| Recent Tax Law Changes Benefit Adoptions
John J. Spina, Esq.
This information is provided as a general guideline on the new tax benefits
available in connection with the adoption of a foreign child. There are
important differences in the law, not discussed here, with respect to the
adoption of a U.S. child. This discussion is not intended as legal advice nor
should such information be relied on without consulting your tax advisor or
adoption attorney regarding your particular facts and circumstances.
In June 2001, President Bush signed into law a tax relief package that included
the permanent extension of the Adoption Tax Credit (ATC) and income exclusion
under an employer-sponsored adoption assistance program. Both provisions were
set to expire at the end of 2001. Although the new ATC and income exclusion are
similar to the provisions enacted in 1996, there are important changes in the
law of which you should be aware. The discussion below attempts to explain the
new tax benefits, particularly as they apply to adoptions of foreign children,
and in the process, answer some frequently asked questions.
I. What are the ATC and Exclusion ?
The ATC is a tax credit for 100 percent of "qualifying adoption expenses"
(discussed below) up to a maximum amount of $10,000 (adjusted for inflation
after 2002). Thus, if you incur $4,000 in adoption expenses in 2002, you could
claim a $4,000 credit once the adoption is finalized. However, if you incur
$12,000 in adoption expenses in 2002, you could only claim a $10,000 credit,
the maximum amount allowed. (A tax credit reduces your tax liability dollar for
dollar and thus is much more valuable than a tax deduction which only reduces
the amount of income on which you have to pay tax.)
In addition to the ATC, if your employer has implemented an adoption assistance
program, you may be able to exclude from gross income the employer’s payments
or reimbursements for your expenses in adopting a child. As with the ATC, this
amount is limited to a maximum exclusion of $10,000 (adjusted for inflation
after 2002). Amounts your employer pays for your adoption expenses are
considered income paid to you by the employer (like salary) on which you
otherwise would have to pay tax. The exclusion allows you to reduce your income
by the amount of the employer payments or reimbursements once the adoption is
finalized.
An adoption assistance program is a written plan of the employer that must meet
certain federal tax law requirements. For information on these requirements,
consult IRS Publication 968 or your tax advisor. You cannot exclude employer
payments or reimbursements for adoption expenses that you incurred before the
employer’s adoption assistance program was in effect.
You may claim both the $10,000 ATC and the $10,000 exclusion for the same
adoption, but not for the same expense. Thus, if you incurred 15,000 in
adoption expenses, $8,000 of which you paid and $7,000 of which your employer
paid through an adoption assistance program, you would be eligible to claim an
$8,000 tax credit for the amounts you paid and exclude from income the $7,000
the employer paid on your behalf.
II. Who qualifies for the ATC and the Exclusion?
The ATC and exclusion are available for persons in the process of adopting a
child, persons who have adopted a child or who are considering adopting a
child. There are income limitations that phase out the ATC and exclusion for
higher income earners, however, the dollar amounts have been significantly
increased under the new law.
The income limitations are based on modified adjusted gross income (modified
AGI), and will be adjusted for inflation after 2002. IRS Form 8839 and the
accompanying instructions will tell you how to figure your modified AGI for the
purpose of the credit and exclusion and will provide the amount by which you
would have to reduce your credit or exclusion if your modified AGI is greater
than $150,000.
Note that married couples must file a joint tax return to take the ATC or
exclusion. The income limits in the table below apply equally to income
reported on the joint return of a married couple as well as income reported on
an individual tax return.
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If your modified AGI is
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Then you will be eligible for |
| $150,000 or less |
The full credit or exclusion. |
| $150,001 to $189,999 |
A reduced credit or exclusion.
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| $190,000 or more
|
No credit or exclusion. |
For example, assume you have $10,000 of qualifying expenses for 2002 and your
modified AGI for 2002 is $165,000. Under the income limitation, your ATC for
2002 would be reduced by an amount provided on IRS Form 8839. If your modified
AGI for 2002 were, for example, $195,000, you would be ineligible to claim the
ATC or exclusion.
III. What are "Qualifying Adoption Expenses"?
Qualifying adoption expenses are reasonable and necessary adoption fees, court
costs, attorney fees, traveling expenses (including amounts spent for meals and
lodging) while away from home, and other expenses directly related to, and
whose principal purpose is for, the legal adoption of an "eligible child." For
a foreign adoptee to be considered an eligible child, he or she must be under
18 years old.
It is important to note that as with other tax credits and exclusions in the
tax law, the IRS will be looking to prevent taxpayers from abusing the ATC and
exclusion by fraudulently claiming expenses that did not exist or by "padding"
actual expenses. Thus, when the tax law provides that qualifying adoption
expenses must be "reasonable and necessary," and "directly related to, and
whose principal purpose is for" a legal adoption, these are legal standards by
which the IRS will review your tax return and determine whether your claim for
the ATC or exclusion is valid. For example, the expense for chartering a
private jet to take you overseas to meet your adopted child probably is not a
reasonable expense for which you could claim the credit or exclusion. In
addition, such a claim would likely serve as a "red flag" to the IRS and may
prompt an audit of your tax return. Thus, as you incur adoption expenses, you
should keep in mind the legal standard when determining what is a qualifying
adoption expense.
