Notice 2014-7 changed all that. The IRS has given notice that it will no longer challenge the excludability of these wages and instead will treat them in the same manner as qualified foster care payments if they meet certain requirements. Note: IRC Sec 131(a) specifies that the exclusion of qualified foster care payments is mandatory.
This change in the IRS’s position allows the exclusion to be applied to all future years and to all prior open years (IRS Website Q&A #5). To qualify as compensation for the exclusion:
- The compensation must be required due to a physical, mental, or emotional handicap with respect to which the State has determined that there is a need for additional compensation.
- The care must be provided in the home of the foster care provider.
- The payments must be designated as qualified foster care or difficulty of care compensation.
- To be excludable, the care payments are limited to a maximum of five individuals age 19 and older or ten individuals age 18 and younger.
This change is a double-edged sword, as some caregivers qualified for the earned income tax credit (EITC) in the past based upon this W-2 income. Now, that income is mandatorily excluded from the total income, and these caregivers lose their EITC based upon that income. Many of these caregivers have income that was low enough that they paid little or no income tax income anyway.
On the other hand, those with substantial other income will welcome the change, as it reduces their income and thus their income tax.
Still other care providers—those with earned income from other sources—may benefit from both the reduction of income and the EITC. The EITC phases out for higher-income individuals, so by excluding the Medicare waiver payment, these individuals’ modified adjusted gross incomes may be reduced so that they qualify for the EITC based on their other earned income. These individuals also may benefit from a lower income tax based upon the exclusion.
CAUTION: Some tax preparers have been entering the W-2 waiver income as if it were regular wages (on Form 1040, line 7) and excluding it by subtracting the same amount on line 21 of the 1040. If you do that, the computer program will still use the W-2 amount in the EITC computation. If you handle it that way, be sure to remove the W-2 waiver payments from the EITC computation.