Tax Treatment of Adoption Expenses: A Sizable Tax Credit Is Available, but with Possible Changes on the Horizon
EXECUTIVE SUMMARY * Families facing high costs of adopting a child may ask their CPA about the adoption expense tax credit. * Besides advising clients about the nonrefundable credit's limits and strategies for carryforward of excess credits, CPAs can also address timing issues as Congress considers whether to extend for 2011 the higher maximum credit amount and income phaseout threshold and other provisions of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), currently scheduled to sunset on Dec. 31, 2010. * The maximum credit for 2010 is $12,170, and the modified adjusted gross income phaseout range is $182,520 to $222,520. Qualified expenses for purposes of the credit generally are those reasonably necessary for legal adoption of a child who is under 18 years old or physically or mentally incapacitated. * For international and domestic adoptions, the credit may be claimed in the tax year in which the adoption is finalized. In addition, for domestic adoptions, qualified expenses in prior tax years may be claimed in the tax year following that in which they were paid or incurred. ********** 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. [ILLUSTRATION OMITTED] ADOPTION EXPENSE CREDIT IRC [section] 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. …