Posts Tagged ‘tax’

Understanding the Adoption Tax Credit

February 25, 2014 By Guest Contributor

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By Megan Asselin, CPA and Abigail Stokes Palsma

In most cases, taxpayers, whether single, registered domestic partners, or married couples, are eligible to claim a tax credit on the federal tax return for the expenses related to the adoption of a child. For the 2013 federal tax return, adopting families are able to claim qualified expenses up to $12,970. Additionally, families who adopt a child from a California Public Agency are eligible for a credit on their California tax return for 50% of qualified costs up to $2,500 per child.

The application of the federal credit varies based on whether the adopted child is in the foster care system, is a domestic child, or is a foreign child. The credit is not allowed when adopting a spouse’s child, however, there is an aggressive tax strategy that some may find helpful. Additionally, there are specific instructions for both the federal and state credits regarding how to claim expenses that occur over multiple years.

Basic Rules for the Adoption Credit

When adopting a child, it is important to keep track of all qualified expenses related to the adoption process. Qualified expenses as defined by the IRS include court costs, attorney fees, traveling expenses (including amounts spent for food and lodging while away from home), and other expenses directly related to the adoption of an eligible child. An eligible child as defined by the IRS, is any child under the age of 18 or any individual who is physically or mentally unable to care for himself.

On both the federal and California tax returns, qualified expenses are documented so that the taxpayer can receive a credit, which lowers the amount of taxes owed. Because the IRS and the California Franchise Board are two different taxing authorities, the same expenses can be claimed on both returns. Yet, because California offers the 50 percent credit only to those who adopt from a state agency and adoption fees are generally waived or very low for these types of adoptions, many adopting families do not receive a significant credit on their California tax return.

The tax credit is nonrefundable, which means that it is used only to decrease the total amount of taxes owed in a particular tax year. However, if the credit is greater than taxes owed, it can be carried over for up to five years on the federal return and until it is used on the California return. If that occurs, the taxpayer can use the tax credit against the tax liability in the subsequent year(s).

Adopting a Foster Child

While domestic and foreign adoptions can both be very expensive, adopting a child from a foster system is typically more affordable. In fact, state and county governments as well as qualified foster care placement agencies provide financial assistance for foster parents who are adopting the child(ren) in their care. Payments of this kind are generally excluded from the family’s income.

Regardless of the amount an adopting family spends, many foster adoptions qualify for the maximum credit if the child is defined as “special needs.” This does not mean that the child has physical or mental disabilities, but rather that he or she meets specific criteria, which might vary by state. In California, a foster child is considered to have special needs if she meets one of the following criteria. The child is/has:

  • Three years of age or older,
  • A race, ethnicity, color, or language that is a barrier to adoption,
  • A member of a sibling group that should remain together,
  • A mental, physical, emotional, or medical disability certified by a licensed professional, or
  • A parental background of a medical or behavioral nature that can be determined to adversely affect the development of the child.

For the California credit, the child must be a U.S. citizen and must be adopted from a California public agency (state, county, or city). Private adoptions and adoptions through a charitable organization do not qualify for the credit.

Case study: Mark and Larry are foster parents for a sibling group of two young children. Their charity-based foster agency provides monthly assistance payments, and now that they have decided to adopt the children, the payments have increased. Sibling groups qualify as “special needs” in a foster adoption. Even though Mark and Larry have received assistance from their agency and the costs related to the adoption process were relatively low, they are still able to claim the maximum adoption credit on their federal tax return for both children because of the children’s “special needs” classification ($12,970 x 2 = $25,940). In the tax year that Mark and Larry adopt the children, the potential credit available to offset their tax liability is $25,940. Because they adopted from an agency that is not a California Public Agency, they are not eligible for a credit on their California tax return.

Adopting a Spouse’s Child

As previously stated, the tax credit is available to be claimed when adopting an “eligible child.” The IRS definition of eligibility excludes the child of the taxpayer’s spouse. Certainly, a taxpayer may adopt his spouse’s child, but he will not receive a tax credit for related expenses. However, there is an aggressive tax strategy that some might find useful.

If the adoption is finalized prior to the marriage, but both the adoption and the marriage happen in the same tax year, the taxpayer can claim the credit. In this case, the child was literally not the child of the taxpayer’s spouse at the time of the adoption, making the child legally “eligible.” This could be confusing, if you are aware that the IRS considers married at any point in the year as married for the entire year. However, this provision only applies to certain Codes, such as the definition of a dependent and rate schedules. It does not apply to the adoption eligibility status of a child.

Caution: If a couple claims the adoption credit in the same tax year they are married, the IRS may perform an audit to verify that the adoption occurred before the marriage. Be prepared to provide documentation of both events should the IRS question the return.

