Enacted on August 20, 1996, Small Business Job Protection Act of 1996 (SBJPA) Public Law 104-188 made several refinements and improvements to the Internal Revenue Code, including the creation of a two-part adoption assistance tax relief program.
Although many areas of the SBJPA merely revised or rewrote existing laws, the adoption assistance provisions are a welcome addition to the tax code.
Prior to enactment of SBJPA, federal adoption assistance was limited to an outlay program providing up to $1,000 of federal reimbursement for expenses related to the adoption of certain special needs children. House Report 104-373, Conf. Rep. on H.R. 3448. The Federal Adoption Assistance program did not provide any benefits to parents adopting other children, and the Code did not contain any provisions to assist with the expenses associated with these proceedings. Recognizing this inequity and the financial hardship caused by the adoption process, the House of Representatives proposed the creation of both a tax credit and an income exclusion to help ease the burdens of adoptions for most taxpayers.
After adding amendments, the Senate concurred, and with President Clinton’s signature, SBJPA ¤ 1807 created new I.R.C. ¤¤ 23 and 137. Title 26 U.S.C. This legislation’s broad reach may encourage more adoptions in the near future; however, due to sunset provisions in the new law, most benefits will expire by 2002.
Federal adoption assistance under the Code is now available through two separate approaches. Under I.R.C. ¤ 23(a)(1), a taxpayer may claim a nonrefundable tax credit on his or her income tax return for qualified adoption expenses. This allows the taxpayer to deduct from income taxes owed an amount equal to the allowed adoption expenses actually paid or incurred. Any excess of allowed credit over tax due may be carried forward and used within the next five years. Under I.R.C. ¤ 137(a), the taxpayer may exclude from taxable income amounts paid by his or her employer for such expenses. This permits the taxpayer to omit from income any employee assistance program reimbursement for adoption expenses. Provided that there are enough expenses so that none are counted twice, the taxpayer may even qualify under both provisions. The statutory language of each section is substantially identical with cross-references between the two sections.
The maximum tax credit or income exclusion available under each section is $5,000 per adopted child. The child must be less than 18 years of age or otherwise unable to care for herself or himself when adopted. If a state certifies that a child should not be returned to his or her parent’s home, and the child requires assistance to encourage placement due to age, ethnic background, medical or emotional conditions, or other factors, expenses of up to $6,000 per special needs child are eligible for the new tax treatment. A special needs child, however, must be a citizen or resident of the United States for the adopting parent to qualify for the extra $1,000 benefit.
As with many tax benefits, the adoption tax credit and income exclusion will be phased out at certain income levels. If the taxpayer’s adjusted gross income (AGI) is less than $75,000 for the year in which the credit or exclusion is claimed, the allowed amount will not be reduced. Between $75,000 and $115,000 of AGI, however, the benefit is partially reduced. For example, at $95,000 of AGI, the maximum tax credit and/or income exclusion is $2000 (or $3,000 for a special needs child). No benefits are available for an AGI of more than $115,000.
Qualified adoption expenses that may be claimed for tax credit or income exclusion are any reasonable and necessary adoption fees, court costs, legal fees, and other expenses directly and principally related to the legal adoption of an eligible child by the taxpayer. If the claimed expense is a capital improvement, such as a wheelchair access ramp, the basis of the property is increased by the expenditure and then reduced by the credit or exclusion. Expenses incurred in violation of any state or federal law in connection with a surrogate parenting arrangement or related to the adoption of a spouseÕs child, such as in a second marriage, are not qualified adoption expenses under the new law.
For both ¤¤ 23 and 137, all expenses must be paid or incurred after December 31, 1996. Comm. Rpt. of P.L. 104-188. With the exception of expenses relating to the adoption of special needs children, the tax credit expires for expenses paid or incurred after December 31, 2001; the income exclusion will expire outright on this date. Expenses reimbursed by one’s employer or the Federal Adoption Assistance program may not be claimed for the tax credit, and any business owner with more than 5-percent ownership may not receive more than 5 percent of the total benefits paid under the company’s adoption assistance program.
