Dollar limit increased. For 2004, the maximum credit increases to $10,390. Also, the maximum exclusion from income of benefits under your employer's adoption assistance program increases to $10,390.

This publication explains two tax benefits available to offset the expenses of adopting a child. The benefits are the adoption credit and the exclusion from income of benefits under your employer's adoption assistance program.

The first part of the publication is for persons who have recently adopted a child, are in the process of adopting a child, or are considering adopting a child. The second part is for employers who provide adoption assistance payments to workers.

You may be able to take a tax credit of up to $10,390 for qualifying expenses paid to adopt an eligible child. The adoption credit is an amount that you subtract from your tax liability.

Also, up to $10,390 paid or reimbursed by your employer for qualifying adoption expenses under an adoption assistance program may be excludable from your gross income. (However, you cannot exclude this adoption assistance if your employer is an S corporation in which you own more than 2% of the stock or stock with more than 2% of the voting power.) An adoption assistance program for this purpose is a separate written plan set up by an employer to provide adoption assistance to its employees. See Adoption assistance program under For Employers, later, for more information.

You may claim both a credit and an exclusion for expenses of adopting an eligible child. For example, you may be able to claim a credit of up to $10,390 and also exclude up to $10,390 from your income. However, you cannot claim both a credit and an exclusion for the same expense.

Limits on the Credit or Exclusion

The credit and the exclusion for qualifying adoption expenses are each subject to a dollar limit and an income limit. These limits apply separately. The credit is also subject to a limit based on your tax liability. Figure these limits on Form 8839, Qualified Adoption Expenses.

How the exclusion limits affect your return.   Because of the dollar limit and the income limit, all or part of your employer's adoption assistance payments may not qualify for the exclusion. On your tax return, you must include in your income any payments that do not qualify for the exclusion.

  All of the adoption assistance payments will be shown in box 12 of your Form W-2, identified with the letter “T.” None of the payments will be included with your taxable wages in box 1 of your Form W-2. Therefore, if all of the payments qualify for the 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.

Your employer is not required to withhold income tax on payments for qualifying expenses under an adoption assistance program. If you must include any of the payments in your income, your withholding may not be enough to cover the tax on those payments. Therefore, you may need to give your employer a new Form W-4 to adjust your withholding, or make estimated tax payments, to avoid a penalty for underpayment of estimated tax.

Dollar Limit

The amount of your adoption credit or exclusion is limited to $10,390 for each effort to adopt an eligible child. For this purpose, an attempt that leads to the successful adoption of a child and any unsuccessful attempt to adopt a different child are treated as one effort. If you can take both a credit and an exclusion, the dollar limit applies separately to each.

If you and another person (other than your spouse if filing jointly) adopt a child and both claim the credit or exclusion, the dollar limit applies to your combined credit or exclusion amounts. You must divide the $10,390 limit between the two of you. You may divide it in any way you both agree.

The $10,390 amount is the maximum amount of qualifying expenses taken into account over all tax years. Therefore, it must be reduced by the amount of qualifying expenses taken into account in previous years for the same adoption effort.

Example 1.

In 2004, you adopt two brothers, Bobby and Sam. Your qualifying adoption expenses paid in 2004 are $7,500 for Bobby and $7,500 for Sam. When you figure the credit, you can take all the expenses into account for both adoptions because they do not exceed the dollar limit of $20,780 ($10,390 for each child).

Example 2.

You pay $3,000 of qualifying adoption expenses in an effort to adopt an eligible child in 2004. However, the adoption is not successful. Later in the year, you pay an additional $9,000 of qualifying adoption expenses for the successful adoption of a different eligible child. Under your employer's adoption assistance program, you are reimbursed for these expenses in 2004. For the dollar limit, you must treat the $12,000 as paid in one adoption effort. Your exclusion from income is limited to $10,390. You must include the remaining $1,610 in your income.

Income Limit

The income limit on the adoption credit or exclusion is based on modified adjusted gross income (modified AGI). For 2004, use the following table to see if the income limit will affect your credit or exclusion.

