Willkie Farr & Gallagher LLP, New York, NY

The Internal Revenue Service (IRS) recently won a long fought victory over the student medical resident exception from employment taxes under the Federal Insurance Contribution Act (FICA). In response to a number of federal court decisions holding that the services of a medical resident fell within the student exception from FICA taxes, the IRS adopted revised regulations which provide that “[t]he services of a full-time employee are not incident to and for the purpose of pursuing a course of study.” The Eighth Circuit reversed two district court decisions that found the revised regulations to be an invalid exercise of IRS regulatory authority. According to the court in Mayo Foundation for Medical Education and Research v. U.S., No. 073242 (8th Cir. 6/12/09), IRS regulations limiting the student FICA exception to students who are not full-time employees is a permissible interpretation of the statute.

FICA Tax Exclusion

The FICA payroll tax, which supports the Social Security System, imposes a tax on both employers and employees based on an employee's wages. Although FICA wages are broadly defined as “all remuneration from employment,” the Internal Revenue Code lists numerous exceptions, including an exception for “service performed in the employ of a school, college, or university … if such service is performed by a student enrolled and regularly attending classes at such school, college, or university.” §3121(b)(10).

The student FICA exception has been part of FICA since 1939, although litigation concerning its application to medical student residents is fairly recent. The progression of cases began with Minnesota v. Apfel, 151 F.3d 742 (8th Cir. 1998), in which the State of Minnesota successfully contended that medical residents in the University of Minnesota residency program were students, and thus exempt from FICA taxes. In response to the Apfeldecision, numerous health care organizations made claims seeking refunds of hundreds of millions of dollars in FICA taxes based on the student exception. In general, the decisions following Apfel narrowly held that the FICA exception was unambiguous and pre-2005 IRS regulations interpreting the statute did not categorically make the medical residents ineligible for the student exception. U.S. v. Mount Sinai Medical Center of Florida, 486 F.3d 1248 (11th Cir. 2007); U.S. v. Memorial Loan-Kettering Cancer Center, 563 F.3d 19 (2d Cir. 2009); U.S. v. Detroit Medical Center, 557 F.3d 412 (6th Cir. 2009); University of Chicago Hospitals v. U.S., 545 F.3d 564 (7th Cir. 2008).

IRS 2005 Final Regulations

In response to a succession of judicial defeats, the IRS published notice of proposed regulations amending existing guidance relating to the student exception. Prop. Regs. §31.3121(b)(10)-2, 69 Fed Reg. 8604 (2/25/04). After extensive public comment and a hearing, final regulations were promulgated, effective April 1, 2005. T.D. 9167, 2005-1 C.B. 261. The final regulations provide guidance on when an employer is considered a “school, college or university,” and when an employee is considered a “student” for purposes of the student FICA exception. As revised, an employer qualifies as a school, college or university only if the employer's primary function is to conduct educational activities. Regarding the determination of student status, the final regulations provide the following:

• An employee must be enrolled in classes creditable towards a degree, certificate or other recognized educational credential at the school, college or university at which he or she is employed.

• An employee must be pursuing a course of study, the outcome of which is a degree, certificate or other recognized educational credential, or must sit for an examination required to receive certification by a recognized organization in a field.

• An employee's services must be incident to and for the purpose of pursuing a course of study in order for the employee to qualify as a student. Most importantly, the final regulations provide that the student FICA exception is not available to any individual who regularly works 40 or more hours per week, is required to be licensed under state or local law to perform their job or is a professional employee, or is entitled to receive retirement or similar benefits.

Mayo Foundation; University of Minnesota

When the Mayo Foundation and the University of Minnesota sued the IRS in 2005 challenging the government's claim that they owed FICA taxes on their wage payments to full-time medical residents, the district court declared the new regulations invalid on the grounds that the new rules clashed with the “plain meaning” of the underlying FICA statute. Mayo Foundation v. U.S., 503 F. Supp. 2d 1164 (D. Minn. 2007); Regents of the University of Minnesota v. U.S., 2008-1 USTC ¶50,262 (D. Minn. 2008). Then, applying the pre-2005 regulations, the court, relying on prior judicial precedent, reached the conclusion that the institutions' payments to the medical residents were excluded under the student FICA exception.

When the IRS appealed the district court decisions, the Eighth Circuit reached a different result. In a consolidated opinion, the court in Mayo Foundation noted that the amended regulations modified the general “incident to” test set forth in the prior student exemption regulations by expressly providing that “[t]he services of a full-time employee are not incident to and for the purpose of pursuing a course of study,” and furthermore, that an employee who works 40 or more hours per week is considered “full-time.” Applying the Supreme Court's doctrine of deference to reasonable agency interpretations of an ambiguous statute as announced in Chevron v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), the court upheld the validity of the amended FICA regulations. While noting that other interpretations of the statute were possible, the interpretation adopted by the IRS did not conflict with the plain language of the statute and was consistent with the origin and purpose of the exception as initially enacted by Congress.

The Eighth Circuit's decision in Mayo Foundation completely changes the momentum of this ongoing battle in favor of the government. Notably, the fact that the IRS changed the rules of engagement had no impact on the court as “[t]he Supreme Court has repeatedly held that agencies may validly amend regulations to respond to adverse judicial decisions, or for other reasons, so long as the amended regulation is a permissible interpretation of the statute.” Given that there are millions of dollars at stake, it is likely the dispute is far from over.

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 ¶5440, Employment Tax Withholding Requirements.