Non-qualifying expenses include, among other things, expenses that violate
state or federal law, expenses for the adoption of your spouse's child,
expenses paid using funds received from any federal, state, or local program,
expenses allowed as a credit or deduction under any other federal income tax
rule, or expenses paid or reimbursed by your employer (except for amounts paid
or reimbursed under an adoption assistance program).
IV. When can you take the ATC and/or Exclusion?
If the eligible child is not a U.S. citizen or resident, you cannot take the
adoption credit or exclusion unless and until the adoption becomes final. You
may claim the credit and/or exclusion as shown in the following tables.
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If you pay qualifying expenses in
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Then take the credit in |
| Any year before the year the adoption becomes final |
The year the adoption becomes final. |
| The year the adoption becomes final |
The year the adoption becomes final. |
| Any year after the year the adoption becomes final |
The year of the payment. |
|
If your employer pays for qualifying expenses under an adoption assistance
program in |
Then take the exclusion in |
| Any year before the year the adoption becomes final |
The year the adoption becomes final. |
| The year the adoption becomes final |
The year the adoption becomes final. |
| Any year after the year the adoption becomes final |
The year of the payment. |
If your employer makes adoption assistance payments in a year before the
adoption of a foreign child becomes final, you must make an adjustment on your
tax return for the earlier year to include the payments in your income. Then,
on your return for the year the adoption becomes final, you may make an
adjustment to take the exclusion.
Prior dollar limits continue to apply to expenses paid before 2002, and the ATC
is not available for expenses incurred before the ATC was enacted. For example,
assume you had $7,000 of expenses in 2001 (when the maximum ATC was $5,000) and
$3,000 of expenses in 2002. You finalize the adoption of a foreign child in
2002 and now can claim the credit. You would be eligible to take an $8,000
credit — $5,000 for expenses incurred in 2001 (the maximum amount allowed under
the old law), and $3,000 for expenses incurred in 2002.
If your tax liability is less than your available credit, you may carry forward
the amount of credit left over, until it is used, for a period of 5 years. For
example, assume in 2002 your tax liability is $4000 but you have $7,000 in
adoption expenses. You can claim a $4,000 credit for 2002 and carry forward the
remaining $3,000 of credit to offset tax liability for the next 5 tax years, if
necessary.
You can also apply the credit to offset any taxes owed under the alternative
minimum tax.
V. How to take the ATC or Exclusion?
You must file IRS Form 8839 with either IRS Form 1040 or Form 1040A to take the
credit or exclusion. As noted above, if you are married, you must file a joint
return to take the adoption credit or exclusion.
You must provide an identifying number for the child on Form 8839. For this,
you must use either a social security number if the child has one or if you
will be able to obtain one prior to filing your tax return, or an individual
taxpayer identification number (ITIN) if the child is a resident or nonresident
alien and not eligible for a social security number. An adoption taxpayer
identification number (ATIN) is not available for a foreign adoptee.
The amount of your adoption credit or exclusion is limited to $10,000 for each
effort to adopt an eligible child. If you can take both a credit and an
exclusion, this dollar limit applies separately to each. The $10,000 amount is
the total amount of qualifying expenses you may take into account whether, for
example, your adoption takes 1 year or 4 years. It must be reduced by the
amount of qualifying expenses taken into account in previous years for the same
adoption effort. For example, assume that in your effort to adopt a child, your
qualifying adoption expenses for 2002 are $3,000. The maximum amount of
expenses you can take into account for future years will be reduced by the
expenses you took into account for 2002. Therefore, the maximum amount of
expenses you could take into account for future years with respect to this
adoption effort is $7,000. Assume now that you pay $6,000 of qualifying
adoption expenses in an effort to adopt an eligible child. However, the
adoption is not successful. You then pay an additional $7,000 of qualifying
adoption expenses for the successful adoption of a different eligible child.
With respect to the dollar limit on the credit, the IRS views the $13,000 of
expenses as paid in one adoption effort. Therefore, because the maximum amount
of expenses you can take into account is $10,000, you would not be able to take
the ATC for $3,000 of qualifying adoption expenses.
VI. What documentation should be kept?
As noted above, the IRS will likely review a tax return claiming the ATC or
exclusion with the same careful attention it reviews tax returns claiming other
tax credits and exclusions. Therefore, it is important that you retain all of
your receipts and records showing payments made in connection with adoption
expenses incurred. You should also keep copies of your tax returns that you
file each year.
VII. For Additional Information
For additional information on the ATC and income exclusion under an
employer-sponsored adoption assistance program, you should consult your tax
advisor or adoption attorney. You may also consult IRS Publication 968 which
provides a fairly clear explanation of the ATC and exclusion as understood by
the agency that will be reviewing your tax return and enforcing the
requirements of these tax provisions. Additional information may also be found
on the IRS web site at www.irs.gov, or by calling the IRS at 1-800-829-1040.
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