Medicaid waiver payments are taxed under IRS Notice 2014-7, which treats qualifying payments as difficulty of care payments excludable from federal gross income when the caregiver lives in the same home as the person receiving care.1Internal Revenue Service. IRS Notice 2014-7 The exclusion applies whether or not you are related to the recipient, and you can still elect to count the excluded payments as earned income when you claim the Earned Income Tax Credit or the Additional Child Tax Credit. What follows is how the rule works, when it applies, and how to put the numbers on your return.
Where the Exclusion Comes From
Notice 2014-7 directs the IRS to treat qualifying Medicaid waiver payments as difficulty of care payments under Section 131 of the Internal Revenue Code.1Internal Revenue Service. IRS Notice 2014-7 Section 131 was originally written for foster care providers, and the IRS extended it to caregivers paid through state waiver programs so the treatment would be the same across states.2Office of the Law Revision Counsel. 26 USC 131 – Certain Foster Care Payments
The payments themselves flow from state programs authorized under Section 1915(c) of the Social Security Act, which lets Medicaid fund home and community-based services for people who would otherwise need care in a nursing facility or similar institution. The tax question is separate from the program question: a payment can be a valid waiver payment and still fail the exclusion test if the living arrangement is wrong.
The Live-In Requirement
To qualify for the exclusion, you must live in the same home as the person you care for. The IRS has confirmed that when the recipient’s home is also your home — meaning you do not maintain a separate residence — the payments are excludable.3Internal Revenue Service. Certain Medicaid Waiver Payments May Be Excludable From Income Family relationship does not matter, but the shared residence does. A caregiver who drives to a client’s home and returns to their own place at the end of a shift does not qualify, no matter how many hours they work.
Keep documentation of the living arrangement. Utility bills, a driver’s license, voter registration, or mail addressed to you at the shared home all help if the IRS asks for verification.
Electing Earned Income for the EITC and Additional Child Tax Credit
This is where many caregivers leave money on the table. Even though the payments are excluded from gross income, you can choose to count them as earned income for purposes of the Earned Income Tax Credit or the Additional Child Tax Credit. The IRS requires an all-or-nothing election: you include all of the excluded payments or none of them, and the payments must otherwise qualify as wages or self-employment income.3Internal Revenue Service. Certain Medicaid Waiver Payments May Be Excludable From Income
For lower-income caregivers, the election can be worth thousands of dollars in refundable credits. Run the numbers both ways before you file. The excluded payments still do not become taxable — you are only borrowing them as earned income for the credit calculation.
How to Report the Payments
The reporting mechanics depend on what tax form your payer sends you.3Internal Revenue Service. Certain Medicaid Waiver Payments May Be Excludable From Income
If You Receive a Form W-2
Look at box 1 and box 12. If the nontaxable payments are reported in box 12 using Code II and box 1 is blank or zero, and you are not electing to count the payments as earned income for a credit, you do not need to report the W-2 on your return at all.
If box 1 shows an amount, report that amount on Form 1040 line 1a, report the box 12 Code II amount on line 1d, and then enter the total nontaxable amount as a negative number on Schedule 1, line 8s. The negative entry cancels out the income so no tax is owed on it while leaving a clear paper trail that ties back to the W-2.
If You Receive a Form 1099-NEC or 1099-MISC
If you are not operating as a sole proprietor, report the amount on Form 1040 line 1d and enter the nontaxable portion on Schedule 1, line 8s.
Sole proprietors handle it on Schedule C. Include the full amount in gross receipts, then deduct the nontaxable portion in Part V as an “Other Expense,” writing “Notice 2014-7” next to the amount. This keeps the Schedule C income figure consistent with what the 1099 reported while zeroing out the tax effect.
Social Security and Medicare Taxes Are a Separate Question
The income tax exclusion does not automatically exempt these payments from FICA. Whether Social Security and Medicare taxes apply depends on your employment relationship.3Internal Revenue Service. Certain Medicaid Waiver Payments May Be Excludable From Income
If an agency employs you, FICA withholding applies in the usual way. If the care recipient is your employer and you are paid wages, FICA generally applies unless a domestic service exception covers the arrangement. Independent contractors do not owe FICA on these payments, but they also do not build Social Security credits from the work. That trade-off matters for long-term retirement planning, not just this year’s return, so it is worth understanding which category you fall into before your first paycheck.
Self-Directed Programs and Your Payroll Trail
Many family caregivers get paid through self-directed (consumer-directed) waiver programs, where the care recipient is the employer of record and a Financial Management Service handles payroll. The FMS processes your pay, withholds and files federal and state employment taxes, and produces your year-end tax form.4Medicaid. Self-Directed Services If your W-2 or 1099 does not reflect the Notice 2014-7 treatment correctly — for example, if the excludable amount is buried in box 1 with no Code II entry — contact the FMS before you file. It is far easier to get a corrected form than to defend a return that departs from what the IRS has on file.
What to Keep
Documentation is what carries you through an audit. Keep timesheets, remittance advices, the recipient’s care plan, and any correspondence with the state Medicaid agency or fiscal intermediary. Keep proof of shared residency for every year you claim the exclusion. And keep copies of every W-2 or 1099 tied to the payments, along with the return that reported them.
Six years of records is a safe baseline. If you have claimed the earned income election, keep the underlying documents at least as long as you would keep records for any other refundable credit.
When the Exclusion Does Not Apply
Notice 2014-7 covers payments made under a state Medicaid Home and Community-Based Services waiver for care provided in the caregiver’s home. It does not cover payments for care delivered somewhere the caregiver does not live, and it does not turn every payment from a state program into tax-free income. If you are paid privately by a family, if the funds come from long-term care insurance, or if the arrangement is not a qualifying waiver program, the exclusion does not reach those dollars. When in doubt, ask the payer to identify the funding source and check the year-end form for a Code II entry in box 12 — its presence is the clearest signal that the payer has treated the payments as excludable under the notice.