CHANGES IN TAX LAW BENEFIT ADOPTING PARENTS

By Sheila Foster, PhD, CPA, associate professor, and Cynthia Bolt-Lee, CPA, associate professor, The Citadel

While the most visible portion of the Small Business Job Protection Act of 1996 (H.R. 3448) was an increase in the minimum wage, it also included important sections that can provide significant benefits to those adopting a child.

Although the primary objective of the IRC is to raise revenues, the government often enacts provisions that accomplish economic or social policies--sometimes at the expense of revenues. The portion of the 1996 act dealing with adoptions clearly had a social goal as its impetus. According to testimony by the Child Welfare League of America to the House Ways and Means Committee, there were 118,800 adoptions completed in 1990; 49%, or approximately 59,000, of these adoptions were between unrelated parties with the remaining 51% being adoptions by relatives. While approximately 91% of adoptions were domestic, foreign adoptions made up almost 9% of all adoptions.

With adoption costs averaging between $10,000 and $20,000, the National Council for Adoption lobbied diligently for tax relief for adoptive parents. The result of these efforts was H.R. 3448 which includes provisions for both an income tax credit and an income exclusion for adopting parents who qualify.

Beginning January 1, 1997, per IRC section 23 (replacing the repealed section 23, Residential Energy Credit), taxpayers are allowed to claim an adoption credit against their Federal income tax liability of as much as $5,000 for qualified adoption expenses for each eligible child. (In the case of a child with special needs, the adoption credit increases to $6,000.) Adoptions of children who are neither citizens nor residents of the U.S. are limited to a maximum credit of $5,000 whether or not that child is deemed to have special needs. Any unused credit can be carried forward five years to reduce future income tax liabilities; however, the aggregate amount of the credit may not exceed $5,000 (or $6,000 for a child with special needs) for each eligible child adopted. Expenses paid in 1996 do not qualify for the credit, and except for the adoption of a child with special needs, the credit is scheduled to expire on December 31, 2001.

For tax years beginning after December 31, 1996, a second tax law change enacted under IRC section 137 allows employers to exclude payments provided under an adoption assistance program for their employees. (The Coast Guard and Armed Forces also are permitted by this section to provide similar qualifying adoption reimbursement programs.) An adoption assistance program (or adoption benefits plan) is a written, nondiscriminating, company-sponsored program in which an employer pays or reimburses all or a portion of an employee's expenses in connection with the adoption of an eligible child. Such plans may also provide time off for an adoptive parent who is an employee. A 1995 survey indicated that of more than 1,000 major U.S. corporations surveyed, nearly 23% already provided employees with some type of adoption benefits.

Beginning January 1, 1997, up to $5,000 of the employer's assistance under a qualifying program is excluded from the employee's taxable income ($6,000 for a child with special needs). The $5,000 and $6,000 limits apply to the aggregate amount of assistance that may be excluded from taxable income per eligible child rather than the amount that may be excluded per year.

Like many other tax benefits, both the income exclusion and the adoption credit are subject to an income limitation and are phased out for high-income taxpayers--in this case, those with a modified adjusted gross income (AGI) between $75,000 and $115,000.

Modified AGI is defined in IRC section 23(b)(2)(B) as adjusted gross income "(i) without regard to sections 911 [gross income for foreign earned income], 931, and 933 [income derived from sources within Guam, American Samoa, the Northern Mariana Islands, or Puerto Rico], and (ii) after the application of sections 86 [taxation of Social Security and tier 1 railroad retirement benefits], 135 [exclusion of income from educational U.S. savings bonds], 137 [exclusion for adoption expenses], 219 [individual retirement account deduction], and 469 [passive activity losses]."

No credit is available for taxpayers with an AGI above $115,000. In calculating the phase-out, the allowed credit or exclusion is reduced by modified AGI above $75,000 divided by $40,000. Therefore, a taxpayer with an AGI of $105,000 ($30,000 above the $75,000 income limit) would have the allowable credit reduced by 75% ($30,000/$40,000). Likewise, a taxpayer with an AGI of $115,000 ($40,000 over the income limit) would have the allowable credit reduced by 100%. Congress intends to adjust the phase-out calculation for inflation on an annual basis.

