Supreme Court Upholds IRS Regulation Saying Medical Residents are “Students” and Subject to FICA Tax

special-report-medical-residents-are-studentsIntroduction

The long running controversy as to whether medical residents are subject to FICA tax drew to a close earlier this month when the Supreme Court issued its opinion in Mayo Foundation for Medical Education and Research et al. v. U.S.  The Court ruled in favor of the government, holding that the patient care services that medical residents at the Mayo Foundation and the University of Minnesota perform as part of their respective medical residency programs do not qualify under the so-called “student FICA exemption” and that the wages paid to the medical residents for such services are therefore subject to FICA tax.

Medical Residents and the Student FICA Exemption

Thus, the student FICA exemption only applies to those individuals who are both students at and employees of the educational institution, and the IRS has long held that a student-employee qualifies for the exemption only if the facts demonstrate that the individual is primarily a student, and not primarily an employee.

The student FICA exemption statute — IRC § 3121(b)(10) — is fairly straightforward as tax statutes go.  It basically states that wages paid to a student in connection with employment services he/she performs for the school, college, university at which he/she is enrolled and regularly attends classes are exempt from FICA tax. Thus, the student FICA exemption only applies to those individuals who are both students at and employees of the educational institution, and the IRS has long held that a student-employee qualifies for the exemption only if the facts demonstrate that the individual is primarily a student, and not primarily an employee. For example, a full-time undergraduate student who works 20 hours a week in the university library is primarily a student and exempt from FICA tax on the wages he receives, while the university controller who enrolls in a 3-hour music appreciation class is primarily an employee and subject to FICA tax on her wages.

Prior to 2005, there were serious disagreements between the IRS and higher education about how this student v. employee balancing test should be administered, but these issues were largely resolved in 2005 when the IRS issued a new set of student FICA exemption regulations and a separate set of safe harbor guidelines, both of which were effective April 1, 2005.  These new IRS regulations and safe harbor guidelines, while pretty much resolving the student FICA exemption issue for most types of student-employees, contained a provision that kept the controversy alive with respect to a small but important category of student-employees — medical residents.

In the pre-2005 IRS regulations, medical residents were not specifically treated but fell under the general balancing test that looked at various facts and circumstances on a case-by-case basis to determine whether the individual’s relationship to the school was primarily as a student or primarily as an employee.  Medical schools and hospitals felt strongly that when this facts and circumstances test is applied to a medical resident the resident should be viewed as primarily a “student” in that the typical resident attends classes, submits papers, sits for exams, etc. and that the resident’s patient care work is simply a part of the overall educational experience, much like an apprentice learning a trade.  The IRS, on the other hand, felt equally as strongly that the medical resident performed valuable and significant services for the hospital, often working in excess of 60-80 hours a week and was therefore primarily an employee.

Litigation Under the Pre-April 1, 2005 Regulations

The University of Minnesota was the first to litigate this issue under the prior IRS regulations.  In 1998, the 8th Circuit, after reviewing the facts and circumstances of the University’s medical residency program, concluded that the residents were primarily students who qualified for the student FICA exemption.  This victory caused hundreds of other medical schools and hospitals to file FICA tax refund claims with the IRS, arguing that they had incorrectly withheld and paid FICA tax on medical resident wages and requesting a refund of those FICA taxes.

The IRS, however, strongly disagreed with the 8th Circuit’s University of Minnesota decision, refused to grant the FICA tax refund claims filed by the other medical schools and hospitals, and continued to litigate the medical resident FICA tax issue.  But instead of litigating the factual balancing test question of whether medical residents are primarily students or primarily employees — a question the government lost in the University of Minnesota case — the IRS pursued a summary judgment approach, arguing that the legislative history underlying IRC § 3121(b)(10) presumptively demonstrates that Congress did not intend medical residents to qualify for the student FICA exemption.  This legislative history-based argument was rejected by four different courts of appeal (the 2nd, 6th, 7th, and 11th Circuits), thus leaving the IRS in the position of having to litigate whether the medical resident is primarily a student or primarily an employee based on the facts of the particular medical residency program, an argument that the government lost in the 8th Circuit.

