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By Carla Neeley Freitag, Esq.
www.taxresearchandwriting.com, Merritt Island, FL
What's new: On March 2, 2010, the IRS announced that an administrative determination was made to accept the position that medical residents are excepted from FICA taxes under the student exception for tax periods ending before April 1, 2005. This decision will resolve numerous pending refund claims and cases.
Section 117 excludes qualified scholarships from a recipient's gross income. To use the exclusion, a recipient must be a candidate for a degree at an educational organization. §117(a). The payment must be used for qualified tuition and related expenses. §117(b). In addition, the exclusion does not apply to any portion of a payment representing payment for past, present, or future teaching, research, or other services required as a condition to receiving the payment. §117(c)(1). The exclusion does not apply to any amount representing payment for services subject to the direction or supervision of the employer. Regs. §1.117-4(c). Whereas an incidental benefit to a grantor will not disqualify a payment from treatment as a qualified scholarship, an individual may not exclude payments to enable the individual to pursue studies or research primarily for the benefit of the grantor. Regs. §1.117-4(c).
In 1966, the U.S. Supreme Court, in Bingler v. Johnson,1 considered a doctoral fellowship program operated by Westinghouse. During the first phase, an individual works full time and also studies at specified universities. After the individual satisfies the preliminary requirements for a doctorate degree, the individual could have an educational leave of absence to work full time on a dissertation. The dissertation topic must be approved and must relate in some way to the employer's business. Additional requirements include submitting periodic progress reports to Westinghouse and promising to work for Westinghouse for at least two years. During the leave, Westinghouse pays the individual 70% to 90% of the individual's salary during the first phase and continues to provide the standard employee benefits. The Court considered whether the individual could exclude the stipends received during the leave of absence as scholarships. The Court held that payments under the doctoral program were taxable income rather than scholarships because "bargained-for payments, given only as a quo in return for the quid of services rendered" are not excludible from income as "scholarships."2
Although Bingler v. Johnson and its contemporary cases appeared to settle the issue of the treatment of resident stipends under §117,3 the issue has again arisen, in the words of a federal district court, in "the recent eruption of a new litigation campaign over the application of FICA taxes to resident payments."4
If stipends paid to medical residents were scholarships, then they would not be subject to FICA taxes because they would not be included as wages in the residents' gross income.5 Using the scholarship exclusion, however, requires satisfaction of several requirements that are problematical for medical residents. Medical residents have already received their medical degree and therefore are not degree candidates.6 Their stipends are generally used for living expenses; they do not pay tuition, fees, and related expenses. Moreover, under Bingler v. Johnson, the stipends represent bargained-for payments given in return for full-time medical services.7 Thus, absent unusual fact patterns, stipends paid to medical residents do not qualify for exclusion as scholarships under §117.8
In CCA 200944027, the Chief Counsel addressed whether grants to post-doctoral fellows, including National Research Service Awards (NRSA) from the Department of Health and Human Services, are subject to FICA taxes.9 The NRSA grants are excludible because they are not payments for services under §117(c). The primary purpose of grants is to benefit the recipient, and the grants are not compensation for past, present, or future services. In contrast, the non-NRSA grants do not qualify as scholarships because the purpose of the grants is to fund the performance of specific services that benefit the taxpayer, the selection of fellows and work assignments is controlled by the taxpayer, stipends are furnished based on the value of the research services provided, and the grantees receive more extensive fringe benefits than the NRSA grantees. Moreover, there is an employment relationship between the taxpayer and the fellows because the taxpayer's behavioral and financial control over the fellows. The CCA concluded that NRSA grants were excludible as scholarships and that the non-NRSA grants were taxable and subject to FICA. Although the NRSA and non-NRSA grants had similarities, the significant differences between them resulted in the different tax treatment.
The Student Exception from FICA Taxes
Employees and employers are responsible for social security and medicare taxes on wages paid by the employers to the employees. §§3101(a), 3111(a). An employee's share of FICA and FUTA taxes is withheld by the employer and remitted to the IRS. §3102. The employer pays its share of the employment taxes directly to the IRS. §3111(a). All remuneration for employment is considered wages unless a specific exception applies. §3121. Under the "student exception," a service performed in the employ of a school, college, or university is not considered as employment if the service is performed by a student who is enrolled and regularly attending classes at the school, college, or university. §3121(b)(10).
Regs. §31.3121(b)(10)-2 was amended by the IRS in 2004.10 For services performed before April 1, 2005, the regulation provided that the status of an employee as a student was determined based on the relationship between the employee and the organization.11 If services were performed for a university, college, or university as an incident to, and for the purpose of, pursuing a course of study at the institution, the employee is considered a student.12
Relying on the pre-amended regulation, the Eighth Circuit Court of Appeals and several federal district courts held that teaching hospitals and universities which had paid the employment taxes on stipends paid to medical residents were entitled to refunds.13 Likewise, the medical residents were entitled to refunds of the taxes they paid. In response to these favorable opinions, over 7,000 medical schools filed claims for refund of FICA taxes paid for their residents.14 The amendment of Regs. §31.3121(b)(10)-2 was prompted by these decisions.
