You won’t run across it very often, because the number of surrogacies compared with conventional births is very small. Generally, surrogacy arrangements are made through surrogacy agencies. Surrogacy is a legal arrangement – the surrogate mother, the parents and the agency all have entered into a binding contract and in the event of a breach of that contract, can be held to the terms of the agreement.
Tax Treatment By The Surrogate – If you go on the Internet you will find a wide variety of opinions related to the taxability of the surrogate fee to the surrogate mother. Some will say it is a gift; however, in a case decided by the U.S. Supreme Court (Commissioner vs. LoBue, Philip, (1956, S Ct)) to be a gift for tax purposes, gifts must be made out of a detached or disinterested generosity. Any payment made by the parents to a surrogate mother is hardly detached or disinterested, so surrogate fees are not gifts.
You will also find many surrogacy agencies are taking the position and advising their clients that surrogacy payments are for pain and suffering, and thus exempt under IRC Sec 104. The title of Sec 104 is “compensation for injury or sickness” and the term “pain and suffering” does not appear anywhere in that code section. Surrogacy hardly meets the definition of physical injury as would be found in a car accident, bungled surgery or other accidental injury. So surrogacy fees hardly fall under the compensation exclusion for injury or sickness.
IRC Sec 61 states: “Except as otherwise provided, gross income means all income from whatever source derived.” There is no exception in the code for surrogacy fees, and as a result, a surrogacy fee is taxable income to the surrogate mother. To complicate matters, the surrogate mother is providing a “personal service” and personal services are subject to self-employment tax as well as income tax when received in the course of a business. Does the surrogacy arrangement rise to the level of a trade or business? The answer depends on the facts and circumstances of each situation. If the surrogate has entered into such an arrangement before or intends to do so again, the fee would likely be considered self-employment income. But if being a surrogate is a one-time activity, an argument could be made that it is not a business, in which case the surrogate fee would be reported as “other income” (for 2018 on line 21 of draft Schedule 1 of Form 1040), but not subject to SE tax.
If the fee is self-employment income, it may be offset with benefits available to any self-employed taxpayer including the ability to deduct health insurance above-the-line rather than as an itemized deduction and to make deductible contributions to a self-employed retirement plan or IRA. Although there is not much in the way of deductible expenses, legal or other costs associated with drafting and executing the surrogate contract would be a deductible business expense.
A self-employment surrogacy activity would fall into the category of a specified service business for purposes of the new deduction for self-employed and pass-through businesses available in years 2018 through 2025. So provided the surrogate mother’s return has a taxable income not exceeding $207,500 ($415,000 if she is married and files a joint return with her spouse), she would be eligible for this Sec 199A deduction, generally equal to 20% of the net self-employment income.
Unfortunately, we have tax novices making their interpretations of the tax code on the Internet and a great many of them attempt to justify what they would like the result to be as opposed to what it actually is.
As a result many, dare we say most, surrogate mothers are not reporting the income, and the IRS is not catching up with them because neither the parents nor the agency is issuing a 1099-MISC to surrogate mothers. The parents are under no obligation to issue a 1099-MISC because it is not related to a business for them. The agency on the other hand is a business, and if the surrogacy fee passes through them, they would have an obligation to issue a 1099-MISC.
Tax Treatment By The Parents
Surrogate mother expenses are not specifically addressed in the code, regulations, etc. Under current tax law the only place a surrogate fee could potentially be deducted is as a medical expense. But. . .
- Per IRC Sec 213(a) medical deductions are allowed for the medical care of the taxpayer, spouse and dependents, and
- Per IRC Sec 213(a)(1)(A) the expenses must be for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.
A surrogate mother is, of course, neither the taxpayer nor the taxpayer's spouse, and typically is not a dependent of the taxpayer. Nor is an unborn child a dependent (Cassman v. United States, 31 Fed. Cl. 121 (1994)). Thus, medical expenses paid for a surrogate mother and her unborn child would not qualify for deduction under § 213(a).
And per Sec 231(a)(1)(A) the fee cannot be construed as treatment for the female parent’s inability to conceive.
Thus, the surrogacy fee, agency fees, legal fees and medical expenses for the surrogate mother and unborn fetus are not deductible by the parents.