Litigation Under the April 1, 2005 Regulations

When the IRS published its new set of student FICA exemption regulations in 2005, it maintained the same fact-based student v. employee balancing test used in the prior regulations, but included a provision stating that those student-employees who are “full-time employees” (defined as employees whose normal work schedule is 40 hours or more a week) will be treated as primarily employees, not students, regardless of the particular facts and circumstances surrounding their student obligations or their employment duties. (Treas. Reg. § 31.3121(b)(10)-2(d)(3)(iii)).  To make sure that everyone understood that this “full-time employee” rule was intended to prevent medical residents from qualifying for the student FICA exemption, the IRS included a specific example in the regulations to this effect.  (Treas. Reg. § 31.3121(b)(10)-2(e)(Example (4))).

Faced with a new IRS regulation that threatened to reverse the medical resident FICA tax exemption granted by the 8th Circuit decision in its 1998 decision, the University of Minnesota brought a FICA tax refund suit for post-April 1, 2005, tax periods arguing that the new full-time employee rule was invalid.  The Minnesota district court agreed, saying that the full-time employee presumption is inconsistent with the unambiguous text of IRC § 3121(b)(10), which, the court said, allows a FICA tax exemption in every case where the educational aspect of the person’s activities predominates over the employment services aspect, regardless of the number of hours worked.  The government appealed this decision to the 8th Circuit, and the University’s case was consolidated with an identical case brought by the Mayo Foundation for Medical Education and Research, which also operated a residency program in Minnesota and had also received a favorable decision at the district court level.  On appeal, the 8th Circuit reversed the district court and upheld the validity of the full-time employee rule.  The University and the Mayo Foundation filed a joint petition for certiorari with the Supreme Court, and the Court decided to hear the case.

Supreme Court Decision

The Supreme Court, in upholding the 8th Circuit’s decision and the validity of the full-time employee presumption in the April 1, 2005 regulations, spent very little time discussing or analyzing the statutory student FICA exemption; rather, it focused primarily on the somewhat esoteric principles relating to the administrative rule-making powers vested in the IRS and other government agencies.

The Supreme Court, in upholding the 8th Circuit’s decision and the validity of the full-time employee presumption in the April 1, 2005 regulations, spent very little time discussing or analyzing the statutory student FICA exemption; rather, it focused primarily on the somewhat esoteric principles relating to the administrative rule-making powers vested in the IRS and other government agencies.

The focus of the Court’s discussion centered on a two-part test that the Court had formulated in 1984 to determine the validity of an administrative regulation.  This test – known as the Chevron test after the case in which the test was announced – said that a regulation’s validity is determined by looking, first, at whether Congress has directly addressed the precise question at issue.  If so, any regulation contrary to such Congressional statement is invalid.  But if Congress has not addressed the issue, the second part of the Chevron test says that the agency determination will not be disturbed unless it is arbitrary, capricious, or manifestly contrary to the statute.

In the University/Mayo case, the Court applied the two-part Chevron test to the full-time employee regulation and found that both tests are met and that the regulation is therefore valid.  It rejected the University/Mayo’s argument that, at least in tax cases involving IRS regulations, a less deferential, multi-factor test set forth in an earlier 1979 decision (the National Muffler case) should be used in place of the second part of the Chevron test, saying, “we are not inclined to carve out an approach to administrative review good for tax law only.”

What Does the Decision Mean?

The immediate impact of the decision is, of course, that effective April 1, 2005, wages paid to medical residents will be subject to the FICA tax.  (Interestingly, on March 2, 2010, the IRS announced that it would grant FICA tax refunds for all claims filed for tax periods before April 1, 2005, when the prior regulations were in place.

But the broader implication for colleges, universities, and all taxpayers is that the Supreme Court has confirmed that the IRS has broad and expansive right to promulgate regulations interpreting a tax statute as it sees fit, even where courts may have held to the contrary.

But the broader implication for colleges, universities, and all taxpayers is that the Supreme Court has confirmed that the IRS has broad and expansive right to promulgate regulations interpreting a tax statute as it sees fit, even where courts may have held to the contrary.  Whether this power will impel the IRS through administrative regulations to begin effectively reversing adverse judicial decisions, or motivate the agency to issue regulations in lieu of litigating an issue, remains to be seen.  But it seems clear that the Supreme Court’s decision in the University of Minnesota/Mayo Foundation case gives the IRS wide latitude in interpreting Internal Revenue Code provisions in a manner favorable to the government.˜

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Bertrand Harding is a tax attorney who operates his own law firm in Alexandria, Virginia, specializing in tax issues facing colleges and universities.  He is the author of The Tax Law of Colleges and Universities (3d ed), which is published by John Wiley & Sons.