Higher Education v. Uncle Sam: FICA Responsibility for Medical Residents Confirmed

If your organization has not paid FICA taxes on behalf of your medical residents since the regulations were amended in 2005 to exclude medical residents from the Exemption, you should consider contacting counsel to discuss the most appropriate way to notify the IRS. On January 11, 2011, the U.S. Supreme Court handed down a definitive decision in favor of the Federal Government and against two hospitals that sponsor graduate medical education programs, ending a long dispute between the parties and promoting consistency regarding application of certain tax provisions. Mayo Foundation for Medical Education and Research v. U.S. Petitioners, the Mayo Foundation ("Mayo") and the University of Minnesota ("UM"), requested the court rule on whether the Treasury Department had the authority to categorically exclude all medical residents who were full-time employees from the definition of "student" for purposes of qualifying for the exemption from Social Security and Medicare taxes (the "Exemption").

Court documents disclosed the fact that medical residents are typically paid a stipend for their clinical services that ranges between $40,000 and $60,000 annually. Therefore, as much as $700 million that medical colleges pay annually in taxes to the federal government on behalf of their residents was at stake. The case had significant implications for the academic community since a finding that medical residents are eligible for the Exemption would have relieved the universities from paying half the amount of Social Security and Medicare taxes (collectively, the "FICA tax") on behalf of their residents.

The FICA tax, which supports the Social Security system, imposes a tax on both employers and employees based on an employee's wages. The FICA tax exempts earnings by students when the earnings are only incidental to the student’s primary purpose of education. The Exemption has generally applied to graduate students who are engaged in significant paid teaching and research activities by exempting all compensation for "services performed in the employ of a school, college, or university" by a "student who is enrolled and regularly attending classes at such school, college or university." According to the government, and pursuant to an amendment to regulations adopted by the Treasury Department, medical residents who are enrolled and regularly attending classes at a school are categorically excluded (with no further investigation into kinds of services performed) from the Exemption because they work in excess of 40 hours per week.

The Petitioners argued, on the other hand, that medical residents register for specific courses, attend lectures, take written examinations, and can choose to pursue electives. In addition to the specific course work outlined above, medical residents also spend, on average, 40 or more hours per week caring for patients under the supervision of attending physicians, and for the purpose of "hands-on" learning. One hundred percent of this hands-on care, according to the Petitioners, is designed to be educational.

The source of the controversy began in 1990 when the Social Security Administration adopted the position that medical residents are categorically ineligible for the Exemption and issued a notice to UM for the unpaid Social Security taxes. UM filed suit and the Eight Circuit Court of Appeals overturned the assessment holding that the stipends paid to medical residents were exempt from Social Security taxes because the residents qualified as "students" under the Exemption, which is identical to the FICA tax exemption. A few years later, a District Court in Minnesota held that Mayo's medical residents were also exempt from Social Security taxes using the same reasoning. The court concluded, in contrast to the government's categorical approach, that medical residents' eligibility should be dependent on a "fact-specific, case-by-case examination" of whether the residents qualify for the Exemption.

Following the district court case, the Treasury Department promulgated amendments to its regulations excluding "full-time employees" from being eligible for the Exemption. The amendment included medical residents as an example of full-time employees ineligible for the exemption, despite the fact that the services performed by the residents may have an inherent educational aspect. Both Mayo and UM filed suit at the District Court level alleging that the government agency did not have the authority to narrowly define student by exempting full-time employees as a result of a number of lost court cases. The District Court agreed and invalidated the new regulation finding that medical residents were "students" within the meaning of the Exemption and that the agency had exceeded its regulatory authority.

The Eighth Circuit agreed to hear the government's appeals related to both Mayo and UM together. Ultimately, the Eighth Circuit reversed, holding that the term "student" was ambiguous and the Treasury Department's decision to issue amendments to regulations clarifying the term was appropriate. However, four other courts of appeal at one time or another had ruled against the government, stating that residents fell within the terms of the Exemption. It was for this reason that final appeal to the Supreme Court was ultimately accepted.

During oral argument, the government's lawyer stated that the Exemption was not meant to apply to "apprenticeships." Specific examples were set forth including judicial clerkships whereby lawyers receive "on-the-job training" but due to the fact that they are not employed by a school, college or university, they would not be entitled to the Exemption. Counsel for the government went even further when stating that not all medical residents are employed by schools, colleges or universities when completing their residency training. Rather, some private, unaffiliated hospitals maintain residency programs outside of an affiliation with an academic institution to provide the "hands-on" instruction. Again, if the Exemption were to apply to the medical residents employed by Mayo and UM, it would not apply to those residents employed directly by private hospitals or other entities whose primary function is not the provision of formal instruction.

The Supreme Court was swayed by the government's proffered arguments and in its unanimous ruling, determined that the agency had the authority to make rules carrying the force of law and that, therefore, the subsequent regulation removing employees that work 40 hours or more from the Exemption was valid. The court conceded that a deferential standard was appropriate and determined that a federal agency's drawing of lines in order to approve administrability and avoid wasteful litigation and continuing uncertainty is legitimate. It is likely that after Mayo, any challenged Treasury regulation will be reviewed under a similar deferential standard.

Some have estimated that had Mayo prevailed in the litigation, the institutions and their medical residents would have received more than $24 millions in refunds from the IRS.

Conclusion and Effect on Pre-April 1, 2005 Claims

Prior to 2005, most medical colleges did not pay FICA taxes for their residents, relying primarily on the Exemption. Even after 2005, during the pendency of this litigation, some colleges continued the trend of nonpayment while awaiting final resolution of the issue by the judiciary. Now that the highest court in the land has spoken, those entities that did not pay FICA taxes on behalf of their medical residents between 2005 and 2011, may be required to pay amounts past due plus interest. Again, if your organization has not paid FICA taxes on behalf of your medical residents since the regulations were amended in 2005 to exclude medical residents from the Exemption, you should consider contacting counsel to discuss the most appropriate way to notify the IRS. Likewise, the payment of FICA taxes will need to be considered for long-term financial planning and tax compliance. Institutions may also want to consider to what degree affiliated teaching hospitals can assist in contributing to these amounts.

Those colleges and medical residents that have been paying FICA taxes since 2005 will see no major impact as a result of the decision and any properly filed FICA refund claims for tax periods ending before April 1, 2005 will not be adversely affected because such tax periods were not subject to the amendments.

Mayo Foundation for Medical Education and Research; Mayo Clinic; and Regents of the University of Minnesota v. United States, S. Ct. Dkt. No. 09-837 (U.S. 1/11/2011).