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.

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 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Legislature also enacted adoption assistance during its 1996 session by reviving a tax benefit that previously had been repealed.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 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.

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 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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