CRS ASSESSES ADOPTION TAX PROPOSALS.

                       ADOPTION TAX PROPOSALS

[1] Included in the Seven-Year Balanced Budget Reconciliation Act of 1995 are tax provisions to reduce the costs associated with adoptions and to encourage families to seek adoptable children. The proposals are for an adoption expense tax credit and a tax exclusion for employer-provided adoption assistance -- both of which are capped at $5,000. Under the proposals, benefits are phased out for taxpayers whose adjusted gross income falls between $75,000 and $115,000. Eligible expenses include reasonable and necessary adoption fees, court costs, attorney fees, or other directly related adoption expenses.

[2] An adoption expense itemized deduction was provided by the Economic Recovery Tax Act of 1981, designed to encourage and reduce the financial burdens for taxpayers who legally adopt children with special needs. The deduction was repealed with passage of the Tax Reform Act of 1986. The rationale for repeal was based on the belief that the deduction provided the greatest benefit to higher-income taxpayers and that budgetary control over assistance payments could best be handled by agencies with responsibility and expertise in the placement of special needs children. The Congress later reconsidered its position and included in the conference report on the Technical and Miscellaneous Revenue Act of 1988 a call for a tax deduction "to encourage and facilitate adoption."

[3] The proposed $5,000 tax credit and/or exclusion amounts are substantially higher than the tax benefit provided by previous tax law. It may be argued that the substitution of a tax credit and/or exclusion, both subject to a phase-out of benefits for high- income taxpayers, alleviates much of Congress' prior criticism that as a deduction, the value of the tax benefit was greatest for higher income taxpayers. While Federal tax assistance has been provided in the past for children with special needs, the proposal in the Seven- Year Balanced Budget Reconciliation Act of 1995 is more broadly based since it pertains to all adoptions. Because the tax benefit level is greater and the proposal encompasses a larger universe of children, it is expected to cost $1,945 million over fiscal years 1996-2002. It should be noted that to the extent that the tax credit and/or exclusion provides homes for children in State programs, then State foster care costs would be reduced.

PROPOSAL FOR AN ADOPTION EXPENSE TAX CREDIT AND A TAX EXCLUSION OF EMPLOYER ASSISTANCE PAYMENTS

[4] Included in the Family Tax Relief portion of Title XI- Revenue Provisions of the Seven-Year Balanced Budget Reconciliation Act of 1995 is a proposal for an adoption expense tax credit and a tax exclusion for employer-provided adoption assistance -- both of which are designed to foster and facilitate adoption. Either the tax credit or the exclusion would reduce the costs associated with adoptions for taxpayers whose incomes fall below $115,000. Both the tax credit and the exclusion amount are capped at $5,000 per adopted child. The tax credit for adoption expenses (while not refundable) may be carried forward five years to offset future tax liability. Employer provided adoption assistance must be received under an established adoption assistance program. In the case of expenses for a foreign adoption, eligibility is established when the adoption is finalized. The tax provisions are not available for children who have attained age 18. In general, married couples are required to file a joint return to be eligible for the credit. Special rules negating the joint return requirement are provided for taxpayers living apart during the previous six months and for legally separated persons.

[5] The bill provides that both the tax credit and tax exclusion amounts are available for expenditures for qualified adoption expenses. Qualified adoption expenses include adoption fees, court costs, attorney fees, and other expenses directly related to a legal adoption. Other directly related expenses might include such expenditures as the costs of a social service review or transportation expenses. The provisions are unavailable for expenditures contrary to State or Federal law and may not be used for a surrogate parenting arrangement. Expenses associated with the adoption of a spouse's child are not eligible expenses. In general, the bill prohibits double benefits. Thus, in general, if a deduction or credit provision is used under other Code sections or if a grant is accepted under a Federal, State, or local programs, or amounts are received from an employer's adoption assistance program, then the proposed tax credit would not be available to provide further favorable tax treatment to the extent of receipts. However, an exception is provided to the double benefit prohibition for grants given for the adoption of a child with special needs. ¹

[6] Both the tax credit and tax exclusion amounts are reduced for taxpayers whose adjusted gross income exceeds $75,000. For incomes over $75,000, the amounts are reduced by the percentage that the excess over $75,000 is of $40,000, so that the amounts are fully phased out for taxpayers whose income exceeds $115,000. Table 1, which follows, provides maximum credit amounts for various adjusted gross income levels.

       TABLE 1. ADOPTION EXPENSE TAX CREDIT AND TAX EXPLANATION

[7] A deduction for adoption expenses was first provided under a provision enacted as part of the Economic Recovery Tax Act of 1981 (P.L. 97-34). It applied only to expenses for adopting hard to place children. Previously, the Congress had viewed adoption expenses as a personal expenditure and not eligible for tax preferred status. In the General Explanation of the Economic Recovery Tax Act of 1981, it was stated that "the Congress was concerned with obstacles to the adoption of children who have special needs which make them hard to place, even without regard to the high cost of adoption. Accordingly, the Act provides a limited deduction intended to encourage, and reduce the financial burdens in connection with, the adoption of children who have special needs."

[8] The Senate originally passed an amendment which provided a deduction from gross income of up to $1,500 in qualified adoption expenses for placement of children with special needs. In the conference agreement, the major change made to this provision was that the deduction was changed from one taken from gross income to an itemized deduction. Thus, the deduction was made available only to taxpayers who itemize their deductions.

