Adoption credit and assistance exclusion.

Guidance on the new adoption provisions added by the Small Business Job Protection Act of 1996 (SBJPA) was issued recently in Notice 97-9.

Adoption Credit 

Under Sec. 23, an individual can obtain an income tax credit for qualified adoption expenses paid or incurred in connection with the adoption of an eligible child. The maximum credit is $5,000 ($6,000 in the case of a "child with special needs"). The IRS defines an eligible child as an individual who, at the time the adoption expense is incurred, is (1) under 18 or (2) physically or mentally incapable of caring for himself. For qualified adoption expenses paid or incurred after Dec. 31,2001, an eligible child also must be a child with special needs.

A "child with special needs" is an otherwise eligible child who satisfies two additional requirements. First, a state must have determined that the child cannot or should not be returned to the parents' home and it must be reasonable to conclude that the child cannot be placed with adoptive parents without adoption assistance because of a specific factor or condition (e.g., a child's ethnic background, age, membership in a minority or sibling group, medical condition or handicap). Second, the child must be a citizen or resident of the U.S., including any U.S. possession.

Qualified adoption expenses include "reasonable and necessary adoption fees, court costs, attorney's fees, traveling expenses" and other expenses directly related to the adoption. An expense paid (by a cash-basis taxpayer) or incurred (by an accrual-basis taxpayer) in a tax year beginning before 1997 does not qualify.

The $5,000 or $6,000 limitation "is with respect to the adoption of each child and is cumulative over all taxable years (rather than an annual limitation)." The maximum amount includes qualified adoption expenses paid or incurred in any unsuccessful attempt to adopt an eligible child before successfully finalizing the adoption of another eligible child. The dollar limitation applies to both married individuals and unmarried individuals adopting an eligible child. Therefore, if an unmarried couple seeks to adopt a child, the $5,000 (or $6,000) dollar limitation would apply to the couple's combined qualified adoption expenses.

The credit is also subject to an income limitation. If the taxpayer's modified adjusted gross income (AGI) is $75,000 or less, the income limitation does not apply; if modified AGI is $115,000 or more, the credit is not available; if modified AGI is between $75,000 and $115,000,the credit is ratably reduced. Modified AGI is AGI for the tax year after applying the income exclusion under Sec. 137, but without applying the exclusions under Secs. 911,931 and 933.

For an eligible child who is a U.S. citizen or resident at the time the adoption commences, the credit is allowed for qualified adoption expenses paid or incurred in the next tax year, unless the expenses are paid or incurred in the tax year the adoption becomes final. This is known as the "one-year delay rule." For expenses paid or incurred in the tax year an adoption becomes final, the credit is allowed in that year.

For an eligible child who is not a U.S. citizen or resident when the adoption is commenced, the credit is available only for adoptions that become final.

Adoption Assistance Exclusion

Sec. 137 provides an exclusion from an employee's gross income for amounts paid or expenses incurred by an employer under an adoption assistance program. The definitions of "eligible child," "child with special needs" and "qualified adoption expenses" in Sec. 137 are the same as under Sec. 23. Similar to the credit, the exclusion is capped at $5,000 (or $6,000 for the adoption of a child with special needs) and is subject to a similar income limitation.

The notice defines an adoption assistance program as "a separate written plan of an employer for the exclusive benefit of its employees." The written plan must be in existence, and the employees must be notified about the plan, before the adoption expenses are incurred. The notice states that the plan must meet the following requirements:

(a) all employees eligible to participate in the program must be given reasonable notice of the program's terms and availability;

(b) a program must benefit the employer's employees generally; eligibility requirements may not discriminate in favor of highly compensated employees or their dependents;

(c) shareholders or owners (or their spouses or dependents) may receive no more than 5% of all the adoption assistance reimbursements or expenses paid by an employer during the year (for this purpose, a shareholder or owner is one who owns on any day of the year more than 5% of the employer's stock, capital or profits interest); and

(d) an employee receiving payments under an adoption assistance program must provide the employer with reasonable substantiation that payments or reimbursements made under the program are qualified adoption expenses.

If the requirements of Sec. 137 are satisfied, an adoption assistance program will constitute a qualified benefit under Sec. 125. Thus, the program may be offered through a cafeteria plan.

The notice further provides that amounts paid or incurred by an employer for qualified adoption expenses are not subject to income tax withholding; these amounts, however, are subject to FICA withholding and FUTA. Ann. 96-134 provides instructions related to reporting adoption assistance payments on Form W-2.

In addition to explaining both the credit and the exclusion, the notice provides information on the coordination of the two provisions. An individual may claim both a credit and an exclusion in connection with the adoption of an eligible child, but may not claim both for the same expense. Also, an individual may not claim a credit for any expense reimbursed by his employer, whether or not the employer makes the reimbursement under an adoption assistance program.

The notice states that a taxpayer will be required to provide available information about the name, age and taxpayer identification number of each eligible child for whom a credit or exclusion is claimed. In lieu of such information, the IRS may require taxpayers to furnish other information, including the identification of the agent assisting with the adoption. The notice also warns taxpayers to maintain records to support any claimed credit or exclusion. The Service will publish forms and instructions on the filing requirements for individuals and the reporting requirements for employers.

Married individuals who want to claim the credit or the exclusion must file a joint return. An exception is provided for couples who lived apart from each other "for the last six months of the taxable year and the individual claiming the credit or the exclusion (1) maintained as his or her home a household for the eligible child for more than one-half of the taxable year, and (2) furnished over one-half of the cost of maintaining that household in that taxable year."

The adoption tax credit and the exclusion are both effective for tax years beginning after 1996. They both generally terminate after 2001 (except for the credit with respect to a child with special needs).

From Gary Q. Cvach, CPA, LL.M., and Martha Priddy Patterson, J.D., Washington, D.C.