Tax Treatment of Adoption Expenses
A sizable tax credit is available, but with possible changes on the horizon.
Of the family-related “life events” with significant implications for taxes, adoption of a child ranks among the potentially most expensive. Most readers of Adoptive Families who answered the magazine’s request to report the costs of a completed adoption gave figures between $25,000 and $30,000 (tinyurl.com/yjxlvre). International adoptions tend to be more expensive than domestic ones. Although at this writing, international child welfare agencies are cautioning against overestimating the prospects for U.S. adoptions of orphans from the Jan. 12 earthquake in Haiti, it appears possible more families than before could be seeking information about foreign adoptions as a result and may ask their tax advisers about tax implications.
At any rate, adoptions, both domestic and international, have historically been relatively common in the U.S., numbering about 127,000 annually in 2000 and 2001, a figure that has changed little from previous decades, according to a 2004 study by the Child Welfare Information Gateway of the U.S. Department of Health and Human Services (childwelfare.gov/adoption).
Families facing high adoption expenses can in many cases avail themselves of one of the Tax Code’s larger personal credits and so recoup thousands of dollars, with relatively few restrictions on what types of costs qualify. CPAs can provide a valuable service to families not only by educating prospective adoptive parents about current provisions but in keeping them apprised of upcoming possible major changes in the adoption expense credit and employer benefits income exclusion. This article provides details about the current status of the tax law and illustrates the potential economic benefits for different incomes and filing statuses.
Editor’s note: The Patient Protection and Affordable Care Act (PL 111-148) temporarily increased the adoption expense credit and fringe benefit exclusion limit for adoption assistance programs and made the credit refundable. The changes are effective for tax years beginning after Dec. 31, 2009. Read more at “Adoption Credit Increased, Made Refundable by Health Care Act,” March 26, 2010, and “Tax Provisions of the Health Care Act,” March 22, 2010.
ADOPTION EXPENSE CREDIT
IRC § 23 provides a credit for qualified adoption expenses paid or incurred by a taxpayer. For 2010, the maximum credit is $12,170 per child, phased out at modified adjusted gross incomes (AGIs) between $182,520 and $222,520. The AGI modification is an adjustment to disregard any claimed foreign earned income exclusion or exclusion of income from sources in Puerto Rico and certain other specified U.S. possessions. The credit is nonrefundable, but for 2010 it is allowed against the alternative minimum tax, and in all tax years, an excess credit may be carried forward up to five years from the year in which it arose. Qualified expenses for domestic adoptions that are paid or incurred in tax years preceding the one in which an adoption becomes final may be claimed in the tax year following that in which the corresponding expenses were paid or incurred. Qualified expenses for domestic adoptions incurred in the year in which an adoption becomes final or in following years may be claimed as a credit in the same tax year. In adoptions of children who are not U.S. citizens or residents, the taxpayer may not claim a credit until the adoption becomes final.
Qualified expenses generally can be any unreimbursed costs not claimed as another tax credit that are reasonable and necessary for the principal purpose of a legal adoption of an eligible child. An eligible child is one who is under 18 or physically or mentally incapable of caring for himself or herself. Qualifying expenses can include adoption fees, court costs, attorney fees and travel, including meals and lodging. Adoption of a “special needs” child allows the taxpayer to claim the full amount of the credit limit, with no requirement to document or even pay or incur related costs. Expenses for the adoption of a stepchild by a stepparent are not qualified expenses eligible for the credit (section 23(d)(1)(C)). The costs of a surrogate parenting arrangement also are not qualified expenses, whether or not the arrangement is legal.
Section 137 allows adoptive parents to exclude from income, as a fringe benefit, adoption expenses paid or reimbursed by an employer program, with the same limits and phaseouts as the credit. Taxpayers may not, however, claim an adoption credit for any amounts that are excluded from income.
STATUS OF THE ADOPTION EXPENSE CREDIT
The adoption credit was introduced in 1997 with a maximum dollar amount of $5,000 ($6,000 for an adoption of a special-needs child). The maximum credit was increased to $10,000 for all children in 2001 as part of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) (PL 107-16). At the same time, employer-provided assistance for adoption was excluded from income, and the threshold for the modified AGI phaseout increased from $75,000 to $150,000. Section 23 also was amended to provide for annual inflation adjustments for the credit limit and phaseout.
As has been widely publicized with its better-known provisions such as the estate and gift taxes, however, the EGTRRA is, as of this writing, scheduled to sunset on Dec. 31, 2010. Several legislative measures have been introduced to retain the higher adoption credit limit. In January 2009, the Adoption Tax Relief Guarantee Act of 2009, HR 213, was introduced, which would make the current adoption credit permanent. A similar Senate bill, S 2816, also proposes to repeal the sunset and, for tax years beginning after Dec. 31, 2010, would allow expenses in a tax year before that in which the adoption becomes final to be claimed for that year, rather than the current one-year lag. As of this writing, neither bill has left committee.
