Adoption Assistance Offers Tax Relief
By Scott B. Franklin
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On Aug. 20, 1996, President Clinton signed into law the Small
Business Job Protection Act of 1996 (SBJPA). 1 As part of election year tax-relief measures, this
legislation made several refinements and
Adoptive parents incur additional costs not faced by
natural parents. Recent federal and Wisconsin tax changes should help
lessen the financial burden and encourage more adoptions. |
improvements to the
Internal Revenue
Code (Code), including the creation of a two-part adoption
assistance tax-relief program. The Wisconsin Legislature also enacted
adoption assistance during its 1996 session by reviving a tax benefit
that previously had been repealed
Federal Changes
Prior to the SBJPA, federal adoption assistance was limited to an
outlay program providing up to $1,000 of federal reimbursement for
expenses related to the adoption of children with certain special needs.
2 Recognizing the financial hardship caused
by the adoption process, Congress created both a tax credit and an
income exclusion to help ease the burdens of all adoptions.
Federal adoption assistance under the Code now is provided by these
two separate approaches. Using I.R.C. section 23, a taxpayer may claim a nonrefundable tax credit on
his or her income tax return for qualified adoption expenses. 3 This credit directly reduces income taxes by an
amount equal to the allowed adoption expenses actually paid or incurred.
Any excess of allowed credit over tax due may be carried forward and
used within the next five years.4 Using
section 137, the taxpayer may exclude from taxable income amounts paid
by his or her employer for such expenses. 5
This permits the taxpayer to exclude from taxable income amounts paid
pursuant to an employee assistance program as reimbursement for allowed
adoption expenses. Provided that there are enough expenses so that none
are counted twice, the taxpayer may qualify under both provisions.
6 The statutory language of each section is
substantially identical with cross-references between the two sections.
7
Benefits vary with adoptee's status and parents' income
The maximum tax credit or income exclusion available under each
section is $5,000 per adopted child. 8 The
child must be under age 18 or otherwise unable to care for himself or
herself when adopted. 9 If a state certifies
that a child should not be placed back into his or her parent's home and
the child requires assistance to encourage placement due to age, ethnic
background, medical or emotional conditions or other factors, expenses
of up to $6,000 per each special needs child are eligible for the new
tax treatment. 10 However, a special needs
child must be a citizen or resident of the United States for the
adopting parents to qualify for the extra $1,000 benefit. 11
As with many tax benefits, the adoption tax credit and income
exclusion is phased out above a certain income level. A taxpayer with
adjusted gross income (AGI) less than $75,000 for the year in which the
credit or exclusion is claimed is eligible for the full amount of the
credit and/or exclusion. Between $75,000 and $115,000 of AGI, the
benefits are partially reduced. 12 By
$115,000 of AGI, the benefits under these sections are eliminated.
Qualified adoption expenses that may be claimed for the federal tax
credit or income exclusion are any reasonable and necessary adoption
fees, court costs, legal fees and other expenses directly and
principally related to the taxpayer's legal adoption of an eligible
child. 13If the claimed expense is a
capital improvement, such as a wheelchair access ramp, the basis of the
property is first increased by the expenditure and then reduced by the
credit or exclusion allowed. 14 The new law
excludes expenses incurred in violation of any state or federal law, in
connection with a surrogate parenting arrangement and in the adoption of
a spouse's child, such as in a second marriage.15
Timing is everything
The tax credit and income exclusion are available for expenses paid
or incurred after Dec. 31, 1996. 16 Except
for expenses relating to the adoption of special needs children, the tax
credit expires for expenses paid or incurred after Dec. 31, 2001;
17 the income exclusion will expire
outright on this date. 18 Expenses
reimbursed by one's employer or the Federal Adoption Assistance program
may
Qualified adoption expenses that may be claimed for the
federal tax credit or income exclusion are any reasonable and necessary
adoption fees, court costs, legal fees and other expenses directly and
principally related to the taxpayer's legal adoption of an eligible
child. |
not be claimed for the tax credit,
19 and
any business owner with more than 5 percent ownership may not receive
more than 5 percent of the total benefits paid under the company's
adoption assistance program.
