IRS Difficulty of Care Income Tax Exclusion: Reporting and Refunds

The IRS difficulty of care exclusion under Internal Revenue Code Section 131 lets foster care providers and certain in-home caregivers leave qualifying payments off their federal taxable income entirely. Since 2014, the same treatment has applied to Medicaid waiver payments made to caregivers who provide nonmedical support to an eligible person living in their home, which is what makes this exclusion relevant to far more families than the “foster care” label suggests.¹ The exclusion is valuable, but claiming it correctly matters: report it the wrong way and you either pay tax you don’t owe or invite a matching notice from the IRS.

What the Exclusion Covers

A difficulty of care payment is compensation for the additional care a qualified individual needs because of a physical, mental, or emotional handicap. The state must have determined that the handicap warrants extra compensation, and the payor must designate the payment as difficulty of care compensation.² Standard maintenance payments for food and shelter are a separate category. For foster children under 19, both the regular maintenance payment and the difficulty of care supplement can be excluded. For individuals 19 and older, only the difficulty of care portion qualifies.

The payment must come through a state or local government foster care program, paid either directly by the government or by a qualified foster care placement agency the state has licensed or designated.² Private arrangements where a family pays you directly to care for a relative do not meet this requirement, no matter how severe the person’s condition.

Notice 2014-7 extended the same treatment to Medicaid waiver payments made to home caregivers. If your state’s Medicaid program pays you to provide nonmedical support services to an eligible individual living in your home, those payments can be excluded from gross income.¹ The exclusion applies whether or not you are related to the person you care for. A parent caring for an adult disabled child, a spouse caring for an injured partner, or an unrelated aide living with an elderly Medicaid recipient can all qualify.

The care must be provided in your home. Payments for care delivered at a facility, a day program, or the recipient’s separate residence fall outside the exclusion, regardless of the person’s condition.¹ This is the single most common reason caregivers lose the exclusion.

Who the Care Recipient Must Be

The person receiving care must be a “qualified foster individual,” meaning someone placed in a foster family home by a state agency, a political subdivision, or a qualified foster care placement agency.² Under Notice 2014-7, Medicaid waiver recipients living in a caregiver’s home are treated as meeting this definition because the state performs similar activities: approving the home, developing a plan of care, and contracting with the provider.¹

For adults, the individual must have a physical or mental condition severe enough to require the specialized care the payments compensate for. A physician’s statement documenting the nature and expected duration of the disability strengthens your position if the IRS questions the exclusion later.

How Many People You Can Care For

The statutory limit is based on the number of individuals you care for, not a fixed dollar amount. You can exclude difficulty of care payments for up to 10 qualified foster individuals under age 19 and up to 5 individuals age 19 or older.² Payments for anyone above those counts become taxable income.

There is no federal per diem dollar cap. Whatever amount the state designates as difficulty of care compensation is excludable in full, as long as you stay within the numerical limits. Most caregivers handling one or two people at home never come close to the ceilings.

How to Report It on Your Return

The mechanics depend on how the paying agency reports your payments.

W-2 With Box 12 Code II

Agencies that correctly identify Medicaid waiver payments as nontaxable may report them on your W-2 in box 12 using Code II rather than including them in box 1 wages. If box 1 is blank or zero and you are not electing to count the payments as earned income for credit purposes, you generally do not need to report anything from that W-2 on your return.³

W-2 With Payments in Box 1

If the agency reports your payments in box 1 as ordinary wages, you have to actively claim the exclusion. Report the box 1 amount on Form 1040, line 1a, and any box 12 Code II amount on line 1d. Then, on Schedule 1, enter the total nontaxable amount as a negative number on line 8s, which is specifically designated for nontaxable Medicaid waiver payments.³⁴

1099-MISC or 1099-NEC

Some agencies issue a 1099 instead of a W-2. Report the income as shown on the form, then back it out on Schedule 1 using line 8s. Leaving 1099 income off your return without the adjustment triggers an automated IRS matching notice.

Claiming Refunds for Past Years

Many caregivers paid tax on these payments for years before learning about the exclusion. You can file Form 1040-X to amend prior returns, but the statute of limitations applies: generally within three years of the original return’s filing date (including extensions) or within two years of paying the tax, whichever is later.⁵

File a separate 1040-X for each year. Enter the original amounts in Column A, the change in Column B, and the corrected figures in Column C. In Part II, explain that you are claiming the Section 131 exclusion (or citing Notice 2014-7 for Medicaid waiver payments) and attach a Schedule 1 showing the line 8s adjustment. Multiple years of refunds can add up, so the paperwork is often worth the effort.

Self-Employment and FICA Tax

The income tax exclusion does not shield these payments from every tax. If you are an independent contractor and not in the trade or business of providing caregiving services, excluded Medicaid waiver payments are generally not subject to self-employment tax.³ Caring for a single family member under a Medicaid waiver typically doesn’t make you a professional caregiver for tax purposes. Operate a caregiving business as a sole proprietor with multiple clients, though, and the payments are self-employment income subject to SE tax, even though they remain excluded from income tax.⁶

For employees, the payments are generally still wages for Social Security and Medicare tax purposes. The agency should withhold FICA and report it on your W-2.³ Exceptions apply to some domestic service arrangements, such as a child under 21 caring for a parent or a spouse caring for a spouse.

There is a downstream consequence worth understanding. If your payments are exempt from both income tax and FICA or SE tax, they do not build your Social Security earnings record. Over years of caregiving, that gap can reduce your future retirement or disability benefits. Full exemption isn’t always the better outcome.

Using Excluded Payments for the EITC and Child Tax Credit

Excluding payments from income normally makes them useless for credits that require earned income. Following the Tax Court’s decision in Feigh v. Commissioner, the IRS agreed that caregivers may choose to include all of their excluded Medicaid waiver payments as earned income for purposes of the Earned Income Credit and the Additional Child Tax Credit.³ The payments stay excluded from taxable income either way; the election only affects those two credits.

The election is all-or-nothing. You include all of your excluded payments as earned income or none of them.³ For lower-income caregivers this can be worth thousands in refundable credits. Run the numbers both ways before filing.

Records to Keep

If the IRS asks, the burden of proving you qualify falls on you. Keep:

The official placement agreement or contract from the state agency, Medicaid waiver program, or licensed placement organization showing the care recipient was placed in your home.
Payment records showing dates, amounts, source, and any designation of the difficulty of care component.
For adult care recipients, a physician’s statement documenting the nature and expected duration of the disability. Without one, the IRS can reclassify the entire payment as taxable.
Proof of shared residence such as utility bills or a lease establishing that the care recipient lived in your home during the periods you received payments.
Copies of every W-2 and 1099 from the paying agency, including any showing box 12 Code II amounts.

Keep these records for at least three years after filing the return that claims the exclusion. If you claim the exclusion on an amended return, the clock runs from the date you filed the 1040-X, not the original return.

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
Internal Revenue Service. 2025 Schedule 1 (Form 1040)
5
Internal Revenue Service. Instructions for Form 1040-X
6
Internal Revenue Service. Family Caregivers and Self-Employment Tax