Adoption Assistance
Offers Tax Relief

By Scott B. Franklin

Editor's Note: Links to I.R.S. forms and state statutes in this article require you to install Adobe Acrobat Reader installed on your computer. To download Acrobat for free, go to the WisBar Toolbox.

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

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

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