Are Difficulty of Care Payments Taxable Under IRS Rules?

Difficulty-of-care payments you receive through a state Medicaid waiver program are generally not taxable for federal income tax purposes, provided the person you care for lives in your home. Internal Revenue Code Section 131 excludes these payments from gross income, and IRS Notice 2014-7 extended that treatment to individual care providers paid under Medicaid waiver programs, whether they are related to the care recipient or not.¹ Employment taxes and tax-form reporting are separate questions with their own rules, and getting those right is where most providers run into trouble.

When Difficulty-of-Care Payments Qualify for the Exclusion

Three things have to line up: the payment source, the care recipient’s status, and where the care happens.

The Payments Must Come Through a Qualifying Program

The money must flow through a state Medicaid waiver program established under Section 1915(c) of the Social Security Act, or a similar program run by a state, a local government, or a state-licensed placement agency acting on the state’s behalf.² Private arrangements between families do not qualify, even when the person receiving care has a documented disability.

The Care Recipient Must Be Approved for Waiver Services

The person you care for must have a physical, mental, or emotional condition that the state has determined requires additional in-home support. The program itself handles that determination as part of its eligibility process, and the recipient must be enrolled and approved for the waiver services you provide.

The Person Must Live in Your Home

This is the requirement that decides most exclusion questions. Notice 2014-7 is explicit that payments for care provided outside the home where the provider resides are not excludable.¹ If you travel to someone else’s house to provide care, those payments are ordinary taxable compensation regardless of how the program is structured.

The IRS looks at where the provider actually resides, not where care happens to be convenient. A shared lease, utility bills at the same address, government-issued identification, and agency records reflecting the same household all help prove this. A temporary visit is not enough. The care recipient has to be an actual resident of your home during the period the payments cover. The exclusion still applies when the recipient is your spouse, parent, child, or other relative, as long as the home and program conditions are met.¹

There Is a Cap on the Number of Recipients

Section 131 limits how many people in a single home can generate excluded difficulty-of-care payments. You can exclude payments for care provided to up to 10 individuals under age 19 and up to 5 individuals aged 19 or older.² Payments for anyone beyond those limits are taxable.

What the Exclusion Actually Covers

Under Notice 2014-7, the entire qualified Medicaid waiver payment is treated as a difficulty-of-care payment and excluded from gross income, provided all the eligibility conditions are met. Section 1915(c) waiver programs are designed to cover home and community-based services other than room and board, so the payments are compensation for care services rather than general living expenses.¹

If you receive a separate payment outside the waiver program for the care recipient’s room, board, or personal expenses, that amount is not covered by the exclusion and must be reported as income. The dividing line is whether the money flows through the qualifying Medicaid waiver program for approved care services.

How to Report the Exclusion on Your Return

Many state agencies still issue W-2s or 1099s reporting these payments as if they were fully taxable. You handle that on your return, and the mechanics depend on which form you receive.

If You Receive a W-2

Some W-2s now include a Box 12 Code II entry identifying nontaxable Medicaid waiver payments. When the code is present, report the Box 1 amount on Form 1040, line 1a, and the Box 12 Code II amount on Form 1040, line 1d. Then enter the total nontaxable amount as a negative number on Schedule 1 (Form 1040), line 8s.³

If your W-2 Box 1 shows zero or is blank and you are not electing to treat the payments as earned income for credit purposes, you do not need to report the W-2 amounts on your return at all.³

If You Receive a 1099-MISC or 1099-NEC

Report the full 1099 amount as income on Schedule C, line 1. Then deduct the nontaxable portion in Part V (Other Expenses) of Schedule C and write “Notice 2014-7” next to it. Because these payments are excludable, the IRS treats them as not self-employment income, so they are not subject to self-employment tax even though they pass through Schedule C.³

Social Security and Medicare Taxes Follow Different Rules

Excluding a payment from income tax does not automatically exclude it from Social Security and Medicare taxes. The two systems have different rules.

Independent contractors receiving a 1099 owe no self-employment tax on payments excluded under Notice 2014-7. Employees are a different story. In many consumer-directed or self-directed Medicaid waiver programs, the care recipient is technically the employer. When that is the case, the payments are treated as domestic service wages for FICA purposes, even though income tax does not apply.³

Domestic service wages have a threshold of their own. For 2026, wages below $3,000 per calendar year from a single household employer are not subject to Social Security and Medicare taxes.⁴ Above that amount, FICA applies. Wages paid by a child to a parent for domestic services, or between spouses, are generally exempt from FICA regardless of amount.

Paying FICA on these wages has an upside worth weighing: the earnings count toward your Social Security record, which can raise future retirement or disability benefits. If the payments avoid both income tax and any employment tax, they will not build your Social Security earnings history. That tradeoff matters when caregiving is your main source of income for years at a stretch.

The Earned-Income Election for the EIC and ACTC

Excluding the payments saves income tax, but it can also leave you with no earned income for the year. If Medicaid waiver payments are your only compensation, you could lose eligibility for the Earned Income Tax Credit and the refundable Additional Child Tax Credit, both of which require earned income.

Starting in 2020, the IRS lets you elect to include all of your excluded Medicaid waiver payments in earned income solely for purposes of calculating the EIC or the ACTC. The election is all-or-nothing. You cannot include only part of the payments. The election only affects the earned income figure for these credits; the payments stay out of your taxable gross income either way.³

For providers with children, this election can be worth thousands in refundable credits. Run the calculation both ways before filing. You keep the income tax exclusion regardless, so the election only helps when it qualifies you for a credit or raises one you would already receive.

Fixing Prior Years With an Amended Return

If you paid income tax on Medicaid waiver payments in an earlier year that should have been excluded, file Form 1040-X to claim a refund. The IRS has confirmed that taxpayers who received payments described in Notice 2014-7 in earlier years may file amended returns to exclude those payments.³

You generally have three years from the date you filed the original return, or two years from the date you paid the tax, whichever is later, to claim a refund.⁵ In Part III of Form 1040-X, explain that the payments are excludable under Notice 2014-7, and attach:

The care recipient’s full name and Social Security number, if available
Documents showing you and the care recipient lived at the same address during the tax year, such as a driver’s license, bank statement, medical bill, or utility bill
Evidence that the person was receiving care under a state Medicaid waiver program

Excluding the payments from an earlier year may change other items on that return, including deductions or credits calculated from the higher income. The IRS recalculates the whole return, so your refund may be smaller than the tax on the excluded amount alone.³

Records to Keep

If the IRS questions the exclusion, you will need to prove that the payments came through a qualifying program, that the care recipient had an eligible condition, and that the person lived in your home. A useful file covers all three:

Your enrollment or provider agreement with the state or its fiscal agent, showing the program operates under a Medicaid waiver
The state agency’s determination that the care recipient qualifies for waiver services
Lease agreements, utility bills, government correspondence, or agency records confirming the same address for you and the care recipient during the payment period
Payment statements or notices from the paying agency
Copies of every W-2, 1099-MISC, or 1099-NEC reporting the payments

Keep these records for at least three years from the date you file the return claiming the exclusion.⁶ For an amended return, the clock runs from the amended return’s filing date.

1
Internal Revenue Service. Notice 2014-7
2
Office of the Law Revision Counsel. 26 USC 131 – Certain Foster Care Payments
3
Internal Revenue Service. Certain Medicaid Waiver Payments May Be Excludable From Income
4
Social Security Administration. Employment Coverage Thresholds
5
Internal Revenue Service. Time You Can Claim a Credit or Refund
6
Internal Revenue Service. Topic No. 305, Recordkeeping