For services performed on or after April 1, 2005, the amended regulation elaborates on the requirements for student status under the student exception. There is an educational aspect and a services aspect of services performed for a school, college, or university. To qualify for the student exception, the services are considered to be incident to, and for the purpose of, pursing a course of study only if the educational aspect is predominant.15 The services of a full-time employee are not considered to be incident to, and for the purposes of, pursuing a course of study.16 An employee who works 40 or more hours weekly is considered a full-time employee. Other factors to consider are whether the employee is a professional and whether the employee receives normal fringe benefits.17 An employee's course load is key in evaluating whether the educational aspect of a relationship between an employee and a school, college, or university predominates over the services aspect.18 A relevant factor is to compare the employee's course load with a typical full-time course workload at the institution.
Example 4 in Regs. §31.3121(b)(10)-2(e) involves a medical resident who works 40 or more hours per week. The student exception does not apply because the resident is a full-time employee. The facts that some of the resident's services have an educational aspect, that the resident will receive a certificate of completion of the residency program, and that the resident will be eligible to take an exam for a medical specialty do not change the result. Thus, for services performed on or after April 1, 2005, medical residents who perform services on a full-time basis are subject to the social security taxes and withholding because the student exception does not apply.19 The full-time employment rule trumps all other factors that may indicate that the educational aspect predominates.
In 2007 and 2008, a federal district court in Minnesota held that the amended regulation was invalid, in part on the ground that the full-time employee provision arbitrarily limited the ordinary meaning of the term "student" as used in §3121(b)(10).20 The Court of Appeals for the Eighth Circuit reversed the district court, holding that the amended regulation was a permissible interpretation of the term "student" in §3121(b)(10).21
Under both the pre-amended and current regulations, the IRS has argued that medical residents are per se not eligible for the medical exception. Courts have almost uniformly rejected this position, holding that each case must be analyzed based on the factors set forth in the regulations.22 There is no "bright line" rule that medical residents are never eligible for the student exception. As a practical matter, however, only a program specifically tailored to the requirements of §117 would pass muster as a scholarship program. Most residents' stipends will be subject to FICA taxes and the employer holding requirements.
Good News for Tax Periods Ending before April 1, 2005
In a March 2, 2010, news release, the IRS announced that it will accept the position that medical residents are excepted from FICA taxes under the student exception for tax periods ending before April 1, 2005.23
Note: Only those educational institutions and medical residents with timely filed refund claims may take advantage of the new IRS position. Those who did not file claims cannot do so now because the limitations period for filing a claim for tax years ending before April 1, 2005, has expired.24
The IRS uses the effective date of the amended Regs. §31.3121(b)(10)-2 as the cut-off date for its concession.25 For tax periods ending on or after April 1, 2005, the IRS will continue to assert that medical residents are not covered by the student exception if they render medical services on a full-time basis. This position is supported by the amended regulation, and several courts have acknowledged that the student exception does not apply under the amended regulation.26
There are two groups of medical schools and residents for purposes of applying the administrative determination: those which are still attempting to resolve the issue administratively or whose claims are in suspense and those presently involved in litigation. Employers and individuals with pending claims filed with the IRS do not have to take any action at this time. The IRS will contact taxpayers who filed claims for refund within the excepted period to supply additional information and procedures. Taxpayers with pending lawsuits are directed to contact the Justice Department. Presumably, the refund suits will be resolved by stipulation or agreement, and pending discovery requests and other motions will be withdrawn. Motions for attorneys' fees will have to be resolved. Presumably, cases, if any, under the pre-amended regulation in which the government is the plaintiff will not be pursued further.
Claims filed by universities and teaching hospitals cover both the institution and the medical residents whose FICA taxes were withheld. Claims filed by individual residents cover only the individual residents. Thus, a medical resident who did not file an individual claim should find out whether the resident is covered under a claim by the employer institution. Claims filed by medical residents do not cover the residents' employers.
For more information, in the Tax Management Portfolios, see Allman, 392 T.M., Withholding, Social Security and Unemployment Taxes on Compensation, and in Tax Practice Series, see ¶1350, Scholarships, Fellowships and Tuition Reductions.
3 E.g., Parr v. U.S., 469 F.2d 1156 (5th Cir. 1972); Hembree v. U.S., 464 F.2d 1262 (4th Cir. 1972), rev'g 71-2 USTC ¶ 9636 (D.S.C. 1971). Rockswold v. U.S., 471 F. Supp. 1385, 1392 (D. Minn. 1979), aff'd, 620 F.2d 166 (8th Cir. 1980); Wertzberger v. U.S., 315 F. Supp. 34 (W.D. Mo. 1970), aff'd, 441 F.2d 1166 (8th Cir. 1971).
