In the case of Feigh v. Commissioner, 152 TC No. 15, the IRS was found to have effectively created an unintended double tax benefit for receipt of a Medicaid waiver payment for care of a taxpayer’s adult disabled children. The Court found that the plain language of IRC §131 did not support the conclusion the IRS arrived at in Notice 2014-7, which treated such a payment as nontaxable to the recipient.

IRC §131(a) provides for an exclusion from income for qualified foster care payments. Such excludable payments include payments which are a difficulty of care payment as defined by IRC §131(c).

IRC §131(c) provides:

(c) Difficulty of care payments

For purposes of this section—

(1) Difficulty of care payments

The term “difficulty of care payments” means payments to individuals which are not described in subsection (b)(1)(B)(i), and which—

(A) are compensation for providing the additional care of a qualified foster individual which is—

(i) required by reason of a physical, mental, or emotional handicap of such individual with respect to which the State has determined that there is a need for additional compensation, and

(ii) provided in the home of the foster care provider, and

(B) are designated by the payor as compensation described in subparagraph (A).

To be excludible, the payment must be made under a state’s (or political subdivision’s) foster care program.

Prior to the issuance of Notice 2014-7, the IRS had routinely taken the position that payments of a difficulty care payment to the parent of a disabled child was not excluded, because the “ordinary meaning” of foster care excludes care by a biological parent.[1]

In this case the taxpayer had received a W-2 reporting such a difficulty care payments. The taxpayer had not included the payment in income, following Notice 2014-7, but did include the amount as earned income in computing an earned income credit under IRC §32 and in computing the refundable child tax credit under IRC §24.

The IRS argued that, since the amount was not taxable under Notice 2014-7, it did not count as earned income for computing those credits. Under IRC §32(c)(2)(A)(i), earned income includes wages, salaries, tips, and other employee compensation, but only if such amounts are includible in gross income for the taxable year.”

The taxpayer argued that nothing in IRC §131 authorized the IRS to treat the payment as not includible in gross income. The Tax Court agreed with the taxpayer’s analysis. The Court notes:

Section 131(c)(1)(A) defines “difficulty of care payments” as, inter alia, “compensation for providing the additional care of a qualified foster individual”. A “qualified foster individual” is “any individual who is living in a foster family home” and who was placed there by an agency of the State or a qualified foster care placement agency. Sec. 131(b)(2). While “[s]ection 131 does not explicitly address whether payments under Medicaid waiver programs are qualified foster care payments”, the IRS reasoned that “Medicaid waiver programs and state foster care programs * * * share similar oversight and purposes.” Notice 2014-7, 2014-4 I.R.B. at 446. As an initial matter, the plain text of section 131 renders it inapplicable to the care of biological adult children. (emphasis added)

The opinion points out that Notice 2014-7 itself concedes that the IRS had previously interpreted the statute to disallow the exclusion when the amounts were paid to the biological parents of an adult child.

The Court also notes that the definition of earned income in §32 cited earlier applies to income includible in taxable income, rather than to income actually included in taxable income. Thus, the fact that the taxpayers had not included the amount in their income did not render it not earned income for purposes of §32.

The IRS protested that the taxpayers should not be allowed a double benefit by obtaining an earned income tax and refundable child tax credit, as there is no statutory provision evidencing that Congress intended recipients of such payments to obtain a double benefit. But the Court noted this double benefit was being created by an erroneous ruling of the IRS, not by Congress:

Respondent’s argument, however, misses that he, not Congress, has provided petitioners with a double tax benefit. Petitioners’ income cannot be reclassified by respondent, through a notice, to fall outside the plain text of section 32. If left alone section 32 would allow petitioners the benefits of earned income for their Medicaid waiver payment, but that payment would remain subject to taxation under section 61. Respondent, however, has decided to disturb this equilibrium by telling taxpayers like petitioners that they need not pay tax on their Medicaid waiver payments.

The opinion also notes that the IRS failed to raise the protective argument in the case that if the amounts were earned income for EITC purposes, the taxpayer should have to include them in income for the year in question.

So, in the end, the taxpayer was able to both exclude the amounts from taxable income and obtain credits based on that (now untaxed) earned income.

[1] Program Manager Technical Advice 2010-007