrowers and the value of any collateral securing
      the
      repayment of our loans. We maintain an allowance for loan losses in an attempt
      to cover the inherent risks associated with lending. In determining the size
      of
      this allowance, we rely on an analysis of our loan portfolio based on volume
      and
      types of loans, internal loan classifications, trends in classifications, volume
      and trends in delinquencies, nonaccruals and charge-offs, national and local
      economic conditions, other factors and other pertinent information. Because
      we
      are a relatively young organization, our allowance estimation may be less
      reflective of our historical loss experience than a more mature organization.
      If
      our assumptions are inaccurate, our current allowance may not be sufficient
      to
      cover potential loan losses, and additional provisions may be necessary which
      would decrease our earnings.







19




In
      addition, federal and state regulators periodically review our loan portfolio
      and may require us to increase our allowance for loan losses or recognize loan
      charge-offs. Their conclusions about the quality of our loan portfolio may
      be
      different than ours. Any increase in our allowance for loan losses or loan
      charge-offs as required by these regulatory agencies could have a negative
      effect on our operating results.




*Fluctuations
      in interest rates could reduce our profitability.*




Changes
      in interest rates may affect our level of interest income, the primary component
      of our gross revenue, as well as the level of our interest expense. Interest
      rate fluctuations are caused by many factors which, for the most part, are
      not
      under our direct control. For example, national monetary policy plays a
      significant role in the determination of interest rates. Additionally,
      competitor pricing and the resulting negotiations that occur with our customers
      also impact the rates we collect on loans and the rates we pay on
      deposits.




As
      interest rates change, we expect that we will periodically experience “gaps” in
      the interest rate sensitivities of our assets and liabilities, meaning that
      either our interest-bearing liabilities will be more sensitive to changes in
      market interest rates than our interest-earning assets, or vice versa. In either
      event, if market interest rates should move contrary to our position, this
“gap”
may work against us, and our earnings may be negatively affected.




Changes
      in the level of interest rates also may negatively affect our ability to
      originate real estate loans, the value of our assets and our ability to realize
      gains from the sale of our assets, all of which ultimately affect our earnings.
      A decline in the market value of our assets may limit our ability to borrow
      additional funds. As a result, we could be required to sell some of our loans
      and investments under adverse market conditions, upon terms that are not
      favorable to us, in order to maintain our liquidity. If those sales are made
      at
      prices lower than the amortized costs of the investments, we will incur
      losses.




*The
      Company could sustain losses if its asset quality declines.*




The
      Company’s earnings are affected by the Bank’s ability to properly originate,
      underwrite and service loans. The Company could sustain losses if it incorrectly
      assesses the creditworthiness of its borrowers or fails to detect or respond
      to
      deterioration in asset quality in a timely manner. Problems with asset quality
      could cause the Bank’s interest income and net interest margin to decrease and
      its provisions for loan losses to increase, which could adversely affect the
      Company’s results of operations and financial condition.




*Loss
      of our senior executive officers or other key employees could impair our
      relationship with our customers and adversely affect our
      business.*




We
      have
      assembled a senior management team which has a substantial background and
      experience in banking and financial services in the Cleveland market. Loss
      of
      these key personnel could negatively impact our earnings because of their
      skills, customer relationships and/or the potential difficulty of promptly
      replacing them.




*Competition
      with other banking institutions could adversely affect our
      profitability.*




A
      number
      of banking institutions in the Cleveland market have higher lending limits,
      more
      banking offices, and a larger market share. In addition, our asset management
      division competes with numerous brokerage firms and mutual fund companies which
      are also much larger. In some respects, this may place these competitors in
      a
      competitive advantage, although many of our customers have selected us because
      of service quality concerns at the larger enterprises. This competition may
      limit or reduce our profitability, reduce our growth and adversely affect our
      results of operations and financial condition.




*The
      Company’s common stock is currently traded on a local basis, the trading volume
      in its common stock has been thin and the sale of substantial amounts of the
      Company’s common stock could depress the price of its common
      stock.*




The
      Company cannot say with any certainty when a more active and liquid trading
      market for its common stock will develop or be sustained. Because of this,
      the
      Company’s shareholders may not be able to sell their shares at the volumes,
      prices, or times that they desire.




The
      Company cannot predict the effect, if any, that future sales of its common
      stock, or availability of shares of its common stock for sale, will have on
      the
      price of the Company’s common stock. The Company, therefore, can give no
      assurance that sales of substantial amounts of its common stock, or the
      potential for large amounts of sales, would not cause the price of its common
      stock to decline or impair its ability to raise capital through sales of its
      common stock.




The
      price
      of the Company’s common stock may fluctuate in the future, and these
      fluctuations may be unrelated to its performance.




The
      Company may issue additional common stock or other equity securities in the
      future which could dilute the ownership interest of existing
      shareholders.







20




In
      order
      to maintain its capital at desired levels or required regulatory levels, or
      to
      fund future growth, the Company’s board of directors may decide from time to
      time to issue additional shares of common stock, or securities convertible
      into,
      exchangeable for or representing rights to acquire shares of its common stock.
      The sale of these shares may significantly dilute the Company’s shareholders
      ownership interest as a shareholder and the per share book value of its common
      stock. New investors in the future may also have rights, preferences and
      privileges senior to its current shareholders which may adversely impact its
      current shareholders.




*The
      Company’s ability to declare and pay dividends is limited by law and it
      may be unable to pay future dividends.*




The
      Company’s ability to pay dividends is derived from the income of the Bank. The
      Bank’s ability to declare and pay dividends is limited by its obligations to
      maintain sufficient capital and by other general restrictions on its dividends
      that are applicable to banks that are regulated by the FDIC and the Department
      of Financial Institutions. In addition, the FRB may impose restrictions on
      the Company’s ability to pay dividends on its common stock. As a result, the
      Company cannot assure its shareholders that it will declare or pay dividends
      on
      shares of its common stock in the future.