20
Special rules address the appropriate year in which to claim the
credit or exclusion. For the adoption of a child who is a citizen or
resident of the United States, the adoption credit is claimed in the tax
year following the year in which the expenses are paid or incurred,
except that the credit for expenses paid or incurred during the year in
which the adoption becomes final is claimed in that year. 21 The income exclusion is taken in the year the
employer pays expenses. 22 Internal Revenue
Service Notice 97-9 clarifies that the credit or exclusion also may be
claimed for an unsuccessful adoption attempt.23However, the expenses of an unsuccessful adoption
are added to those relating to a successful adoption when considering
the maximum benefit of $5,000 (or $6,000) per adopted child. In the
adoption of a foreign child, expenses may be claimed for credit or
exclusion only in the year a successful adoption becomes final, even if
paid or incurred earlier. 24 If the
adoption is not completed, the credit may not be claimed.
Next Page
Receiving the benefits
To claim the tax credit or take the income exclusion, married
adoptive parents must file a joint tax return unless the rules governing
head of household status apply. 25 The Code
particularly calls for the Internal Revenue Service (IRS) to draft rules
assuring that unmarried individuals who pay expenses pertaining to the same child are treated as one taxpayer for the
purposes of this tax benefit,26 thus
reinforcing Congress's intent that the maximum benefit is $5,000 (or
$6,000) of total tax credit and/or income exclusion per child no matter
how many persons (unmarried cohabitants or other interested parties) may
be financing the adoption.
The legislation also instructs the IRS to draft any other appropriate
regulations to help carry out the new provisions. 27
Although regulations have not yet been proposed, Notice 97-9 provides a
detailed analysis that may form the preliminary basis for the
regulations. The IRS recently released the final version of Form 8839, on which
the tax benefits are computed and claimed, and Publication 968, which explains the new
rules. The new two-page form calculates both the allowed tax credit
carried to Line 42 of the Form 1040 and the
amount of taxable employer benefits that need to be added back to Line 7
Wages. (Qualified adoption expenses paid by an employer will be noted as
Code T in box 13 of Form W-2.28 Since the amount excluded on the Form W-2 may
not equal the allowed exclusion after applying all applicable
limitations, taxpayers will need to ensure that proper estimated tax
payments are made to avoid underpayment penalties.29) All employer-paid amounts are exempt from
income tax withholding, but still are subject to Social Security,
Medicare and federal unemployment taxes. 30
Wisconsin's legislative enactment
Wisconsin also has taken action to provide tax assistance to adoptive
parents. 1995 Wisconsin Act 261 31 was
approved on April 22, 1996, and created section 71.05(6)(b)22
of the Wisconsin Statutes. This provision permits the deductions of up
to $5,000 of adoption fees, court costs and legal fees related to the
adoption of a child. The parents must be full-year state residents and
the final adoption order must have been issued by a Wisconsin court
under the provisions of Wis. Stat. section 48.91(3). 32 The expenses for which the deduction is claimed
must have been paid during the year of the deduction or the two prior
years.33
The adoption expense deduction was first available on the 1996
Wisconsin income tax returns. The amount claimed is reported as a Line 4
subtraction modification on the return and reduces federal AGI by the
amount of expenses claimed, up to $5,000. Prior to 1986 Wisconsin
taxpayers could have taken deductions for up to 100 percent of qualified
adoption expenses. After its decade-long absence, this renewed benefit
should be welcomed by Wisconsin's adoptive parents, but statistics have
not been compiled indicating the number of taxpayers who have used the
reinstated deduction. 34 An amended 1996
Wisconsin return could be filed if a taxpayer was eligible for the state
credit, but failed to claim it on his or her original return.
Unlike its federal counterpart, the Wisconsin subtraction
modification was enacted without any fanfare and has been publicized
only briefly in a Wisconsin Department of Revenue publication 35 and in the instructions to the tax forms.
Although both the federal and state tax codes now have their own
seemingly independent versions of adoption tax benefits, there is a
relationship between the two provisions.
