IRS Definitions and Explanations, Page 2

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 partof 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.

Caution: 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 adopt a child and both claim the credit or exclusion, the dollar limit applies to your combined creditor exclusion amounts.

The $10,960 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 2006 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 $21,920 ($10,960 for each child).

Example 2.

You pay $3,000 of qualifying adoption expenses in an effort to adopt an eligible child in 2006. 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 2006. For the dollar limit, you must treat the $12,000 as paid in one adoption effort. Your exclusion from income is limited to $10,960. You must include the remaining $1,040 in your income.

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Credits: U.S. Internal Revenue Service