Client Services

Employee Communication: Tax Exclusion or Credit?

Tax-Free Adoption Assistance Reimbursements

You are not taxed on the Qualified Adoption Assistance reimbursements paid to you by the [Name of Company] Adoption Assistance Plan up to the Plan’s limits on reimbursements. In other words, the company’s reimbursements of your qualified adoption expenses are excludable from your income. The company’s payments may be excluded in more than one year, but the total exclusion may not exceed $12,150 (for 2009) per adoption. The amount you may exclude is phased out ratably over a $40,000 modified adjusted gross income range, beginning at $182,180 and ending at $222,180 for 2009. Both the phaseout amount and the $12,150 exclusion amount are subject to annual cost-of-living adjustments.

All benefits paid under the Plan (whether or not excludable from taxable income) are subject to both the Social Security and Medicare portions of the Federal Insurance Contributions Act (“FICA”) and federal unemployment tax under the Federal Unemployment Tax Act (“FUTA”) and may be subject to state and/or local taxes in certain states.

Employer reimbursed benefits include those paid under salary reduction plans such as that offered by the company. To qualify for tax-free treatment, you must satisfy the Plan’s terms and the relevant IRS requirements, including filing IRS Form 8839, Qualified Adoption Expenses, with your federal income tax return. The Plan will not reimburse you unless you substantiate the adoption expenses you have incurred. Also, substantiation is one of the conditions for tax-free treatment. Furthermore, you may not claim any tax credit or other tax benefit for the tax-free reimbursements you receive under this Plan.

A very unique and advantageous rule applies to the calculation of adoption expenses for a child with special needs. The federal government has enacted even greater incentives to encourage such adoptions. You are eligible for reimbursement and to claim the income exclusion regardless of whether you have any actual adoption expenses. The Internal Revenue Code provides that your actual qualified adoption expenses for the adoption of a child with special needs are increased in the year the adoption is finalized by "deemed adoption expenses": the difference between $12,150 and the total actual qualified expenses for the adoption incurred during that year and all prior taxable years.

Adoption Assistance Tax Credit

Separate from the exclusion for Plan reimbursements, you may be eligible for a qualified adoption tax credit of $12,150 on your 2009 federal income tax return. The adoption assistance tax credit is 100 percent of your qualified expenses. This means that qualified expenses are fully paid by the federal government. This tax credit lets you treat your qualified adoption expenses as a credit against your federal income tax liability. In determining the amount of that tax credit, you may take into account as much as $12,150 of eligible expenses for the adoption of each eligible child. The exclusion is phased out generally over the same income range as the adoption tax exclusion. However, for purposes of determining the phaseout of the employer exclusion, modified adjusted gross income excludes all employer payments or reimbursements for adoption expenses, whether or not they are taxable to the employee. If you are unable to use the entire tax credit during the current year, the tax credit may be carried forward for use in future years for a maximum of five years.

Coordination of Credit and Exclusion

You may claim both a credit and an exclusion for the adoption of an eligible child. However, you may not claim both a credit and an exclusion for the same qualified adoption expenses. Also, you may not claim a credit or exclusion for any expense reimbursed or paid for by your spouse’s employer or any other governmental or nongovernmental entity, whether or not reimbursed under an adoption assistance program.

No matter what your income tax bracket, you will almost always come out ahead by claiming the tax credit instead of tax-free reimbursements under the Plan. The Plan should be used for adoptions with actual expenses in excess of $12,150 and for all adoptions of children with special needs. Because the actual determination of the preferable method for treating these expenses depends on a number of factors such as your tax filing status, number of dependents, impact of incurring expenses in multiple years, etc., you must determine your position individually to make this decision. Please refer to IRS Form 8839, Qualified Adoption Expenses, or consult your own tax advisor for more information.

How the Exclusion Limits Affect Your Income Tax Return

Adoption assistance payments are shown in box 12 of your Form W-2, identified with the letter “T”. None of the payments for qualified adoption expenses are included with your taxable wages in box 1 of your Form W-2. Therefore, if all of the payments qualify for the adoption exclusion, you will not need to adjust the amount of wages and other income you report on your tax return. But if any of the payments do not qualify for the exclusion, you must include in your income the payments that do not qualify. See Form 8839 and its instructions. If you are married, you may only claim the exclusion for Plan reimbursements or the adoption tax credit if you file a joint return, unless you are legally separated under a decree of divorce or separate maintenance.

Because of the dollar limit and the income limit, adoption assistance payments to certain highly compensated employers may not qualify for the adoption exclusion. [ The same is true for international adoption. ] On your tax return, you must include in your income any payments that do not qualify for the exclusion. If you receive adoption assistance reimbursements in a year before an international adoption is final, you must include the payments in your income in the year of payment. Then in the year the adoption becomes final, you can make an adjustment on your return to take the exclusion. SeeForm 8839 and its instructions.

When to Claim the Credit and Exclusion

The year in which you can claim the tax credit for adoption-related expenses depends on three things: (1) whether the adoption is domestic or foreign; (2) whether the expenses are paid or incurred before or after the adoption is finalized; and (3) whether the adoption is for a child with special needs.

If a domestic adoption is not final, an employee should claim a tax credit for qualified adoption expenses in the tax year following the year in which he or she paid or incurred the expenses.

For domestic qualified adoption expenses paid during or after the tax year in which an adoption becomes final, an employee should claim the tax credit in the tax year in which he or she paid the expenses.

Similar timing rules for claiming the tax credit apply to foreign adoptions, except that such adoptions must have become final before an employee may claim any tax credits. In some situations, this requirement will shift the timing of an employee’s tax credit claim; in other situations, the timing will not change.

The following tables illustrate when to claim the tax credit and when to claim the income exclusion.

When to Claim the Tax Credit

after the year the                               the year of the payment             the year of the payment
adoption becomes final

When to Claim the Income Exclusion

after the year the                               the year of the payment             the year of the payment
adoption becomes final

 

IRS Form 8839 -- Complexity and Taxpayer Burden

The tax provisions associated with the adoption tax credit and the gross income exclusion can be very complex, especially the actual tax computation. For this reason, you should consider filing your tax return with the assistance of tax preparation software or an income tax preparer. To claim the benefits of the adoption tax credit or the employer exclusion, you must complete and file IRS Form 8839 as part of your annual income tax return. Form 8839 is one of the more complicated personal income tax forms issued by the IRS. The form consists of two pages, plus instructions with detailed information on how to proceed in different situations and several “worksheets” taxpayers can use to calculate the applicable tax credit or income exclusion for the year. Even with computerized tax preparation software, some complexity can still remain in trying to determine which expenses qualify and in dealing with concepts that are unfamiliar to most taxpayers.

Before completing Form 8839, you will need to gather information about the expenses incurred in the adoption process, determine which expenses are “qualifying,” and determine the year in which those qualifying expenses may be claimed for both income tax purposes and Plan reimbursement purposes. The tax filing process does not require that you submit with your tax returns either the details of the expenses by category or documents verifying the expenses.

Related Information

• Complimentary Model Plan Documents
• Frequently Asked Questions