Federal changes partially apply to Wisconsin
The starting point for preparing a Wisconsin tax return is the
taxpayer's federal adjusted gross income. The federal AGI then is
adjusted by various addition and subtraction modifications, including
the Wisconsin adoption modification, to compute Wisconsin taxable
income. Therefore, each year the Legislature must adopt the updated
federal Code as the basis for Wisconsin's tax laws. The state budget
finally enacted late last fall updated the Wisconsin tax reference to
the Code as of Dec. 31, 1996.
The Code allows a credit based on adoption expenses up to $5,000 (or
$6,000). This credit reduces the amount of federal taxes owed and will
not affect the Wisconsin tax return. The Code also includes the $5,000
(or $6,000) income exclusion for employer-provided benefits which are
not subject to federal income taxes but which are subject to Social
Security, Medicare and federal unemployment taxes. These federally
excluded amounts also will be excluded for Wisconsin income tax
purposes, including the extra $1,000 benefit for special needs children.
The broader definition of allowable expenses used
|
Scott
B. Franklin, Marquette 1995, is a staff accountant with Kohler and
Franklin CPAs, Milwaukee, where he concentrates in the firm's tax and
business advisory practices. He also is an instructor with the Becker
CPA Review Course. He received his B.B.A. in accounting from U.W.-
Madison. Franklin thanks attorney John C. Vitek for assisting with this
article. |
for the federal exclusion and the income-based phaseout of the exclusion
also will carry to the Wisconsin return. Wisconsin unemployment taxes
will continue to be assessed on the preexclusion income. Just as with
the federal credit, allowable expenses not used for the income exclusion
(subject to Wisconsin's tighter definition) can be used for the
Wisconsin modification.
Conclusion
Even though most of the federal tax relief is subject to sunset in
2002, Wisconsin's subtraction modification is a permanent part of the
state's tax statutes. Although finances should never be the sole reason
to adopt or not, the reality is that adoptive parents do incur
additional costs not faced by natural parents. While a natural child
will result in pregnancy-related medical expenses, such costs usually
are covered by insurance or may be claimed as an itemized tax deduction.
These recent tax changes should work to equalize the economics of
adoption with "natural parenting" and encourage additional adoptions
where the financial impacts are a concern.
Endnotes
1 Public Law 104-188.
2 House Report 104-373, Conference
Report on H.R. 3448.
3 I.R.C. § 23(a)(1).
4 I.R.C. § 23(c).
5 I.R.C. § 137(a).
6 I.R.C. §§ 23(d)(1)(D),
137(d); Comm. Rpt. on P.L. 104-188.
7 See, e.g., I.R.C.
§§ 23(h), 137(d).
8 I.R.C. §§ 23(b)(1),
137(b)(1).
9 I.R.C. §§ 23(d)(2),
137(d).
10 I.R.C. §§ 23(d)(3),
23(b)(1), 137(b)(1), 137(d).
11 I.R.C. §§
23(d)(3)(C), 137(d).
12 I.R.C. §§ 23(b)(2),
137(b)(2).
13 I.R.C. §§ 23(d)(1),
137(d).
14 I.R.C. §§ 23(g),
137(e).
15 I.R.C. §§
23(d)(1)(B), 23(d)(1)(C), 137(d).
16 Comm. Rpt. on P.L.
104-188.
17 I.R.C. §§ 23(d)(2),
137(d).
18 I.R.C. § 137(f).
19 I.R.C. § 23(b)(3).
20 I.R.C. § 137(c)(2),
Notice 97-9 (I.R.B. 1997-2) § II.2.D.2.
21 I.R.C. § 23(a)(2).
22 I.R.C. § 137(a).
23 Not. 97-9, §§
I.E.1., II.F.1.
24 I.R.C. §§ 23(e),
137(e).
25 I.R.C. §§ 23(f),
137(e).
26 I.R.C. § 23(h).
27 I.R.C. § 23(h).
28 I.R.S. Announcement
96-134.
29 Not. 97-9, § II.G.2.
30 Not. 97-9, § II.G.1.
31 Assembly Bill 78.
32 Wis. Stat. §
71.05(6)(b)22.
33 Id.
34 Ms. Marcy Stock, Wisconsin
Department of Revenue.
35 July 1996 Wis. Tax Bull., No.
97.
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