IRS Notice 2014-7: Medicaid Waiver Exclusion, EITC, and W-2 Fixes

IRS Notice 2014-7 lets certain Medicaid waiver payments be excluded from your federal gross income by treating them as “difficulty of care” payments under Section 131 of the Internal Revenue Code. The exclusion applies when you provide nonmedical care under a state Medicaid waiver to someone who lives in your home, whether or not you are related to that person. It affects what you owe, what refundable credits you can claim, and even whether you can contribute to an IRA.¹

Who Qualifies

Three conditions all have to be true. The payments must come from a state Medicaid waiver program, most commonly a Home and Community-Based Services waiver under Section 1915(c) of the Social Security Act. The payments must be for nonmedical support services provided under a plan of care. And the care recipient must live in your home.¹

You do not need to be a licensed healthcare professional. Family members, friends, and other individual care providers can all qualify, as long as the payments run through a qualifying Medicaid waiver program and you share a household with the person you care for.²

Payments for care provided outside your home do not qualify. If you commute to someone else’s residence to provide services and go back home at the end of the day, those payments remain taxable.

What “The Provider’s Home” Means

The IRS defines the provider’s home as the place where you live and regularly carry out the routines of your private life, such as sharing meals and holidays with family.²

If you move into the care recipient’s home and do not keep a separate residence, that home is your home for exclusion purposes, and the payments qualify. If you work at the care recipient’s home during the day but keep your own separate place where you actually live your daily life, you do not meet the test. The rule is about where both of you live together, not where the care happens.

How the Payments Get Reported to You

Which form you receive depends on how the paying agency classifies you. If it treats you as an employee, you get a Form W-2. Many agencies now report nontaxable Medicaid waiver payments in Box 12 with Code II rather than as wages in Box 1. When your W-2 shows nothing (or zero) in Box 1 and the excludable payments in Box 12 Code II, and you are not electing to count those amounts as earned income for credit purposes, you do not have to report the W-2 amounts on your return at all.²

If the agency does not treat you as an employee and you are not running a separate business, you may get a Form 1099-NEC or Form 1099-MISC. Agencies that know payments are excludable under Notice 2014-7 are not required to file a 1099-NEC for those amounts.²

Not every payer has updated its systems. Some still put excludable amounts in Box 1 of the W-2, and some issue 1099s for payments that should have been excluded.

When Your W-2 Is Wrong

If your W-2 puts excludable payments in Box 1 instead of Box 12 with Code II, start by asking the employer or agency to issue a corrected W-2. If they will not or cannot do so in time, file Form 4852 as a substitute. On Form 4852 you enter the correct wage information, explain how you figured the amounts (using pay stubs, payment records, or state agency documentation), and describe your efforts to get a corrected form.³

If a corrected W-2 arrives after you have already filed on Form 4852 and it shows your return was wrong, file an amended return on Form 1040-X.

When You Get a 1099

A 1099 does not automatically mean self-employment tax. If you do not have a separate trade or business of providing these services, report the 1099 amount on Form 1040 line 1d and subtract the excludable amount on Schedule 1, line 8s. The payments are not self-employment income and are not subject to self-employment tax.²

Claiming the Exclusion on Your Return

If your W-2 shows amounts in both Box 1 and Box 12 Code II, put the Box 1 amount on Form 1040 line 1a and the Box 12 Code II amount on Form 1040 line 1d. Then on Schedule 1, line 8s, enter the total nontaxable Medicaid waiver payment amount as a negative number in the preprinted parentheses. That negative amount flows through and reduces your adjusted gross income.²

Because line 8s is negative, lines 8z, 9, and 10 on Schedule 1 can end up negative too. That is the math working as intended, not a software glitch.

If You File Schedule C

Caregivers who operate as sole proprietors take a different path. Include the full amount from your 1099-NEC or 1099-MISC on Schedule C line 1 as gross receipts. Then report the excludable amount as an expense in Part V (Other Expenses) and write “Notice 2014-7” next to it. That zeroes out the excludable income so it is not hit by self-employment tax.²

If you provide both qualifying services (in-home care for someone who lives with you) and non-qualifying services (clients who don’t live in your home), separate the amounts. Only the payments tied to a qualifying shared living arrangement can be excluded. Timesheets and service logs are essential for documenting the split.

