If my W-2 shows state wages and Virginia withholding but the income is excluded difficulty-of-care pay, does Virginia tax it?

Plain-English summary

A care provider filed a 2017 Virginia return reporting zero federal adjusted gross income (FAGI), because his pay was excluded "difficulty of care" income under a Medicaid waiver program. His W-2 showed no federal wages, but it did show an amount as state wages with Virginia tax withheld — so the Department adjusted his return and cut his refund. He appealed.

The Department reversed itself and will issue a refund: because the income was properly excluded from FAGI, Virginia can't tax it — and the state-wage boxes on the W-2 don't change that.

Why the income isn't taxable in Virginia

Virginia starts its income tax computation from FAGI and conforms to federal definitions (Va. Code § 58.1-301). The rule is simple: income that is properly excluded from FAGI is not subject to Virginia income tax (unless a Virginia modification adds it back, which none did here).

Under IRC § 131, qualified foster-care payments are excluded from a care provider's gross income. The IRS extended this in Notice 2014-7 to Medicaid waiver payments under the "difficulty of care" provision — payments for nonmedical support services provided under a plan of care to an eligible person living in the care provider's home. So the taxpayer's pay was correctly left out of his federal income, making his FAGI zero.

The W-2's state boxes didn't matter

The Department had assessed tax only because the W-2 reported state wages and Virginia withholding. The ruling is explicit: "The fact that state wages were reported on the W-2 and state income tax was withheld has no bearing on whether the income was properly excluded from FAGI." Since the income was excludable federally, it stayed out of FAGI and out of Virginia tax. The adjustment was reversed and a refund will be issued as warranted.

(The Virginia withholding shown on the W-2 is money already sent to Virginia; with no tax actually due, that's exactly why the taxpayer was owed a refund.)

What this means for you

• Difficulty-of-care / Medicaid-waiver pay isn't Virginia taxable when it qualifies for the federal exclusion under IRC § 131 and IRS Notice 2014-7.
• Ignore the state-wage boxes for this purpose. A W-2 can show state wages and withholding even when the income is federally excluded — that reporting doesn't create Virginia tax.
• If Virginia was withheld on excluded pay, you may be due a refund. Report the income consistently with your federal return (FAGI) and claim back the withholding.
• The exclusion has conditions: the care recipient must live in your home and the payments must be for nonmedical support under a plan of care.

Common questions

Q: My Medicaid-waiver pay was excluded on my federal return but my W-2 shows state wages. Do I owe Virginia tax?

A: No. If the pay qualifies as difficulty-of-care income excluded from FAGI, Virginia doesn't tax it. The state-wage entry on the W-2 doesn't change that.

Q: Virginia tax was withheld from my excluded pay. Can I get it back?

A: Yes. With no Virginia tax actually due on the excluded income, the withholding should come back to you as a refund — which is what happened in this ruling.

Q: What makes pay qualify as difficulty-of-care income?

A: Under IRS Notice 2014-7, it must be a Medicaid-waiver payment for nonmedical support services provided under a plan of care to an eligible individual living in your home.

Citations and references

• Va. Code § 58.1-301 — Virginia conforms to Internal Revenue Code terminology
• Va. Code §§ 58.1-322.01 through 58.1-322.04 — Virginia income modifications
• IRC § 131 — qualified foster-care / difficulty-of-care payments excluded from gross income
• IRS Notice 2014-7, 2014-4 IRB 445 — Medicaid waiver payments excludable as difficulty-of-care income

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 19-97

Original ruling text

August 27, 2019

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you seek a refund of individual income tax paid by * (the “Taxpayer”) for the taxable year ended December 31, 2017.

FACTS

The Taxpayer filed a Virginia resident income tax return for the 2017 taxable year. The Department adjusted the Taxpayer’s federal adjusted gross income (FAGI), as reported on his Virginia return, based on W-2 information. As a result, the Taxpayer’s refund was reduced. The Taxpayer appeals, contending the income at issue was properly excluded from his FAGI as difficulty of care income.

DETERMINATION

Virginia Code § 58.1-301 provides, with certain exceptions, that the terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia . For individual income tax purposes, Virginia “conforms” to federal law, in that it starts the computation of Virginia taxable income with FAGI. Income properly included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Virginia Code § 58.1-322.01 through § 58.1-322.04.

IRC § 131 excludes qualified foster care payments from inclusion in the gross income of a foster care provider, under certain conditions. The IRS has clarified that this exclusion extends to payments received under a Medicaid waiver program under the difficulty of care provision of IRC § 131. The payments must be made to an individual care provider for nonmedical support services that were provided under a plan of care to an eligible individual living in the care provider’s home. See IRS Notice 2014-7, 2014-4 IRB 445.

The Taxpayer’s W-2 reported no wages for federal income tax purposes and no federal income tax was withheld, consistent with the reporting of the difficulty of care income exclusion. Thus, the Taxpayer’s federal return reported no taxable wages. Because the Taxpayer reported no other sources of income, his FAGI was reported as zero on his federal return. The Taxpayer’s Virginia return reported a FAGI of zero to match the federal return. Under review, the Department found that the Taxpayer’s W-2 included an amount reported as state wages and state income tax withheld and issued an assessment. The fact that state wages were reported on the W-2 and state income tax was withheld has no bearing on whether the income was properly excluded from FAGI. Because Virginia starts its computation of taxable income with FAGI, income is not subject to Virginia income tax to the extent it is properly excludable from FAGI. Accordingly, the adjustment is reversed and a refund will be issued as warranted.

The Code of Virginia sections cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s web site. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1937.A