W-2 income for being the caregiver for a parent who lives in our house - isn't it tax exempt?

TurboTax can exempt income under Notice 2014-7 per the IRS instructions. This Notice provides that certain payments received by an individual care provider under a state Medicaid Home and Community-Based Services Waiver (Medicaid waiver) program, are difficulty of care payments and excludable as income.  

Since you received a W-2, you should enter the information in TurboTax and then show an offset for this entry so that you will not be taxed on the payments. This will reconcile your tax return with what the IRS has received and then show the corresponding offset to explain why it is not taxable. You will also be able to recover the federal and state taxes that were withheld from your payments. Please see the steps listed below to enter your W-2 into TurboTax. 

It is also important to inform you that a recent court case, ruled that IHSS payments and Medicaid Waiver Payments are considered "earned income" for purposes of calculating the earned income tax credit and other credits. Even though the income is not taxable for income tax purposes, a taxpayer can choose to show the payments as earned income to claim a credit. 

The instructions below include steps to enter the payments as earned income to receive a credit or to report them as unearned income. Either way the payments will not be subject to federal or state income taxes. 

1. Sign into TurboTax Online, click Continue your return, then pick up where I left off (if you are using TurboTax CD/ Download, then just open your return on your computer); 

2. Click on Federal from the menu on the left-hand side and then click on Wages & Income at the top; 

   1. If you choose to report your payments to receive a credit:  

      1. Click Edit/Add next to Job (W-2);  

      2. click on Add a W-2; 

      3. enter the information as reported on your W-2. Enter the amount you received for IHSS Payments in Box 1 (even if this amount is not reported in box 1 of your W-2). 

   2. If you choose not to report it as earned income to receive a credit:  

      1. Scroll down to "Less Common Income";  

      2. click on Show More; 

      3. click on Start or Revisit next to Miscellaneous Income, 1099-A, 1099-C; 

      4. click on Start or Revisit next to Other reportable income; 

      5. select Yes 

      6. enter "In-Home Support Services Payments, EIN # (enter EIN number from W-2)" in the description box and then enter the amount from box 1 your W-2; 

      7. click Continue.  

3. To enter the offset for the payments (whether you chose to report as earned income or not):  

   1. Click on Wages and Income at the top of the screen; 

   2. scroll down to "Less Common Income"; 

   3. click on Show More; 

   4. click on Start or Revisit next to Miscellaneous Income; 

   5. click on Start or Revisit next to Other Reportable Income; 

   6. select "Yes" or "Add Another Income Item"; 

   7. in the "Description" section, enter "IRS Notice 2014-7 excludable income" and in the "Amount" section, enter the W-2 box 1 amount (or amount of IHSS Payments) as a negative (-) number. 

For more information, refer to IRS Notice 2014–7, 20144 I.R.B. 445 and the IRS FAQs.