Case Study: Marcia and Jane have been Registered Domestic Partners for five years. Jane has a ten-year-old daughter from a previous marriage, and Marcia legally adopted her in early 2013. After DOMA was overturned in 2013, Marcia and Jane decided to marry before the end of the year so that they could take advantage of the tax benefits married couples are eligible for. In order to receive the adoption credit, Marcia and Jane must file their federal tax return jointly, even though this draws attention to the fact that Marcia has adopted Jane’s child. The couple has kept clear records to show that the adoption was final several months before they married. Marcia and Jane do not use the same strategy for their California tax return. Even before DOMA was overturned, the State of California allowed for Registered Domestic Partners to file their state tax return jointly. In the eyes of state laws, they were provided the same tax benefits as married couples, including credits associated with dependents. Therefore, Marcia and Jane’s income has already been adjusted to account for costs associated with raising Jane’s daughter. Even if that weren’t the case, Jane’s daughter was not adopted from a state agency, so no state-based adoption credit is available to the two moms.

How to Claim the Federal Credit when Expenses Span More Than One Year

The federal adoption credit is limited to $12,970 in 2013 for each adoption effort. If costs for the same adoption effort occur in multiple years, the dollar limit for the subsequent year must be reduced by the amount claimed in the previous year. In other words, the most a family can claim for an adoption is the maximum amount allowed, whether all of the costs were incurred in the same year or multiple years. In the Instructions for Form 8839, Qualified Adoption Expenses, the IRS published the following charts that clarify when to claim expenses. A domestic adoption refers to the adoption of an eligible child who is a U.S. citizen. A foreign adoption refers to the adoption of a child that is not yet a citizen or resident of the U.S.

Domestic Adoption

IF you pay qualifying expenses in… THEN take the credit in…
Any year before the year the adoption becomes final The year after the year of the payment.
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 The year of the payment.

 

Foreign Adoption

IF you pay qualifying expenses in… 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 after the year of the payment.
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.

 

For eligible California adoptions, the credit is available in the year the adoption becomes final. Expenses that were incurred in the prior taxable year can only be included in the computation of expenses in the year the adoption was finalized.

Case Study: Jack and Jill are adopting a domestic baby through a private adoption agency. They spent $3,970 in legal fees in 2012, but the adoption was not final, so they cannot yet claim the expenses on federal tax return. Because the agency is private, they are not eligible for the California credit. In 2013, they expect to pay an additional $12,000 to finalize the adoption. When they prepare their 2013 federal tax return, they may claim only the maximum $12,970, even though they spent a total of $15,970.

Case Study: Mike and Sue are adopting a foreign baby. They began the process in 2011, when they paid initial fees to the agency. They continued through the process and incurred the bulk of their expenses in 2012. They brought the baby home and finalized the adoption in 2013, incurring expenses for travel, as well as the final attorney, agency and court fees. Mike and Sue report all eligible adoption expenses incurred from 2011 to 2013 on their 2013 tax return and apply the $12,970 maximum credit to reduce their tax liability that year. Since the baby is not a U.S. Citizen, Mike and Sue cannot claim the California tax credit.

Case Study: George and Anthony adopted a foster baby through the Los Angeles County Department of Children and Family Services. Assume that adoption costs through this governmental entity are waived. Therefore, there is no credit to claim on the California tax return. However, because the foster baby fits the definition of “special needs,” George and Anthony are able to claim the maximum credit on their federal tax return, or $12,970.

Employer Adoption Assistance Programs

As noted in the preceding IRS charts, there is a second tax benefit available to adopting families who receive assistance through their employer’s adoption assistance programs. When an adopting family receives assistance through such a program, the amount received reduces qualified expenses and is also excluded from the gross income.

Case Study: Jennifer is adopting a domestic baby. Her employer pays $3,000 of her attorney fees through an adoption assistance program. When she files her federal tax return, she must reduce the amount of the qualified expenses by $3,000. This amount will also be excluded from her gross income since this is an employer benefit that is not taxed and has already been applied to the qualified expenses.

For more information about the adoption tax credit or to schedule a free 30-minute consultation, please contact Megan Asselin at MAsselin@vlsllp.com or 626-857-7300, ext. 309.

Megan Asselin, CPA is a Senior Manager at Vicenti, Lloyd & Stutzman LLP in Glendora, specializing in tax, audit, and general accounting services. Abigail Stokes Palsma is the Knowledge Manager for Vicenti, Lloyd & Stutzman. An earlier version of this article was published in February 2014 by Bienvenidos, https://bienvenidos.org/adoption-tax-credit/.

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