IF your modified AGI is...		THEN the income limit...
$155,860 or less		will not affect your credit or exclusion.
$155,861 to $195,859		will reduce your credit or exclusion.
$195,860 or more		will eliminate your credit or exclusion.

Example.

In 2004, you adopt an eligible child. Your qualifying adoption expenses are $12,000 and your modified AGI is $175,860. After you apply the dollar limit ($10,390), you apply the income limit. You use Form 8839 to figure your credit. The income limit reduces your credit by 50%. Your adoption credit is $5,195.

Modified AGI.   Your modified AGI for purposes of the exclusion may be different from your modified AGI for purposes of the credit. To figure your modified AGI for the purpose of both the credit and the exclusion, add back the following items to your adjusted gross income (line 37 of Form 1040 or line 22 of Form 1040A).

• The foreign earned income exclusion.

• The foreign housing exclusion or deduction.

• The exclusion for income earned by bona fide residents of American Samoa or Puerto Rico.

To figure your modified AGI for purposes of the exclusion, also add back the student loan interest deduction and the tuition and fees deduction. Also, your modified AGI for purposes of the exclusion includes all benefits you received from your employer's adoption assistance program. Use the worksheet in the Form 8839 instructions to figure your modified AGI for purposes of the exclusion.

Tax Liability Limit

The amount of your allowable adoption credit for a year cannot be more than the total of your regular tax (after reduction by any foreign tax credit) and alternative minimum tax (AMT) for that year, minus the following amounts.

1. Credit for child and dependent care expenses.

2. Credit for the elderly or the disabled.

3. Education credits.

4. Retirement savings contributions credit.

5. Child tax credit.

6. Mortgage interest credit.

If your credit is more than this limit, you can carry forward the unused credit to your next 5 tax years, or until used, whichever comes first. Use the worksheet in the Form 8839 instructions to figure your credit carryforward.

The income limit, discussed earlier, does not apply to a credit carried forward.

When To Take the Credit or Exclusion

When you can take the adoption credit or exclusion depends on whether the eligible child is a citizen or resident of the United States (including U.S. possessions) at the time the adoption effort begins.

Child who is a U.S. citizen or resident.   If the eligible child is a U.S. citizen or resident, you can take the adoption credit or exclusion even if the adoption never becomes final. Take the credit or exclusion as shown in the following tables.

  

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 child.   If the eligible child is not a U.S. citizen or resident, you cannot take the adoption credit or exclusion unless the adoption becomes final. Take the credit or exclusion as shown in the following tables.

  

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.

  Note. For the credit, the amount of expenses paid or incurred before 2002 that can be taken into account is limited to the pre-2002 dollar limits. The limit on these expenses is $5,000 ($6,000 in the case of a child with special needs).

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 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 makes adoption assistance payments in a year before the adoption of a foreign child is final, you must include the payments in your income in the year of payment. Then, on your return for the year the adoption becomes final, you can make an adjustment to take the exclusion. See Form 8839 and its instructions.

  

Your employer is not required to withhold income tax on payments for qualifying expenses under an adoption assistance program. If you must include the payments in income in the year paid because your adoption of a foreign child is not final, your withholding may not be enough to cover the tax on those payments. You may need to give your employer a new Form W-4 to adjust your withholding, or make estimated tax payments, to avoid a penalty for underpayment of estimated tax.

When adoption is final.   When the adoption becomes final depends on the type of immediate relative (IR) visa under which the child enters the United States.

• IR-3 visa. The adoption of a child who enters the United States on an IR-3 visa is treated as final in the year the competent authority enters a decree of adoption. The competent authority is the court or other governmental agency of the foreign country that has jurisdiction and authority to make decisions in matters of child welfare, including adoption.

• Other IR visas. The adoption of a child who enters the United States on an IR visa other than an IR-3 visa is treated as final in the year in which a court of the state in which the child and parents reside enters a decree of adoption, re-adoption, or otherwise recognizes the adoption decree of the foreign country.