Difficulty of Care Payments: A Powerful (and Often Missed) Tax Benefit for Parents
- Aaron Engleman, Two Teachers' Tax Service
- 2 hours ago
- 3 min read
Parents who care for a totally and permanently disabled child in their home often receive compensation through Medicaid waiver or similar state programs. In many cases, that income is reported on a Form W-2, but what many taxpayers (and even preparers) don’t realize is that this income may not be taxable at all.
Understanding how “difficulty of care” payments work, and how to report them correctly, can have a major impact on your tax liability and refund.
What Are Difficulty of Care Payments?
Under IRS Notice 2014-7, certain payments received for providing in-home care to an individual with a physical, mental, or emotional disability are considered difficulty of care payments.
These payments are:
Typically funded through Medicaid Home and Community-Based Services (HCBS) waiver programs
Paid to caregivers (including parents) providing care in their own home
Intended to compensate for the additional challenges and costs of caregiving
Most importantly: If the caregiver and the individual receiving care live in the same household, these payments are generally excludable from federal taxable income.
Why You Might Still Receive a W-2
Even though the income may be excludable, many agencies (such as Fiscal Management Services providers) still issue a Form W-2 reporting the wages.
This creates confusion because:
The income appears taxable at first glance
The IRS still expects to see it reported somewhere on the return
The key is not to ignore the W-2—but to properly offset it.
How to Report Difficulty of Care Payments on Form 1040
When the income is reported on a W-2, the IRS allows you to exclude it by making an adjustment on your return.
Step-by-Step Approach
Enter the W-2 as normal
Include Box 1 wages on Form 1040
Create an offsetting adjustment
Go to Schedule 1 (Form 1040), Part I – Other Income
Enter a negative amount equal to the W-2 wages
Label the adjustment clearly
Use a description such as: “IRS Notice 2014-7 excludable income”
This effectively zeros out the taxable income, while still allowing the IRS to match the W-2 to your return.
💡 Many tax software programs include a specific entry field for “Medicaid waiver payments” or “Notice 2014-7 income,” but the underlying concept is the same: include → then subtract.
Key Indicators That Your W-2 Qualifies
Not every caregiving W-2 automatically qualifies, but there are common signs that the income may be excludable:
1. No Social Security or Medicare Wages
Box 3 (Social Security wages): $0
Box 5 (Medicare wages): $0
This often indicates the payer recognizes the payments as non-FICA wages, consistent with difficulty of care treatment.
2. Entries in Box 14
Box 14 may include descriptions such as:
“Medicaid Waiver”
“Difficulty of Care”
“Excludable income”
These are strong indicators the payments fall under Notice 2014-7.
3. You Live With the Individual Receiving Care
This is a critical requirement:
The caregiver and care recipient must reside in the same home
The care must be non-medical support services provided under a qualifying program
Important Nuances
These payments are excluded from income tax, but IRS guidance has historically been less explicit regarding FICA treatment in all cases.
Even when excluded, the income may still be treated as earned income for certain credits (such as the Earned Income Credit), depending on how it is reported.
If incorrectly reported in prior years, taxpayers may be able to amend returns and claim refunds.
Why Proper Reporting Matters
Getting this right can significantly change a tax return:
Potential Benefits
Eliminate federal income tax on the caregiving income
Increase eligibility for credits and deductions
Avoid unnecessary self-employment tax (if misclassified)
Potentially generate larger refunds
Potential Risks of Doing It Wrong
Overpaying taxes by thousands of dollars
IRS notices due to mismatched W-2 reporting
Missing out on refundable credits
Final Thoughts
Difficulty of care payments are one of the most impactful, and most misunderstood, areas of tax law affecting families with disabled dependents.
If you receive a W-2 for caring for your child:
Don’t assume it’s taxable
Don’t ignore it either
Report it correctly and offset it properly
Done right, this single adjustment can dramatically improve your tax outcome, and ensure you’re not paying tax on income the IRS has already said should be excluded.
Questions? Call, text or email me for more information.
Aaron Engleman, Enrolled Agent
Two Teachers’ Tax Service
269-449-8277
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