For the adoption of a child who is a citizen or resident of the United States, the adoption credit is claimed in the tax year following the year in which expenses are paid or incurred. However, the credit for expenses paid or incurred during the year in which the adoption becomes final is claimed in that year. The income exclusion is taken in the year expenses are paid by the employer. Internal Revenue Service Notice 97-9 clarifies that the credit or exclusion may also be claimed for an unsuccessful adoption. However, expenses for an unsuccessful adoption are added to those relating to a successful adoption when considering the maximum benefit of $5,000 (or $6,000) per adopted child. With respect to the adoption of a foreign child, however, expenses may only be claimed for credit or exclusion in the year a successful adoption becomes final, even if paid or incurred earlier. If the adoption is not completed, the credit may not be claimed.
To claim the tax credit or take an income exclusion, married adoptive parents must file a joint tax return unless the special rules governing head-of-household status apply. The Code particularly calls for the IRS to draft rules assuring that unmarried individuals who pay expenses pertaining to the same child are treated as one taxpayer for purposes of this benefit, thus reinforcing Congressional intent that the maximum benefit is $5,000 (or $6,000) of total tax credit and/or income exclusion per child no matter how many persons (unmarried cohabitants or other interested parties) may be financing the adoption.
The legislation also instructs the IRS to draft any other appropriate regulations to help carry out the new provisions. Although none have been drafted or proposed, Notice 97-9 was issued on Dec-ember 31, 1996, and is a detailed analysis of the new provisions. This notice may form the preliminary basis for the new regulations.
As of this writing, the IRS has not yet created the tax form on which the credit will be computed and claimed. It is anticipated that the new form will relate to the tax credits section on page two of the Form 1040.
On December 16, 1996, the IRS published Announcement 96-134, which contains a brief statement that qualified adoption expenses paid by an employer will be noted as a new Code T in box 13 of the Form W-2. The employer-paid amounts will be exempt from income tax withholding, but are still subject to Social Security, Medicare, and federal unemployment taxes. Because the amount excluded on the revised W-2 may not equal the allowed exclusion after all applicable limitations for the particular tax year (such as waiting until a foreign adoption is completed), taxpayers must ensure that proper estimated taxes are paid to avoid potential underpayment penalties.
Although the SBJPA was mainly aimed at helping the small business economy, the adoption tax credit and income exclusion created by the act should help encourage additional adoptions where the financial impacts are a serious concern. Once the act’s effectiveness can be gauged, perhaps the sunset provisions will be removed so as to continue these positive new tax laws.
Sample. Tax Clauses
1. Nontaxable/nondeductible
Any payment by Wife to Husband pursuant to this clause is designated as not includible in the gross income of the Husband under ¤ 71(b)(1)(B) and not allowable as a deduction to Wife under ¤ 215 of the Internal Revenue Code of 1954, as amended. The parties agree to treat the payment for federal income tax purposes consistently with this designation.
2. Taxable/deductible
(a) Husband will pay to Wife, as alimony or separate maintenance payments, $900 per month beginning June 1, 1996, and continuing for a total of ninety-six (96) months until May 31, 2004. Husband’s payment obligation pursuant to this Paragraph will end, and he will be released from the obligation of payment upon the death of Wife, or upon his death, provided that the life insurance provisions in paragraphs ____ and ____ have been complied with.
(b) The parties hereby agree that the payments provided in Paragraph 2(a) above shall be taxable to Wife and deductible by Husband. The parties stipulate and agree (i) that said alimony payments are necessary for the support and maintenance of Wife; and (ii) without which, Wife will not have sufficient income from other assets or employment to maintain herself. The parties further agree that the alimony shall continue even if any other condition occurs that would terminate the alimony under the Divorce Code or in the event of any subsequent filing of bankruptcy by Husband.