[9] The Economic Recovery Tax Act of 1981 provided a deduction of up to $1,500 per special-needs child for qualified expenses. In the conference report, qualified adoption expenses were defined as reasonable and necessary adoption fees, court costs, attorney fees, and other expenses which are directly related to the legal adoption of a child with special needs." Special-needs children were described generally as children which a State has determined cannot or should not be returned to the natural parents and who, because of ethnic background, age, membership in a sibling group, medical condition, or physical, mental, or emotional handicap, are not expected to be adopted without assistance payments.

[10] In November 1984, the Treasury Department reported to President Reagan a proposal to repeal this deduction and replace it with a direct expenditure program. The Treasury Department rationalized that the adoption of children with special needs should be controlled by agencies familiar with the needs of such children. Further, it was felt that such agencies should have budgetary responsibility for the costs of such programs. Thus, a grant program was felt to be a better mechanism for Federal support than the tax system. President Reagan, in the President's Tax Proposals to the Congress for Fairness, Growth, and Simplicity, proposed repeal of this deduction and stated that he ". . . anticipated that a direct expenditure program would be enacted to continue Federal support for families adopting children with special needs. The effective date of such program should be coordinated with the proposed repeal of the current deduction."

[11] In response, the Congress repealed the itemized deduction and provided matching funds for administrative expenses (such as adoption fees, court costs, attorney fees, and other directly related expenses) incurred for adoption expenses of children with special needs. The repeal of the tax deduction for adoption expenses was accomplished in the Tax Reform Act of 1986 (P.L. 99-514). The rationale provided in the General Explanation of the Tax Reform Act of 1986 for this change was stated as follows:

          The Congress believed that Federal benefits for families

AN ASSESSMENT

[13] There are a number of observations that can be made regarding the proposed adoption expense tax credit and proposed exclusion from income of employer provided payments from adoption assistance programs. While Federal tax assistance has been provided in the past for the placement of special needs children, the credit and/or exclusion are more broadly based. Both the proposed tax credit and tax exclusion would apply to the majority of adoptions -- not just adoptions of special needs children.

[14] The substitution of a tax credit (which can be carried forward for a five-year period) and tax exclusion alleviates Congress's prior criticism that as a deduction, the value of the tax benefit was greatest for higher income taxpayers. This is especially true in light of the modified adjusted gross income phase-out provision. It appears that the proposed credit and exclusion are designed to both provide tax relief to lower and upper moderate income families for the costs associated with adoptions and to encourage families to seek adoptable children. Under the proposal, taxpayers with adjusted gross incomes of less than $75,000 can receive the full exclusion or tax credit. The phase out applies to taxpayers whose adjusted gross income are between $75,000 and $115,000, with no benefit provided for taxpayers exceeding the $115,000 cap. It appears that the rationale for the cap is that taxpayers with incomes over $115,000 have the resources for adoption such that the Federal Government does not need to provide special benefits in the form of tax allowances so that adoption is affordable. The phase out also reduces the revenue costs of the provisions.

[15] Prior tax law provided a maximum tax deduction of $1,500. Thus, a taxpayer in the 70-percent tax bracket would have received a maximum tax benefit of $1,050. As such, the proposed $5,000 (tax credit or exclusion amount) would provide a benefit substantially higher than the largest benefit available under prior tax law. This revenue loss would stem not only from the larger tax benefit level but also the ability to carry forward the tax credit for a five-year period. On the other side of the issue of revenue costs, the adoption tax credit and exclusion may reduce the costs of foster care to the extent they find homes for children in State programs. While the revenue costs associated with adoption credit or exclusion is a one time revenue loss, foster care payments may go on year after year.

[16] It appears that the proposed tax credit and exclusion are in addition to the direct expenditure program undertaken in 1986 to replace the tax deduction of that time. However, in light of the proposal -- specially in regards to the carryforward feature of the tax credit -- the need for a direct Federal assistance program for adopting children with special needs is called into question. In general, assistance payments would offset the proposed tax credit or exclusion. The offset applies in all cases except for special needs children. Thus, it can be said that, in general, only in special needs adoption cases or where an individual receives a grant greater than $5,000, would the benefit from receiving the grant exceed that of the tax credit. ² Some have assumed that tax credits and direct government grants are similar since both may provide benefits at specific dollar levels. However, some argue that tax credits are often preferable to direct Government grants because they provide greater freedom to the taxpayer. Such freedoms include the timing of expenditures, the amount to spend, etc., while government programs typically have more definitive rules and regulations. Additionally, in the case of grants, absent a specific tax exemption, a grant may result in taxable income to the recipient.

[17] Use of a tax mechanism does, however, add complexity to the tax system, since the availability of the credit must be made known to all taxpayers and space on the tax form must be provided (with accompanying instructions). The provisions will also add to the administrative burdens of the Internal Revenue Service. The criticism of the previous tax deduction that the Internal Revenue Service had no expertise in adoptions and was therefore not the proper agency to administer a program of Federal assistance for adoptions, would also apply to the proposed adoption credit and exclusion.

REVENUE EFFECTS

[18] Table 2 provides the Joint Tax Committee's estimate of the loss in Federal revenues which would stem from providing a $5,000 tax credit or $5,000 exclusion from income for assistance payments from an employer provided adoption assistance plan.

   TABLE 2. $5,000 TAX CREDIT AND/OR EXCLUSION FOR EMPLOYER PROVIDED

² In some cases, a grant (even when taxable) might be more beneficial to a taxpayer than the exclusion, since tax savings from an exclusion are a function of the taxpayer's tax rate times the excluded amount.