Uncle Sammy understands that adoption proceedings can be an expensive process. That is why the Small Business Job Protection Act created a non-refundable tax credit for qualified adoption expenses and a new exclusion for employer-provided adoption assistance programs. Congress created the new tax benefits because it believed that the financial costs of the adoption process should not be a barrier to adoption and because it wanted to encourage not only regular adoptions, but also adoptions of children with special needs.
The credit and exclusion were effective for taxable years beginning in 1997. But, you should know that the exclusion for adoption assistance programs and the general adoption credit is due to expire on December 31, 2001. For year 2002 and beyond, only the credit for the adoption of a child with special needs will remain. So, if adoption is in your future, you might want to make sure that it's in your near future if you want to jump on the adoption credit bandwagon.
Adoption Credit Overview
The law allows a credit for the amount of qualified adoption expenses that you pay during the tax year, but the year that the credit is allowed will depend on whether the child is a U.S. citizen or resident.
If domestic adoption expenses are paid the year before the adoption becomes final, the credit is allowed for the taxable year following the year the expenses were paid (the year the adoption becomes final). If the expenses for a domestic adoption were paid or incurred during or after the year the adoption becomes final, the credit is allowed for that year. A credit for the expenses of a foreign adoption is not allowed until the tax year that the adoption becomes final. What does this mean exactly?
Example: Let's say that Jack and Jill pay qualified adoption expenses of $2,000 in 1997, $1,500 in 1998, and $2,500 in 1999 for a domestic adoption. The adoption became final in 1999. Jack and Jill are allowed a credit of $2,000 in 1998 (representing the expenses paid in 1997). Jack and Jill will also receive a credit of $3,000 in 1999 (representing $1,500 of expenses paid in 1998, and $1,500 of the $2,500 in expenses paid in 1999 that are allowed to be claimed in 1999 because that was the year the adoption became final).
What happens to the "lost" $1,000? While Jack and Jill actually paid $6,000 in qualified adoption expenses, only the first $5,000 is available for the credit. If Jack and Jill adopted a child with special needs, their 1999 credit would have increased to $4,000, since the expense limitation for a special needs child is $6,000.
If Jack and Jill paid the same expenses for a foreign adoption, they would not have been able to take any of the credit until 1999... the year in which the adoption became final. And, their dollar limitations would also be the same: $5,000 or $6,000 for a special needs child.
As we noted above, the adoption credit is scheduled to end relatively soon. So, remember that for either a domestic or foreign adoption, no credit is allowed for expenses paid before January 1, 1997, or after December 31, 2001, except for the expenses of adopting a special needs child. As the law is currently written, the credit for the expenses of adopting a special needs child does not have a scheduled ending date. But, always understand: Congress giveth, and Congress can taketh away.
In addition, should you pay qualified adoption expenses but, for whatever reason, the adoption is not successful, you are allowed to claim the credit in the next taxable year following the year that the expenses were paid. However, before you begin to see tax credit dollar signs dance before your eyes, you should also know that, as noted above, this is a non-refundable credit. So, the credit will only reduce your taxes to zero... not below. Uncle Sammy will not write you a refund check if your non-refundable credits exceed your income tax liability, but all is not completely lost. If your credit exceeds your income tax liability, you can carry the excess credit forward for five years.
There is some additional bad news: The adoption credit is not exempt from the Alternative Minimum Tax (AMT). So, if you are in the AMT zone, your adoption credits might be much less than you anticipate (or hope for). Make sure you are familiar with your AMT status before you spend your credit dollars on little Johnny's new highchair.
The credit is limited to $5,000 of aggregate expenses for each child, or $6,000 for a child with special needs. The dollar limitation is "per child," and is cumulative over all taxable years for each child; it's not an annual limitation. Therefore, the maximum total amount, over all tax years, that may be taken into account in connection with your effort to adopt any one eligible child is $5,000 (or $6,000 if the child has special needs). Period.
Adopt two children and your limitation would rise to $10,000 (or $12,000 for two special needs children), but the maximum expenses for each child would still max out at $5,000 (or $6,000 for a special needs child).
There are a lot of qualifications here. Qualified child. Qualified expenses. What are all of those qualifications? We take a closer look at them in Part II of this three-part series.