5 In U.S. v. Detroit Medical Center, 557 F.3d 412 (6th Cir. 2009), aff'g in part and vac'g and rem'g on other grounds, 98 AFTR2d 7995 (E.D. Mich. 2006), the Court of Appeals speculated that Congress could have chosen to exclude scholarships from gross income and the income tax but to consider them as wages subject to the FICA taxes. Id. at 415-16. In CCA 200944027, the Chief Counsel stated that, "in general," fellowship stipends that are excludible from gross income under §117 are not subject to FICA.
7 For an analysis of the case law and the factors indicating that the purpose of a stipend is for the primary benefit of the employer or for the primary benefit of developing the recipient's research skills, see CCA 200944027. The CCA also discusses relevant factors in determining whether a payment is or is not compensation for past, present, or future services.
8 U.S. v. Detroit Medical Center, 557 F.3d 412, 417 (6th Cir. 2009), aff'g in part and vac'g and rem'g on other grounds, 98 AFTR2d 7995 (E.D. Mich. 2006); U.S. v. Mount Sinai Medical Center, 353 F. Supp. 2d 1217, 1230 n.7 (S.D. Fla. 2005). AccordParr v. U.S., 469 F.2d 1156 (5th Cir. 1972); Hembree v. U.S., 464 F.2d 1262 (4th Cir. 1972), rev'g 71-2 USTC ¶9636 (D.S.C. 1971). In U.S. v. Partners Healthcare System, Inc., 2006 U.S. Dist. Lexis 97908 (D. Mass. 2006), the taxpayer argued not that resident stipends were excludible as scholarships or fellowships but that they were excludible as payments "in the nature of" scholarships and fellowships. The stipends were not excludible and were subject to FICA.
13 Minnesota v. Apfel, 151 F.3d 742, 747-49 (8th Cir. 1998), aff'gMinnesota v. Chater, 1997 U.S. Dist. Lexis (D. Minn. 1997); U.S. v. Mayo Foundation, 282 F. Supp. 997 (D. Minn. 2003) (resolved by stipulation that stipends excluded from FICA); See alsoCenter for Family Medicine v. U.S., 2008-2 USTC ¶50,488 (D.S.D. 2008); U.S. v. Mount Sinai Medical Center, 2008-2 USTC ¶50,469 (S.D. Fla. 2008); Regents of the Univ. of Minn. v. U.S., 2008-1 USTC ¶50,262 (D. Minn. 2008), rev'd and rem'd, 568 F.3d 675 (8th Cir. 2009); Mayo Foundation v. U.S., 503 F. Supp. 2d 1164, 1174-78 (D. Minn. 2007) , rev'd and rem'd, 568 F.3d 675 (8th Cir. 2009).
19 The amended regulation unambiguously clarified the position of the IRS regarding residents and the student exception. In Minnesota v. Apfel, 151 F.3d 742, 747-49 (8th Cir. 1998), the Eighth Circuit Court of Appeals held that the medical residents in that case were covered by the student exception under the pre-amended regulations. The Eighth Circuit reached the opposite conclusion under the amended regulations in Mayo Foundation v. U.S., 568 F.3d 675 (8th Cir. 2009).
20 Mayo Foundation v. U.S., 503 F. Supp. 2d 1164, 1174-78 (D. Minn. 2007), and Regents of the Univ. of Minn. v. U.S., 2008-1 USTC ¶50,262 (D. Minn. 2008), rev'd and rem'd, 568 F.3d 675 (8th Cir. 2009).
22 U.S. v. Detroit Medical Center, 557 F.3d 412 (6th Cir. 2009), aff'g in part and vac'g and rem'g on other grounds 98 AFTR2d 7995 (E.D. Mich. 2006); U.S. v. Mount Sinai Medical Center, 486 F.3d 1248 (11th Cir. 2007), vac'g and rem'g 97 AFTR2d 1840 (S.D. Fla. 2006); Center for Family Medicine v. U.S., 456 F. Supp. 2d 1115 (D.S.D. 2006). In Albany Medical Center v. U.S., 2007-1 USTC ¶50,168 (N.D.N.Y. 2007), and U.S. v. Memorial Sloan-Kettering Cancer Center, federal district courts in New York held that medical residents do not qualify for the student exception as a matter of law. Both judgments were vacated by U.S. v. Memorial Sloan-Kettering Cancer Center, 563 F.3d 19 (2d Cir. 2009).
25 Regs. §31.3121(b)(10)-2 (2004) is applicable for services performed before April 1, 2005. The amended regulation is effective for services performed on or after April 1, 2005. Regs. §31.3121(b)(10)-2(f). If a calendar year taxpayer's taxable period ended on December 31, 2004, the announced position would not apply for services rendered after that date in January through March of 2005. The old regulation, however, would continue to apply for services performed before April 1, 2005.
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