Josh Kroll, with the North American Council on Adoptable Children (NACAC), recently shared this post with NFPA on Facebook:
I have had a few questions recently about taxes and foster/adoptive parenting.
1. Claiming children as dependents - foster parents as well as adoptive parents may be able to claim children as dependents. To claim the children you must meet all five tests - age, relationship (foster and adoptive parents are just fine), residency, support and joint filing tests.
The two big issues are support and residency. In 2005 the support test changed to the child can't provide more than half of their own support--foster care payments are not support provided by the child (and subsidy should be treated the same way). Residency is the other big issue, you have to have the child with you more than half the year (if the child was born or died during the year, then more than half of the year that they are alive).
Sometimes another parent (birth or foster) may claim the child before you, in that case the IRS will kick it out. You then need to challenge and document you had the child more than half the year.
Read more here: http://www.irs.gov/
2. Do I report my foster care payments or adoption subsidy as income to the IRS? No, in rare circumstances foster care payments may be considered taxable income. Basically if you have 5 young adults over the age of 19 in your foster family you count it as income. Or if 10 children under the age of 19 in your foster family who qualify for difficulty of care rates, the DOC rates is taxable income. Also if you are paid to maintain space in your home for emergency foster care, then you must report ath income.
Go to this page and scroll up just a little bit to read the whole section: http://www.irs.gov/
Adoption subsidy has not been directly expressed in IRS publications for years. But NACAC has the 1974 Revenue Ruling as well as two Private Letter Rulings (1988 and 2008) and Chief Counsel Advice (2002) that says that adoption is not taxable for the IRS.