IRS Difficulty of Care Payments: How Live-In Caregivers Get Tax-Free Wages

If you live in the same home as the person you care for and your wages come through a state Medicaid waiver program, those wages may be completely tax-free at the federal level. This is the IRS "difficulty of care" exclusion under Notice 2014-7 — one of the most valuable and least understood tax benefits available to family caregivers.

What the Difficulty of Care Exclusion Is

IRS Notice 2014-7, issued in 2014, established that certain Medicaid waiver payments to caregivers qualify as "difficulty of care" foster care payments under Section 131 of the Internal Revenue Code. The practical effect: these payments are excluded from the caregiver's gross income for federal income tax purposes.

In plain language, if you meet the requirements, the wages you receive for providing care are not taxed as income. You do not owe federal income tax on them, and they do not increase your adjusted gross income (AGI).

Who Qualifies

The exclusion applies when all three conditions are met:

1. The payments come through a state Medicaid waiver program. This includes Section 1915(c) Home and Community-Based Services (HCBS) waivers, Consumer Directed Personal Assistance Programs (like New York's CDPAP or California's IHSS), and Structured Family Caregiving programs. The key is that the payment must flow through an authorized state Medicaid program — not from the care recipient's personal funds under a private care agreement.

2. The caregiver and care recipient live in the same home. The IRS requires co-residency. If you have your own separate residence — even if you stay overnight frequently — the exclusion does not apply. The caregiver and care recipient must share the same household as their primary residence.

3. The care recipient qualifies for the Medicaid waiver. The person receiving care must be enrolled in the waiver program and have an assessed need for the level of care being provided.

The exclusion applies to both related and unrelated caregivers. You do not need to be a family member. However, the co-residency requirement means it most commonly benefits adult children who have moved in with a parent, or parents who live in the caregiver's home.

What the Exclusion Covers

Federal income tax: Excluded entirely. The payments are not reported as taxable income on the caregiver's Form 1040.

FICA taxes: The exclusion can also exempt the payments from Social Security and Medicare taxes, depending on how the state structures the program. Many states have updated their Fiscal Intermediary systems to stop withholding FICA on difficulty-of-care-excluded payments.

State income tax: Varies by state. Some states follow the federal exclusion automatically; others do not. Check your state's tax code or consult a CPA familiar with household employment.

The EITC Advantage

Here is the part most people miss: even though the wages are excluded from gross income, the caregiver can still elect to include them as "earned income" when calculating the Earned Income Tax Credit (EITC) and the Additional Child Tax Credit (ACTC).

This creates an unusual situation where a caregiver pays zero federal income tax on their wages but can still claim a refundable tax credit based on those same wages. For lower-income caregivers, this can result in a significant tax refund — sometimes thousands of dollars — on income that was never taxed.

To claim this, the caregiver must make the election on their tax return. It is not automatic.

How to Claim the Exclusion

If your Fiscal Intermediary already applies it: Many state Fiscal Intermediaries now recognize the exclusion and issue a W-2 showing $0 in Box 1 (wages) for live-in caregivers. If your W-2 already shows this, no additional action is needed — the exclusion is already reflected.

If your W-2 shows taxable wages: You may need to file an amended return or adjust your return to exclude the payments. Attach a statement explaining that the wages qualify for the IRS Notice 2014-7 exclusion. Include documentation of co-residency (shared address on the W-2, utility bills, or lease/deed showing the same address).

If you previously paid taxes on these wages: You can file amended returns (Form 1040-X) for open tax years (generally the last three years) to claim a refund of taxes paid on wages that should have been excluded.

Limitations and Rules

The exclusion is capped. It applies to care for no more than 10 qualified individuals aged 18 and under, or no more than 5 individuals aged 19 and older. For most family caregivers caring for one aging parent, this cap is irrelevant.

Private-pay arrangements do not qualify. If you are paid directly by your parent under a personal care agreement — not through a state Medicaid waiver — the difficulty of care exclusion does not apply. Those wages are taxable household employment income under normal IRS rules.

Co-residency must be genuine. The IRS can challenge the exclusion if the caregiver maintains a separate residence. Shared utility bills, a shared mailing address, and consistent documentation strengthen the claim.

Common Mistakes

Assuming all caregiver wages are tax-free. Only Medicaid waiver payments to live-in caregivers qualify. Private-pay wages, VA stipends (PCAFC is separately tax-free under its own authority), and wages from non-live-in arrangements are not covered by Notice 2014-7.

Not telling the Fiscal Intermediary about co-residency. Some FIs default to withholding taxes unless the caregiver notifies them of the shared living arrangement and requests the exclusion. Proactively submit documentation of co-residency when you enroll.

Ignoring the EITC election. Many qualifying caregivers leave thousands of dollars in refundable tax credits on the table by not electing to count their excluded wages as earned income for EITC purposes.

The Getting Paid to Care for a Family Member toolkit includes a tax compliance worksheet that walks through the Notice 2014-7 exclusion, the EITC election, and the W-2 verification steps — along with the IRS family exemptions for FICA and FUTA that apply to close family caregivers.