The Tax Court in Feigh, (2019) 152 TC No. 15 has ruled that Medicaid Waiver payments, even though excluded from income, are still earned income for purposes of claiming EITC and additional child tax credit. This is opposite to the IRS’s position in Notice 2014-7 and may open the door to some substantial refunds from open years.
Background: IRS Notice 2014-7 specified the IRS would no longer challenge the excludability of Medicaid waiver wages and instead will treat the payments as excludable from gross income under IRC Sec 131 (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, and since the Medicaid waiver payments are considered difficulty of care foster care payments, the notice ruled a taxpayer may not choose to include them in gross income.
This change was a double-edged sword, as some caregivers qualified for the earned income tax credit (EITC) and additional child tax credit (ACTC) in the past based upon this income. As a result of these payments being mandatorily excluded from income, these caregivers lost their EITC and ACTC based upon that income.
Tax Court Case: The taxpayers in the court case received payments under a state Medicaid waiver program for providing care to their adult disabled children in the family home, and excluded the Medicaid waiver payments from income but still treated them as earned income when computing the EITC and ACTC, disregarding Notice 2014-7. The IRS disallowed the credits and the taxpayers filed a timely Tax Court petition.
The Tax Court held that Notice 2014-7 could not reclassify the taxpayer’s Medicaid waiver payment to remove a statutory tax benefit. Specifically, the Court found that where income does not fall within the plain text of a statutory exclusion from gross income, IRS cannot reclassify that income through a Notice so that it no longer qualifies as "earned income" for the purpose of determining tax credits.
The Court reasoned that IRS cannot remove a statutory benefit provided by Congress. Interpretive rulings do not have the force and effect of regulations, and they may not be used to overturn the plain language of a statute which was exactly what IRS sought to do with Notice 2014-7. The EITC and the ACTC are acts of legislative grace provided by Congress. While deductions and credits are allowed only to the extent authorized by statute, the IRS is not free to circumscribe the credits that the legislature has chosen to authorize through statute; that is a power only Congress has. Accordingly, to the extent IRS sought to use Notice 2014-7 to deprive the taxpayers of a benefit bestowed by Congress, the Court held that it was prohibited from doing so.
Not addressed in the Tax Court case was the question of whether the taxpayers should have included their Medicaid waiver payment in gross income as IRS did not raise this issue in its notice of deficiency or plead it in this case. IRS chose not to argue in the alternative that the taxpayers' Medicaid waiver payment should be included in gross income, but instead argued that the taxpayers were precluded by Notice 2014-7 from including their payment in gross income for purpose of the credits.
The IRS has since modified their Q&A on the subject. Q&A #9 asked whether a taxpayer could choose to include the Medicaid waiver payments in gross income (thus qualifying EITC). The IRS’s original answer was no. Now Q&A #9 says “reserved”.
Amended Opportunity? This is an apparent amended opportunity for all open years. Even though the court case constitutes substantial authority, the IRS has not stated whether they will acquiesce to the case. So, since an amended return would be taking the court’s position over Notice 2014-7, it would be wise to attach a Form 8275, Disclosure Statement, stating the Tax Court case as the reason for disregarding the provisions of Notice 2014-7. (See Reg Section 1.6662-3(a) & Reg Section 1.6662-4(d)(2) for rules for disclosure of return reporting positions that are contrary to an IRS Notice).
It may be best practice to wait and see how this plays out. Currently open years are not affected until April 15, 2020.