On Dec. 3, 2009, the House passed the Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009, HR 4154, that would repeal the EGTRRA sunset of adoption expense credit provisions along with the EGTRRA’s estate tax provisions. As of mid-February, the Senate had not acted on the bill. A Senate-passed substitute amendment to the House health care bill, HR 3590, the Patient Protection and Affordable Care Act, included an increase in the adoption credit amount to $13,170 for 2011. It also would delay the sunset of the EGTRRA adoption credit and fringe benefit exclusion provisions by one year and would make the credit refundable (section 10909 of the act). However, the future of this bill was clouded by the loss of a 60- vote Democratic supermajority in the Senate with the election of Republican Sen. Scott Brown of Massachusetts on Jan. 19. Unless one or more of these bills or some other measure is enacted, the adoption expense credit will revert to its 1997 status in 2011.
Practice point. Because of the unsettled status of the credit after the end of this year, taxpayers and their CPA advisers may want to explore making major expenditures during the 2010 tax year but also monitor the above legislation and adjust their plans accordingly.
Here’s an illustration of what could happen if the higher EGTRRA credit limit and income phaseout and inflation adjustments are not extended:
Case 1. Nora and Wilson adopt a child in 2011 through a domestic adoption agency. They had been hoping to adopt in 2010 and were chosen by a birth mother in June of that year. However, when the baby was born in September 2010, the birth mother decided that she wanted to keep the child. Nora and Wilson were heartbroken. They had already spent $3,500 in agency fees, travel costs, etc. They did not want to give up, and sure enough, another birth mother picked them in December 2010. Their child was born in January 2011, and the adoption became final in March of that year. Their total adoption expenses are $13,500, and modified AGI for 2011 is $105,000. If the higher adoption expense credit limit is not extended, Nora and Wilson are eligible for a credit of only $1,250 in 2011 ($5,000 – ($5,000 x ($105,000 – $75,000) = $40,000)) instead of more than $12,170 ($12,170 adjusted for inflation for the 2011 year). Their after-tax, out-of-pocket adoption costs are $12,250 (instead of less than $1,330).
Case 2. Consider Jerome and Kay, who in 2010 adopted internationally. International adoptions can sometimes be quicker than domestic private adoptions, and they were on their way to pick up a boy in Korea in November 2010. They were able to finalize the adoption before the end of 2010. Jerome and Kay’s modified AGI for 2010 is $145,000, and it appears likely to be the same in 2011. Total adoption costs are $36,000. They are eligible for the full amount of the credit in 2010 ($12,170), but if the adoption had instead become final in 2011 and the EGTRRA provisions had sunset with no other change, their income would be too high for the threshold amount of $75,000.
Practice point. If, because of changing tax laws or other reasons, it becomes important for taxpayers to finalize an adoption before the end of 2010, they may want to give more consideration to a special-needs child or international adoption, both of which can often be processed more quickly than domestic private adoptions. Adoptions of children placed as foster children by a domestic public child welfare agency are often the quickest and least expensive but offer little control for adoptive parents.
WHO’S ELIGIBLE TO CLAIM THE ADOPTION CREDIT
Married couples must file jointly to receive the credit. An unmarried couple who adopts a child is treated as one taxpayer for purposes of the credit limitation. They may, however, combine their qualified adoption expenses and allocate the credit between them in any way they agree (see section 23(i) and Notice 97-9).
Practice point. Unmarried couples who adopt may wish to allocate the credit to the person in the higher tax bracket; however, if one but not the other taxpayer is subject to the phaseout, the credit should be allocated to the person not subject to the phaseout.
Case 3. Jon and George, a same-sex couple, adopted a child using a domestic agency. Their state of residence allows adoption by same-sex couples. (The Human Rights Campaign lists 10 states and the District of Columbia as recognizing joint adoption petitions by same-sex couples. See tinyurl.com/ygypo95.) They paid $18,000 in qualified adoption expenses. Jon’s modified AGI was $65,000, and George’s modified AGI was $135,000. George is in a higher tax bracket than Jon; therefore, he claimed the adoption credit. Since George’s modified AGI is below the phaseout amount, the entire credit of $12,170 is available.
WHEN THE CREDIT MAYBE CLAIMED
As stated earlier, for domestic adoptions, if the adoptive parents pay or incur adoption expenses during a tax year before an adoption becomes final, the credit will be available for those outlays in the following tax year. Expenses paid or incurred during or after the year when the adoption becomes final are creditable in the year when paid or incurred. Expenses for unsuccessful domestic adoptions are treated in the same manner as expenses of nonfinalized adoptions (that is, they are creditable in the following tax year). The income limitation applies in any year when the credit is claimed. In the case of international adoptions, the adoption credit may be claimed only for the year when the adoption becomes final or in following years. Therefore, no credit is available for an international adoption that does not become final (see special rules, section 23(e)).
Practice point. Families may wish to take steps to make sure that an adoption of a child who is not a U.S. citizen, once undertaken, will become final. If it does not, unlike with a domestic adoption, they will be unable to claim any credit.