Both the credit and the exclusion apply only to qualified adoption expenses associated with the legal adoption of an eligible child. According to IRC sections 23(d)(1) and 137(d), qualified adoption expenses include "reasonable and necessary adoption fees, court costs, attorney fees, and other expenses" directly related to the legal adoption of an eligible child by a taxpayer. These qualified expenses would include any specific purchases directly related to the child's care or needs. For example, the cost of structural changes in the home to accommodate a wheelchair that are required as a condition of an adoption would qualify for the credit or exclusion. To the extent that a credit or exclusion is allowed, any expenses that would ordinarily increase the basis of property, such as an elevator or a wheelchair ramp in a personal residence, cannot be used as a basis increase for the related asset.

Several restrictions apply to the credit and exclusion. The adoption must be legal; expenses in violation of state or Federal law are not allowed. Expenses associated with a surrogate parenting arrangement are not considered qualified adoption expenses for the purposes of IRC sections 23 and 137. An individual who incurs expenses related to the adoption of his or her spouse's child cannot take advantage of these provisions.

Expenses that are covered under an employer adoption assistance program cannot be used a second time to qualify for the adoption credit. Therefore, $5,000 in adoption expenses paid by an employer under an assistance program and excluded from the taxpayer's income could not also be used to claim the adoption credit. Additionally, funds received under any Federal, state, or local program are disallowed as this would result in a double benefit to the taxpayer.

Unless they are physically or mentally unable to care for themselves, eligible children cannot be over age 17. A child is classified as one with special needs (with a maximum exclusion or credit of $6,000) if the state "has determined that the child cannot or should not be returned to the home of his or her parents" or if there is "a specific factor or condition (such as ethnic background, age, or membership in a minority or sibling group or the presence of factors such as medical conditions, or physical, mental, or emotional handicaps)" that indicates that the child cannot be placed for adoption without adoption assistance [IRC section 23(d)(3)(A and B)]. A child must be either a citizen or a resident of the U.S. in order to qualify as one with special needs.

The timing of the expenses and credit is somewhat unusual. Qualified expenses for purposes of the adoption credit are allowed in the tax year following the tax year during which the expense is paid or incurred except for 1) the year the adoption becomes final and 2) adoption of a child who is not a U.S. citizen or resident. Expenses paid or incurred during the tax year an adoption is finalized are deductible for that tax year rather than being deferred to the following year. For adoptions involving children who are neither citizens nor residents of the U.S., all expenses are treated as if paid or incurred in the tax year during which the adoption is finalized. Unless the adoption is finalized for these children, there are no qualifying expenses. Consequently, because 1997 is the first year in which qualifying expenses may be paid or incurred, adoption credits would be allowed in 1997 only for adoptions that were finalized during that tax year. In all other cases, those expenses paid or incurred in 1997 would be deferred for purposes of the credit or exclusion until 1998 or until the adoption is finalized if the child is not a U.S. citizen or resident.

As an example, assume that a couple incurs $7,000 in qualified unreimbursed adoption expenses in 1997. Because the adoption is not finalized in 1997, the couple is unable to use those expenses to claim the adoption credit until 1998. Assume further that the couple's modified AGI is less than $75,000 and that additional expenses of $8,000 are paid in 1998, the year during which the adoption is finalized. Even though the couple has paid $15,000 in adoption expenses, they will be allowed a credit of only $5,000 (or $6,000 as appropriate) against their tax liability in 1998. If their tax liability for 1998 is less than $5,000, the unused amount of the credit is carried forward for five tax years.

Assume the same situation as above but increase the couple's modified AGI for 1998, the year the expenses may be used to claim the credit, to $95,000. In this case, the couple must reduce their adoption credit as follows: the $20,000 excess (AGI over $75,000) is divided by $40,000 as required by law. The resulting ratio of .50 is multiplied by $5,000 resulting in an allowable credit of $2,500. If their tax liability for 1998 is less than $2,500, the unused amount of the allowable credit of $2,500 is carried forward for five tax years.

Taxpayers may take advantage of both provisions of the tax law simultaneously. For example, if the parent pays $15,000 in adoption expenses, and the employer reimburses the employee $4,000 under a qualified adoption assistance program, $5,000 of the remaining $11,000 of unreimbursed expenses still qualify for the credit.

Married couples generally must file a joint return to be eligible to benefit from either the adoption credit or the income exclusion. However, regulations are expected to be forthcoming to deal with the specifics of these sections of the
code as they relate to unmarried taxpayers. Future regulations should also
address W-2 preparation given the AGI limitation required for the phase-out
of the exclusion. The Treasury Department is required to study the tax
effect of these tax changes and report to the related congressional committees by January 1, 2000.

Editor:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editor:
Richard M. Barth, CPA