(c) If Husband files for bankruptcy within five (5) years of the date of this Agreement, this Agreement shall constitute conclusive evidence of the parties’ intent that the obligation of this Paragraph is in the nature of support and maintenance and is not dischargeable in bankruptcy under the current bankruptcy law or any amendment to it. Further, if Husband institutes an action in bankruptcy or any other bankruptcy proceeding is instituted in which Wife’s right to the alimony becomes a matter for judicial review, Husband agrees to consent to any motion filed by Wife with the Bankruptcy Court requesting that the Bankruptcy Court abstain from deciding the dischargeability of this alimony obligation and any other obligations due her hereunder in order to allow the _______ court to rule on this issue.
[Editor's note: The bankruptcy law may preempt anything at the state court level, including a statement within a document. The bankruptcy court has the right to review and interpret the document as it sees fit.]
(d) If for any reason Husband is successful in having this obligation discharged in bankruptcy, or if any alimony payments made to Wife are deemed a preference by a court of competent jurisdiction in bankruptcy, then the parties agree that this Agreement shall be null and void as resolution of Wife’s pending economic claims in a certain divorce action filed at ________ in the ________ court, including Wife’s claim for equitable distribution; alimony pendente lite; alimony, spousal support, and counsel fees; costs, and expenses set forth in Complaint filed by Wife as plaintiff in the above action. Any release of any of Husband’s other obligations arising out of the marriage pursuant to this Paragraph also shall be null and void. With the effective date that Husband’s obligation ceases under this section due to the bankruptcy discharge, or the effective date of any Order requiring repayment of alimony by Wife as a preference in bankruptcy. Wife shall have the right to prosecute her economic claims in the divorce action as if this Agreement had not been entered and any order of support in any form shall be effective retroactive to the date of discharge or date of receipt of any payment Wife is required to repay.
(e) Said alimony or separate maintenance payments shall be tax includible to Wife pursuant to IRC ¤ 71 and tax deductible to Husband pursuant to IRC ¤ 215.
3. Change in law
(a) This Agreement has been negotiated and executed on the assumption that the payments described in this Paragraph will be deductible to Husband and taxable to Wife. If, as a result of a final and binding judicial determination, or because of a subsequent change in the governing law or in its authoritative interpretation, it is established that any or all of said payments are not deductible by Husband, then provided that the payments are therefore also not taxable to Wife, she shall, not later than the due date for the applicable return, pay to Husband a sum equal to the decrease in her [increase in his] tax liability. If Wife fails to pay the amount, Husband may, in addition to such other remedies as may be provided by law, deduct such amounts from the sums payable by him to her under this Agreement.
(b) If pursuant to any final and binding ruling, decision, or decree by the Internal Revenue Service or any court as a result of any legislation, regulation, tax examination, or audit, all or any part of the amounts paid under Paragraph 1 shall not be deductible by Husband for the purpose of computing his federal income tax liability and not includable in Wife’s gross income for the purpose of computing her federal income tax liability, the payments made pursuant to Paragraph 1 shall be readjusted by agreement of the parties so that:
[Option 1] Wife shall receive the same net after-tax amount as she would have received had the payments been includible in her gross income for the purposes of computing her federal income tax liability.
[Option 2] The amount of adjusted alimony payable to Wife shall be reduced by the amount of federal income tax payable by Husband, which is attributable to the nondeductibility of such alimony payments from his gross income.
[Option 3 - a fuzzy choice]
The economic result intended by the parties is achieved.
BY SCOTT B. FRANKLIN
Scott B. Franklin, B.B.A., J.D., is a staff accountant with the Milwaukee, Wisconsin accounting firm of Kohler and Franklin, Certified Public Accountants. He concentrates in the firm’s tax and business advisory practices and is a member of the Wisconsin Bar. The author wishes to thank Sandra Kohler Stern and Nina M. Vitek for their assistance with this article.