Counting Excluded Payments as Earned Income for EITC and ACTC

Even though the payments are excluded from gross income, you can elect to count them as earned income when calculating the Earned Income Tax Credit and the Additional Child Tax Credit. The IRS adopted this position after the Tax Court’s decision in Feigh v. Commissioner.⁴

The election is all-or-nothing. You must include all of your excludable Medicaid waiver payments as earned income, not just a portion. And it applies only for EITC and ACTC purposes; the payments remain excluded from gross income for income tax.²

For a caregiver with children and little or no other taxable income, the election can mean thousands of dollars in refundable credits. If your only income is excludable Medicaid waiver payments and you do not make the election, your earned income is effectively zero and you are disqualified from both credits. Run the numbers both ways before filing.

IRA and Retirement Plan Contributions

Before 2020, caregivers whose only income was excludable difficulty of care payments had no “compensation” for IRA purposes, which shut them out of retirement contributions. The SECURE Act added Section 408(o)(5), letting you treat excluded difficulty of care payments as compensation when figuring your IRA contribution limit.⁵

If the standard IRA deduction limit is more than your includable compensation, you can increase your nondeductible IRA contribution limit by the lesser of the excluded payments or the amount by which those payments exceed your taxable compensation. Section 415(c)(8) applies the same idea to employer-sponsored defined contribution plans, treating excluded difficulty of care payments as compensation for contribution-limit purposes. Those contributions are treated as after-tax investment in the contract.⁶

The practical point: if your only income is excludable Medicaid waiver payments, you can still contribute to a traditional or Roth IRA.

Social Security and Medicare Tax

Excluding payments from income tax does not automatically exempt them from Social Security and Medicare (FICA) taxes. The answer depends on your employment relationship with the payer.

If an agency is your employer, the payments are subject to FICA even though they are excluded from income tax.
If the care recipient is your employer, FICA generally applies, but domestic service exceptions may exempt services performed for a spouse, for a child, or by a child under 21 for a parent. There is also a cash wage threshold: if total cash wages are below $3,000 in 2026, no FICA taxes apply.
If you are an independent contractor, the payments are not subject to FICA. And because the excludable payments are not self-employment income, they are not subject to self-employment tax either.

²⁷

Classification matters beyond current taxes. Caregivers treated as independent contractors with excludable income will not accumulate Social Security credits on those payments, which can leave gaps in the earnings record used to compute future benefits.

Amending Prior Returns to Claim the Exclusion

If you paid income tax on qualifying Medicaid waiver payments in a prior year, file Form 1040-X to claim a refund. You must file the amended return within three years from the date you filed the original return or two years from the date you paid the tax, whichever is later.²

On the 1040-X, explain clearly that you are applying the difficulty of care exclusion under IRS Notice 2014-7. Attach a copy of your original W-2 or 1099 and any documentation from your state Medicaid agency confirming your enrollment in a qualifying waiver program.

You can file Form 1040-X electronically for the current year and the two prior tax years using tax filing software. Older tax years still require a paper form.⁸

Processing generally takes 8 to 12 weeks, and some cases stretch to 16 weeks because of the manual review involved.⁹ When approved, the IRS pays the refund with interest. Interest on overpayments starts accruing from the later of your original filing deadline or the date the IRS receives a processable return, and stops when the refund is issued. The IRS has a 45-day administrative window before interest begins.¹⁰

1
Internal Revenue Service. IRS Notice 2014-7
2
Internal Revenue Service. Certain Medicaid Waiver Payments May Be Excludable From Income
3
Internal Revenue Service. Form 4852, Substitute for Form W-2, Wage and Tax Statement
4
Internal Revenue Service. Action on Decision: Feigh v. Commissioner
5
Office of the Law Revision Counsel. 26 USC 131 – Certain Foster Care Payments
6
Office of the Law Revision Counsel. 26 USC 415 – Limitations on Benefits and Contribution Under Qualified Plans
7
Internal Revenue Service. Publication 926 – Household Employer’s Tax Guide
8
Internal Revenue Service. About Form 1040-X, Amended U.S. Individual Income Tax Return
9
Internal Revenue Service. Amended Return Frequently Asked Questions
10
Internal Revenue Service. Interest