The Adoption Tax Credit was introduced in 1996 as a means of helping low and middle-income families offset some of the costs of the adoption process. While the credit is meant to ease the financial burden of adoption, a report from the Taxpayer Advocate Service suggests that claiming this key tax break may have inadvertently lead to an audit for thousands of adoptive families.
According to the agency’s 2012 Annual Report to Congress, approximately 90 percent of returns claiming the adoption tax credit for the 2012 filing season were flagged for additional review. Income and a lack of proper documentation for expenses were cited as the most common reasons. Of the returns that were flagged, nearly 70 percent were selected for an audit, affecting more than 35,000 families. Statistically, only around one percent of all tax returns are subject to an audit.
The Taxpayer Advocate Service report also points out that of the returns that were audited, more than 55 percent resulted in no change in tax liability with regard to taxes owed or refunds due. Approximately $668.1 million was claimed in adoption credits for the 2011 tax year but the IRS disallowed only 1.5 percent of all claims, resulting in just $11 million in increased tax revenue. Conversely, the IRS had to pay out $2.1 million in interest to taxpayers who had their refunds held beyond the 45-day period allowed under federal law. The median refund due for those who were qualified to receive the credit was more than $15,000.
The report suggests that the root of the problem can be traced to the passage of the Patient Protection and Affordable Care Act in 2010, which changed the way the adoption credit was calculated. For the 2010 and 2011 tax years, the credit was worth $13,170 per child and it was fully refundable. This effectively meant that taxpayers who had no tax liability could get the credit as a refund, which lead to an increased number of adoptive families receiving money back at tax time. When faced with the task of verifying the accuracy of the adoption credit claims, the IRS began flagging the majority of returns that included the credit to detect potential fraud.
The Taxpayer Advocate Service called the IRS’s handling of the affected returns “misguided” and expressed concern over the economic impact felt by the adoptive families targeted for an audit. The agency has recommended that the IRS take steps to ensure that eligible families are able to claim the credit without the fear of an audit. Specifically, it’s been suggested that the IRS provide taxpayers with examples as to what type of documentation is needed for the credit, allow for e-filing of returns that claim the credit when supporting documentation is included in an electronic format and develop a third-party affidavit to allow for verification of an adoptive child’s special needs status.
Families who claimed the adoption credit for the 2012 tax year are less likely to find themselves the target of an audit. The passage of the American Taxpayer Relief Act in January made the credit permanent but it also made it non-refundable, which means it won’t increase your refund if Uncle Sam owes you money. This could change, however, if the credit becomes refundable at some point in the future. Several lawmakers, including Senators Bob Casey, D-Pa., and Mary Landrieu, D-La., recently introduced the Adoption Tax Credit Refundability Act of 2013 which would restore the refundable portion of the credit. More families would be able to reap the economic benefits of the adoption credit but the audit risk could once again increase if the IRS fails to take corrective action.
If you’re considering adoption or you’ve already begun the process, you need to know what tax benefits you may be eligible for. Check out Topic 607 on the IRS website to find out who qualifies for the adoption credit and what you need to document your claim.