Question: An employee has asked our company to consider adding an adoption assistance benefit. We know there's already a federal tax credit that individuals can claim for adoption expenses — and we're a small company with a tight benefits budget. Does it make sense for us to offer an adoption assistance plan of our own?
Answer: The Internal Revenue Code does have a generous tax credit for qualified adoption expenses. For 2017, the maximum credit is $13,570 — for adoption of special needs children — or for other adoptions, equal to qualified adoption expenses, the same as the maximum nontaxable reimbursement by an employer's qualified adoption assistance program. And if an employer has an adoption assistance benefit, employees will be able to choose whether to take the tax credit for a qualified expense or submit that expense to the employer-provided program for reimbursement. (Employees may take full advantage of both the tax credit and the tax exclusion for employer reimbursements — just not for the same expenses.) In 2016 the credit for adoptions in general was $13,460.
Despite the tax credit for individuals, there are still reasons to consider establishing an adoption assistance plan at your company. Here are some points to consider:
- Adoption expenses frequently exceed the maximum tax credit. Many adoptions result in expenses that exceed the maximum tax credit. Employer reimbursements can be used to reduce the burden of those additional expenses.
- Because employer-provided adoption benefits are subject to FICA, most employees will use the tax credit first. For many taxpayers, the tax credit is economically superior to an employer-provided reimbursement because payments under an adoption assistance program are considered wages subject to FICA tax but the adoption tax credit isn't. Consequently, employees who don't have enough expenses to fully utilize both the tax credit and the adoption assistance exclusion will likely exhaust the credit before seeking reimbursement from an adoption assistance program.
- Lower-income employees may be unable to take full advantage of the tax credit. The tax credit is nonrefundable that is, it cannot reduce the federal income tax owed below zero). Thus, the value of the tax credit is limited by the employee's federal income tax liability. While unused credits may be carried forward up to five years, every year the credit is delayed reduces its present value, and after five years, the unused credits expire.
- Employer-provided adoption benefits can help employees' cash flow. Employees may not have sufficient liquid assets to pay adoption expenses. Direct payment or prompt reimbursement by an employer may reduce this burden and lower the overall cost of adoption by eliminating or diminishing employees' need to borrow to cover their costs.
- Adoption assistance plans can provide tax benefits to employees even if the employer pays nothing. While employers commonly contribute to their adoption assistance benefit programs, a qualified adoption assistance program can also provide meaningful financial benefits without any employer contributions (other than the cost of establishing and administering the program).
First, adoption assistance benefits may be offered under a cafeteria plan and paid for entirely with pre-tax salary reductions. (The appeal of pre-tax salary reductions to pay for adoption expenses is somewhat diminished by the irrevocable election, "use-or-lose," and other cafeteria plan requirements.)
Second, the unique rules applicable to special-needs adoptions allow employees to obtain a substantial income tax exclusion if their employer has a qualified adoption assistance program, regardless of how much the employer contributes. If the employer has the right documentation in place, an employee who adopts a special-needs child can take the full maximum tax exclusion ($13,570 in 2017), whether the employer offers a maximum reimbursement of $13,570, some lesser amount (for example, $5,000), or no reimbursement at all. By taking advantage of this opportunity, even employers on very tight budgets can help employees lower their federal income taxes when they adopt children with special needs.