Case 4. Mary and Stewart, a married couple filing jointly, adopted a child through a domestic private adoption agency. The adoption became final in 2010. They incurred expenses of $5,000 in 2008; $9,500 in 2009; and $4,500 in 2010. Their modified AGI was below the threshold amount for all years. They claimed a credit of $5,000 in 2009 (the year after the expenses were paid), and the remainder of $7,170 (total credit of $12,170 less amount claimed in 2009) in 2010 when the adoption became final. If Mary and Stewart adopted internationally, the entire credit would have been available in 2010, the year when the adoption became final. However, if they attempt to adopt internationally and the adoption does not become final, they may not claim any credit.
It’s important to keep in mind that the phaseout applies to the credit year, which for years before the adoption year is a year after the expenses were paid or incurred. Thus, in that situation, if a taxpayer’s income increases sufficiently the year after incurring adoption expenses, some or all of the credit could be lost. Phased-out credits aren’t carried forward; however, excess credits carried forward aren’t subject to phaseout (Senate Committee Report 105-174, PL 105-206).
Case 5. Josephina and Marcus adopted a child through a domestic adoption agency. The adoption became final in 2010. They incurred expenses of $5,000 in 2008; $9,500 in 2009; and $4,500 in 2010. Their modified AGI was $190,000 in 2009 and $225,000 in 2010. Their credit in 2009 was $4,022.50, the 2008 cost of $5,000 phased out for the income above the 2009 threshold ($5,000 – ($5,000 x ($190,000 – $182,180) divided by $40,000)). In 2010, their income is over the upper phaseout limit, so they are ineligible for the credit that otherwise would be generated in that year from $9,500 in 2009 expenses and $4,500 in 2010 expenses.
Case 6. Assume the same facts as above, plus that Josephina and Marcus have a $3,000 tax liability in 2009 without regard to the adoption credit. That amount of the credit may be claimed in 2009 and the remainder of $1,022.50 ($4,022.50 – $3,000) carried forward to 2010. Although their income in 2010 exceeds the phaseout ceiling, they may claim the carryforward because the phaseout was applied in the year the credit was generated.
CLAIMING A CREDIT FOR MORE THAN ONE CHILD
As mentioned earlier, if a taxpayer’s tax liability is less than the credit amount, the credit can be carried forward to five future tax years. If the taxpayer is eligible for multiple adoption tax credits, the carryforwards are used on a first-in, first-out basis.
Case 7. Rob and Sally adopted a child in 2008. In 2010, they adopted again. Both adoptions cost more than the credit amount. The couple’s modified AGIs were $60,000 and $75,000 for 2008 and 2010, respectively. Their tax liabilities before the credit were $3,500 in 2008, $4,000 in 2009 and $6,000 in 2010. The credit available in 2008 was $11,650. Rob and Sally claimed $3,500 in 2008 to reduce their tax liability to zero and carried the remainder of $8,150 ($11,650 – $3,500) forward. In 2009, they claimed $4,000 of the credit and had a carryover of $4,150 ($8,150 – $4,000). In 2010, they became eligible for an additional adoption tax credit of $12,170. They claimed the remainder of the old credit ($4,150) and $1,850 of the new credit ($4,150 + $1,850 = $6,000); their carryover to the five subsequent tax years is $10,320.
SPECIAL SITUATIONS
Special-needs children. A special-needs child is a U.S. citizen or resident with a special condition or factor, as determined by a state, such as ethnic background, age, medical condition or handicap, because of which it is reasonable to conclude that the child will not be adopted without the provision of adoption assistance, and who is free to be adopted (a state has concluded he or she cannot or should not be returned to the home of the biological parents). The taxpayer receives the full credit amount for the year when the adoption becomes final (subject to modified AGI phaseout) regardless of actual expenses paid or incurred. A special-needs adoption that doesn’t become final may still be treated as a regular adoption; that is, the credit is limited to qualified expenses claimed in the tax year after they were paid or incurred.
Stepparent adoption. Section 23(d)(1)(C) specifically excludes expenses related to the adoption of the taxpayer’s spouse’s child from qualified adoption expenses. Some jurisdictions may recognize same-sex marriages and thus consider a same-sex spouse a stepparent. For federal tax purposes, however, the Tax Code does not; therefore, in this circumstance, this provision is moot and such partners will be treated as an unmarried couple.
Surrogacy. Adoptions may arise from surrogate birth arrangements, either by artificial insemination or embryo transfer. In many cases, a contract specifies that the intended parents will be listed on the birth certificate, and some states allow prebirth parentage orders; thus, no legal adoption takes place. But even if the intended parents must adopt the child, section 23(d)(1)(B) denies them the adoption credit.
EXECUTIVE SUMMARY
Sonja Pippin (sonjap@unr.edu) is an assistant professor in the Department of Accounting and Information Systems at the University of Nevada, Reno.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.
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OTHER RESOURCES
Articles and reports
- Adoptive Families, “Cost of Adoption Update”
- Child Welfare Information Gateway, U.S. Department of Health and Human Services, How Many Children Were Adopted in 2000 and 2001?
