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Adoption Assistance Plans - Commentary: Putting the Children First
Putting the Children First: Tax Breaks Encourage Adoption Assistance
Congress often has difficulty coming together in a bipartisan manner on social and tax issues, especially when tax breaks are intended to elicit a specific social response. One area where Congress has effectively used tax incentives in a socially conscious and yet bipartisan way involves tax breaks for individuals choosing to adopt children, including the adoption of children with "special needs."
Obviously, no parent or prospective parent will choose to adopt a child based on tax considerations. In my own family's situation, the nuances between a tax credit under Code Section 23 and a gross income exclusion under Code Section 137 were the least of our considerations during the adoption process, especially during our daughter's actual arrival in the wake of the September 11 terrorist attacks.
We were much more concerned with locating our daughter and her adoption agency escort after the airline lost them for three days when their flight was diverted half way across the Pacific Ocean on September 11th. The airline could not even locate what country our daughter was in -- luckily we found out after the fact that she had been safe and sound the entire time in Fairbanks, Alaska. It wasn't until well after our daughter's ultimate joyous arrival that I even began to examine the tax issues associated with her adoption.
Although I had a working knowledge of the tax credits and income exclusions associated with adoptions, I had never really examined these tax breaks in great detail since client inquiries about adoption assistance prior to 2002 had been relatively insignificant. My first practical encounter with any tax issues associated with our daughter's adoption was in the filing of our own Form 1040. Unlike our son, for whom obtaining a Social Security number was a relatively easy process after his birth, obtaining the tax identifying number for our daughter was a completely different process.
Instead of applying for and immediately receiving a Social Security number, adoptive parents will typically need to apply for an Adoption Taxpayer Identification Number (ATIN) using Form W-7A (Application for Taxpayer Identification Number for Pending U.S. Adoptions) or an individual taxpayer identification number using Form W-7 (Application for IRS Individual Taxpayer Identification Number). As part of our own tax filing process, I began to examine in greater detail the other tax issues associated with adoption and I was spurred on by inquiries from others in our adoption classes.
My own analysis was timely due to congressional action in the spring of 2002: The Job Creation and Worker Assistance Act of 2002 (P.L. 107-147), enacted March 9, 2002, slightly modified the much more expansive changes that were enacted less than a year before by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). The provisions of both laws are important and should be summarized as part of the tax considerations for anyone considering an adoption or who has already commenced the adoption process.
The primary tax benefits in an adoption are the tax credits available under Section 23 and the gross income exclusion under Section 137 (the latter can be a qualified benefit when coordinated with a Section 125 cafeteria plan). EGTRRA amended the credit and the exclusion in several important ways for taxable years beginning after Dec. 31, 2001.
EGTRRA increased an employee's tax credit for adoption expenses under Section 23 from a general limitation of $5,000 to a new maximum limit of $10,000 per eligible child, including children with special needs. Furthermore, EGTRRA made it possible for an employee earning up to $150,000 a year to claim the credit in full. Prior law phased out the credit for adoptive parents earning $75,000 a year, and barred any credit for those whose modified adjusted gross income (AGI) exceeded $115,000.
Now, both the credit and the income exclusion begin to phase out at $150,000 and are fully phased out at $190,000. Both the $10,000 and the $150,000 limits are subject to inflation adjustments to the nearest multiple of $10 after 2002. For 2003, the new amounts for the tax credit and the gross income exclusion have been increased to $10,160 and $152,390, respectively.
Both a tax credit and an exclusion from gross income can be claimed for the same adoption, but not for the same expenses incurred in that adoption. If the total costs for an adoption do not exceed $10,000, then it is generally advisable to take advantage of the tax credits under Section 23 rather than using the gross income exclusion under Section 137 for qualified adoption assistance payments (available in tandem with a salary reduction election under a cafeteria plan).
Of course, the expenses for most adoptions now exceed $10,000. In fact, Adoption.com reports that domestic agency and private adoptions can cost from $8,000 to $28,000 depending on a variety of factors (e.g., travel expenses, birth mother reimbursements, medical expenses, state requirements, services provided) and international adoptions typically cost between $12,000 to $30,000, with the median in the $15,000 to $20,000 range. Therefore, it is important to take full advantage of both the tax credit and the gross income exclusion if at all possible.