*Liquidity
      needs could adversely affect the Company’s results of operations and financial
      condition.*




The
      Company relies on dividends from the Bank as its primary source of funds. The
      primary source of funds of the Bank are customer deposits and loan repayments.
      While scheduled loan repayments are a relatively stable source of funds, they
      are subject to the ability of borrowers to repay the loans. The ability of
      borrowers to repay loans can be adversely affected by a number of factors,
      including changes in economic conditions, adverse trends or events affecting
      business industry groups, reductions in real estate values or markets, business
      closings or lay-offs, inclement weather, natural disasters and international
      instability. Additionally, deposit levels may be affected by a number of
      factors, including rates paid by competitors, general interest rate levels,
      returns available to customers on alternative investments and general economic
      conditions. Accordingly, the Bank may be required from time to time to rely
      on secondary sources of liquidity to meet withdrawal demands or otherwise fund
      operations. Such sources include Federal Home Loan Bank advances and federal
      funds lines of credit from correspondent banks. While the Bank believes that
      these sources are currently adequate, there can be no assurance they will be
      sufficient to meet future liquidity demands. The Bank may be required to
      slow or discontinue loan growth, capital expenditures or other investments
      or
      liquidate assets should such sources not be adequate.




*Our
      business is dependent on technology, and an inability to invest in technological
      improvements may adversely affect our results of operations and financial
      condition.*




The
      financial services industry is undergoing rapid technological changes with
      frequent introductions of new technology-driven products and services. In
      addition to better serving customers, the effective use of technology increases
      efficiency and enables financial institutions to reduce costs. We have made
      significant investments in data processing, management information systems
      and
      internet banking accessibility. Our future success will depend in part upon
      our
      ability to create additional efficiencies in our operations through the use
      of
      technology, particularly in light of our past and projected growth strategy.
      Many of our competitors have substantially greater resources to invest in
      technological improvements. We cannot make assurances that our technological
      improvements will increase our operational efficiency or that we will be able
      to
      effectively implement new technology-driven products and services or be
      successful in marketing these products and services to our
      customers.











21





**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**June
                1, 2007
            
            459
            
            $
            8.65June
                1, 2007
            
            1,041
            
            $
            15.57





The
      aggregate proceeds of the shares sold were $20,179.





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 June 30,
                2007.


Our
      ability to declare and pay dividends on our common stock is limited by law
      and
      we may be unable to pay future dividends. We derive our income solely from
      dividends on the shares of common stock of the bank. The bank’s ability to
      declare and pay dividends to us is limited by its obligations to maintain
      sufficient capital and by other general restrictions on its dividends that
      are
      applicable to banks that are regulated by the FDIC and the TDFI. In addition,
      the Federal Reserve Board may impose restrictions on our ability to pay
      dividends on our common stock. As a result, we cannot assure our shareholders
      that we will declare or pay dividends on shares of our common stock in the
      future.




**ITEM
      3:  DEFAULTS UPON SENIOR SECURITIES**




(a)
            None




(b)
            None




**ITEM
      4:  SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS**




(a)
            The
                annual meeting of the Bank’s stockholders was held May 17,
                2007.




(b)
            Not
                applicable.




(c)     (1)    The
      following directors were elected by the following tabulation:






Number
                  of shares voting
              For
              Against
              Abstain
              Broker
                  Non-VotesLen
                  D. Graham
              709,742
              708,640
              0
              1,102
              0Clyde
                  A. Kyle Jr
              709,742
              706,436
              0
              3,306
              0Lester
                  T. Simerville Sr.
              709,742
              708,089
              0
              1,653
              0James
                  F Williams Jr
              709,742
              708,640
              0
              1,102
              0


(2)    The
      ratification of the appointment of Crowe, Chizek and Company, LLP as independent
      auditors for the Company for the fiscal year 2007 was as follows:




Number
      of  shares
      voting            For           Against              Abstain          
Broker Non-Votes





709,742                          639,955    64,117                    5,670              0






22




**ITEM
      5:  OTHER INFORMATION**




(a)
            None




(b)
            None




**ITEM
      6:  EXHIBITS**




2.1*
            Articles
                of Share Exchange of Southern Heritage Bank
              and
                Southern Heritage Bancshares, Inc. as filed on August 31,
                2004.


2.2*
            Plan
                of Share Exchange dated as of August 23, 2004
              between
                Southern Heritage Bank and Southern Heritage Bancshares,
                Inc.




3.1*
            Charter
                of Southern Heritage Bancshares,
                Inc.


3.2*
            By-laws
                of Southern Heritage
                Bancshares, Inc.





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.




*Previously
      filed as an Exhibit to Southern Heritage Bancshares, Inc.’s
      Form 8-K as filed with the Securities Exchange Commission on August 31,
      2004 and incorporated by reference herein.











23







**SOUTHERN
      HERITAGE BANCSHARES, INC.**




**FORM
      10-Q**




Quarter
      ended June 30, 2007




**SIGNATURES**




In
      accordance with the requirements of the Exchange Act, the Registrant caused
      this
      report to be signed on its behalf by the undersigned thereunto duly
      authorized.









Southern
                Heritage Bancshares, Inc.(Registrant)August
              14, 2007
            
            /s/
                J. Lee Stewart(Date)
            
            J.
                Lee StewartChief
                Executive OfficerAugust
              14, 2007
            
            /s/
                Steven W. Ledbetter(Date)
            
            Steven
                W. Ledbetter,Chief
                Financial Officer




















































24