IRC Section 131 Difficulty of Care Payments: Exclusion and Reporting

Under IRC Section 131, difficulty of care payments — compensation for the extra care a person needs because of a physical, mental, or emotional disability, provided in the caregiver’s own home — are excluded from federal taxable income. IRS Notice 2014-7 extended that exclusion beyond traditional foster care to payments made to caregivers through state Medicaid Home and Community-Based Services waiver programs. The exclusion removes both income tax and self-employment tax, and caregivers who paid tax on these payments in prior years can amend to claim a refund.

What Qualifies as a Difficulty of Care Payment

Section 131 defines difficulty of care payments as compensation for the additional care a person needs because of a disability. Three things must be true: the state must have determined that the extra care is necessary, the paying agency must designate the payments as difficulty of care compensation, and the care must be provided in the caregiver’s home rather than in a facility.¹

The exclusion originally applied only to traditional foster care. In 2014, the IRS issued Notice 2014-7 to say that payments a state or its agent makes to a caregiver for nonmedical support services under a Medicaid waiver plan of care also qualify, as long as the caregiver and the person receiving care live together in the caregiver’s home. The person receiving care is treated as having been “placed” by the state agency for statutory purposes, even without a formal foster care placement.²

There is a cap on how many recipients you can cover: up to ten individuals under age 19, and up to five who are 19 or older.¹ For a family member caring for one or two people, this never comes up. It matters mainly for larger care homes.

The Shared Home Requirement

Whether the care happens in the provider’s home is the single most important eligibility question. The IRS defines the provider’s home as the place where the caregiver actually lives and carries out the routines of daily life: eating meals, spending holidays, sleeping most nights.³ Traveling to someone else’s residence during the day and returning to your own at night does not meet the standard.

A few common situations show how this works:

A parent who receives waiver payments for caring for a disabled child at home qualifies. The family home is clearly the caregiver’s home.
If you move in with an elderly parent or disabled relative and give up your separate residence, the recipient’s home becomes your home, and you qualify.
If you provide care in the recipient’s home during the week but keep your own residence for weekends and holidays, you do not qualify. You still have a separate home where your private life happens.
More than one caregiver living in the same household with the care recipient can each exclude their own payments.

The relationship between caregiver and recipient does not matter. Parent, spouse, adult child, sibling, or unrelated caregiver, the test is the same: do you genuinely share a home. If the IRS asks for proof, utility bills, lease agreements, bank statements, and government-issued IDs showing a shared address are all useful.³

How to Report the Exclusion on Your Return

How you report depends on what form your payments came on. Older advice about entering a negative number on Line 8z of Schedule 1 is outdated; the IRS added a dedicated line for these payments.

W-2 Payments

Many states and agencies now report nontaxable Medicaid waiver payments in Box 12 of the W-2 using Code II, rather than including them in Box 1 as taxable wages.³ If Box 1 is blank or zero and the payments appear only under Box 12 Code II, and you are not electing to treat them as earned income for tax credit purposes, you do not need to report the W-2 on your return.

If Box 1 still shows an amount (some agencies have not updated their systems), report it on Form 1040, Line 1a. Report any Box 12 Code II amount on Form 1040, Line 1d. Then enter the total nontaxable amount on Schedule 1, Line 8s, in the parentheses provided, which makes it a negative that removes the income from your total.⁴

1099-MISC or 1099-NEC Payments

Some agencies treat caregivers as independent contractors and issue Form 1099-MISC or 1099-NEC. If you do not run a separate home care business, report the payment on Form 1040, Line 1d, then enter the nontaxable amount on Schedule 1, Line 8s.⁵ Line 8s is specifically labeled for nontaxable Medicaid waiver payments, and that is the line to remember regardless of the form the payments arrived on.

Electing to Include the Payments for the EITC and Child Tax Credit

Excluding waiver payments also removes them from your earned income, and that can wipe out the Earned Income Tax Credit or shrink the Additional Child Tax Credit. Both credits are calculated from earned income, so a caregiver whose only income is excluded waiver payments has, on paper, no earned income at all.

The IRS lets you elect to include all of your excludable waiver payments as earned income for the EITC and the ACTC while still excluding them from taxable income.³ The election followed Feigh v. Commissioner, in which the Tax Court held that excludable payments still count as earned income for credit eligibility. The IRS agreed to follow the ruling.⁶

The election is all-or-nothing. You include all of your nontaxable waiver payments in earned income, or none of them. Spouses each decide separately for their own payments.⁷

To make the election for the ACTC, use the Earned Income Worksheet in the Schedule 8812 instructions and enter zero on Line 4 of that worksheet if you want to include all of your nontaxable waiver payments as earned income.⁷ The EITC election works the same way through Schedule EIC. For a caregiver with qualifying children, the EITC alone can be worth several thousand dollars, and this election is available for all open tax years, so it can also be claimed retroactively through an amended return.

Self-Employment and Payroll Tax

Excludable waiver payments are not subject to self-employment tax, even when reported on a 1099-MISC or 1099-NEC, and whether or not you have a separate home care business.³ If tax software tries to route the 1099-NEC income to Schedule SE, make sure the exclusion is applied before the SE calculation runs.

If your employer withheld Social Security and Medicare taxes on payments that should have been excluded, first ask the employer to correct the error and refund the overwithholding. If the employer will not do so, you can file Form 843 with the IRS to recover the excess Social Security and Medicare taxes. Attach a statement from the employer showing any amounts already refunded or credited; if the employer will not provide one, explain why and attach the W-2. The filing deadline is three years from the date the return was filed or two years from the date the tax was paid, whichever is later.⁸

Amending a Prior Return for a Refund

If you paid federal income tax on waiver payments in a prior year, file Form 1040-X to amend that year’s return and claim a refund. The amended return recalculates your tax with the payments excluded; the refund equals the extra tax paid because the payments were treated as taxable.³

The window is limited. Refund claims must be filed within three years from the date the original return was filed or two years from the date the tax was paid, whichever is later.⁹ Where the tax was paid through withholding at filing, the three-year window from the filing date is usually what applies. Miss it and the refund is gone.

On Form 1040-X, explain that you are excluding Medicaid waiver payments under IRS Notice 2014-7 and attach the original W-2 or 1099 showing the reported income. Many amendments can be filed electronically, though older years may still require paper. The IRS generally processes amended returns in 8 to 12 weeks, with more complex cases taking up to 16 weeks.¹⁰

An amendment also reopens the EITC and ACTC election. If your original return did not claim those credits, you can exclude the waiver income and elect to include it as earned income for credit purposes on the same 1040-X, often producing a refund substantially larger than the income tax recovery alone.

1
Office of the Law Revision Counsel. 26 U.S.C. 131 – Certain Foster Care Payments
2
Internal Revenue Service. IRS Notice 2014-7 – Certain Medicaid Waiver Payments
3
Internal Revenue Service. Certain Medicaid Waiver Payments May Be Excludable From Income
4
Internal Revenue Service. Instructions for Form 1040 (2025)
5
Internal Revenue Service. 2025 Schedule 1 (Form 1040)
6
Internal Revenue Service. Action on Decision 2020-02 – Feigh v. Commissioner
7
Internal Revenue Service. 2025 Instructions for Schedule 8812 (Form 1040)
8
Internal Revenue Service. Instructions for Form 843
9
Office of the Law Revision Counsel. 26 U.S.C. 6511 – Limitations on Credit or Refund
10
Internal Revenue Service. Where’s My Amended Return?