The impact of these tax breaks can be illustrated as follows: the adoptive parents have a modified AGI of $70,000 and the employer provides an adoption assistance program in conjunction with its cafeteria plan. If the adoptive parents make the full salary reductions and are taxed at a federal income tax rate of 27 percent and at a state income tax rate of 6 percent, then the net after-tax costs of their $20,000 in adoption expenses can be as little as only $5,645. This is because the parents may receive a direct dollar-for-dollar $10,000 benefit from the tax credit, as well as the $10,000 gross income exclusion and $3,000 for the child's personal exemption. The tax benefit from the $10,000 income exclusion and the $3,000 personal exemption is $4,355 ($3,575 at the federal level and $780 at the state level), assuming, as is often the case, that the state exclusion and exemption provisions parallel the federal provisions. One should also examine any available state tax credits for adoptions.
A "special needs" child is defined as any child who is a U.S. citizen or resident that a state has determined (1) cannot or should not be returned to the biological parents; and (2) that specific factors or conditions (ethnic background, age or race or physical, mental or emotional handicap) indicate that he or she cannot be placed with adoptive parents absent adoption assistance. Congress has also tried to encourage Americans to adopt special needs children. The tax credit and the exclusion are available for the maximum amount regardless of whether the adopting parents ever actually incur qualified adoption expenses or any expenses whatsoever.
To illustrate these principles, assume that the adoptive parents in the above example adopt a child with special needs and incur $5,000 in expenses. They would still be entitled to a full tax credit of $10,000 and a federal gross income exclusion of $10,000.
Many employers will not want or will be unable to directly contribute to an employee's adoption costs in any meaningful way. In fact, the average maximum employer cash reimbursement reported in a recent study by Hewitt Associates was $3,100 for 2000. However, an employer need not even incur any direct out-of-pocket expenses.
An employer may effectively provide adoption assistance without any direct cash outlay simply by offering adoption assistance as a qualified benefit under an existing Section 125 cafeteria plan. If an employer already maintains a cafeteria plan for its employees, then it should consider implementing an adoption assistance plan that is funded solely through an employee's salary reduction elections. To implement an adoption assistance plan, the plan or program must satisfy the following requirements:
- it must be established in a separate written document;
- it must limit eligibility to employees;
- it must provide reasonable notice to employees; and
- it must require substantiation of qualified adoption assistance expenses.
The timing of the deductions and the tax credits can be critical. Unfortunately, both the tax credit and the adoption assistance reimbursements typically will lag behind the date the expenses are incurred. This can put an obvious strain on finances.
For international adoptions, the credit is claimed in the year that is the later of when the adoption becomes final or the qualified adoption expenses are paid. For domestic adoptions, the credit can be taken in the year the adoption becomes final or, if earlier, the year after the year of payment. Notwithstanding these rules, the tax credit can never be taken in a year earlier than that in which the adoptive parents pay the expenses.
An important timing consideration also exists for any adoption assistance provided through the use of a salary reduction election under a Section 125 cafeteria plan. The "use-it-or-lose-it" aspects of a cafeteria plan take on added significance in the adoption context since the adoption expenses in an international adoption typically cannot be reimbursed until the adoption becomes final. Thus, care must be taken to coordinate the salary reduction election to ensure that the salary is reduced in a year in which the adoptive parents know with certainty that the adoption will become final.
Although adoptions can be quite expensive, proper tax planning can eliminate or drastically reduce the net after-tax cost to many adoptive parents.
Of course, nobody considering the joys of adoption should ever consider the adoption tax benefits as anything other than an important means to reduce the financial burden that the adoption expenses can create. However, the practical reality is that adoptions are expensive and they are becoming more so. Therefore, it is only prudent in weighing whether prospective parents can afford to adopt a child that they and their employers take into consideration the very favorable tax effects of the tax credit and the income exclusions that Congress has extended to encourage adoption.
Even if an employer does not intend to directly fund out-of-pocket cash reimbursements for qualified adoption expenses, all employers should actively consider implementing an adoption assistance plan that employees can choose as a qualified benefit under the employer's cafeteria plan to take advantage of the salary reduction effect.
David R. Fuller is a partner at McDermott, Will & Emery's Washington, D.C. office.
