Employment Taxes
In a unanimous decision, the Supreme Court held that individuals in medical residency programs at teaching hospitals are subject to FICA on the stipends they receive for the work they perform while participating in the medical residency programs.
Background
The Mayo Foundation for Medical Education and Research (Mayo) offers residency programs to doctors who have graduated from medical school and seek additional instruction in a chosen specialty. These programs train doctors primarily through hands-on experience. Although residents are required to take part in formal educational activities, these doctors generally spend the bulk of their time—typically 50–80 hours a week—caring for patients. Mayo pays its residents annual stipends of over $40,000 and also provides them with health insurance, malpractice insurance, and paid vacation time.
The Federal Insurance Contributions Act (FICA) requires employees and employers to pay taxes on all wages employees receive and defines “wages” to include “all remuneration for employment.” FICA defines “employment” as “any service . . . performed . . . by an employee for the person employing him” but excludes from taxation any “service performed in the employ of . . . a school, college, or university . . . if such service is performed by a student who is enrolled and regularly attending classes at [the school]” (Sec. 3121(b)(10)). Since 1951, the IRS has construed the student exception to exempt from taxation students who work for their schools “as an incident to and for the purpose of pursuing a course of study” (16 Fed. Reg. 12474). Until 2005, the IRS determined the application of the exception on a case-by-case basis, primarily basing its determinations on the numbers of hours the individual worked and his or her course load.
The Social Security Administration (SSA) also applied a case-by-case approach to the corresponding student exception in the Social Security Act but always held that resident physicians are not students. In 1998, the Eighth Circuit held that the SSA could not categorically exclude residents from student status, given that its regulations provided for a case-by-case approach (Minnesota v. Apfel, 151 F.3d 742 (8th Cir. 1998)). Following that decision, the IRS received more than 7,000 claims seeking FICA tax refunds on the ground that medical residents qualified as students under Sec. 3121(b)(10).
In December 2004, after the issuance of proposed regulations and public hearings, the IRS issued final regulations providing that “[t]he services of a full-time employee”—which includes an employee normally scheduled to work 40 hours or more per week—“are not incident to and for the purpose of pursuing a course of study” (Regs. Sec. 31.3121(b)(10)-2(d)(3)(iii)). The regulations explain that this analysis “is not affected by the fact that the services . . . may have an educational, instructional, or training aspect” (Regs. Sec. 31.3121(b)(10)-2(d)(3)(i)). The regulations also contain an example in which the individual is a medical resident whose normal schedule requires him to perform services 40 or more hours per week; the example concludes that the resident is not a student.
After the IRS issued these regulations, Mayo filed a suit in district court seeking a refund of the money it had withheld and paid on its residents’ stipends during the second quarter of 2005. Mayo asserted that its residents were exempt under Sec. 3121(b)(10) and that the regulations containing the full-time employee rule were invalid.
The district court granted Mayo’s motion for summary judgment (Mayo Found. for Med. Educ. and Research, 503 F. Supp. 2d 1164 (D. Minn. 2007)). The court held that the full-time employee rule is inconsistent with the unambiguous text of Sec. 3121, which the court understood to dictate that an employee is a student so long as the educational aspect of his service predominates over the service aspect of the relationship with his employer. In making its determination, the court applied the factors governing the analysis of tax regulations set forth in National Muffler Dealers Assn., 440 U.S. 472 (1979).
The IRS appealed, and the Eighth Circuit reversed (Mayo Found. for Med. Educ. and Research, 568 F.3d 675 (8th Cir. 2009)). In its decision, the Eighth Circuit, instead of applying the standards for regulatory analysis found in National Muffler, applied the standards set out in Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). The Eighth Circuit concluded that “the statute is silent or ambiguous on the question whether a medical resident working for the school full-time is a ‘student’” for purposes of Sec. 3121(b)(10) and that the IRS’s amended regulation “is a permissible interpretation of the statutory student exception.” Mayo appealed the decision to the Supreme Court, which agreed to hear the case.
The Supreme Court’s Decision
The Supreme Court, in a unanimous decision, affirmed the Eighth Circuit and held that the Mayo medical residents were subject to FICA. In its opinion, it found that the Eighth Circuit had properly applied the Chevron standards of regulatory analysis instead of the National Muffler standards. The Supreme Court found, as had the Eighth Circuit, that Congress had not precisely addressed the question at issue in the case in Sec. 3121(b)(10) and that the IRS’s interpretation of the statute in the regulations was a permissible interpretation, so the IRS’s interpretation was entitled to deference from the courts.
With respect to which standards should be applied in an analysis of tax regulations, the Court stated that “the principles underlying our decision in Chevron apply with full force in the tax context.” The Court also pointed out that case law that preceded Chevron, suggesting that less deference to a regulation is required when a regulation is adopted under a general grant of authority to an agency as opposed to a specific grant of authority, had been superceded by the Court’s opinion in Mead Corp., 533 U.S. 218 (2001). In Mead, the Court clearly states that it is appropriate to apply the Chevron analysis to regulations adopted under a general grant of authority. The Court also noted that in its opinions in Mead and Long Island Care at Home, Ltd., 551 U.S. 158 (2007), it had found that where an agency had issued regulations after engaging in its full notice and comment procedures (as the IRS had done in the case of the regulations at issue here), a Chevron analysis was warranted. Thus, the Court applied the Chevron standards.
Under the first Chevron step, the Court looked at whether Congress had addressed the point at issue in the statute. The Court found that it had not because Sec. 3121(b)(10) did not define the term “student” or speak “to the precise question whether medical residents are subject to FICA.” The Court also pointed out that medical residents were expressly excluded from exemptions they might otherwise invoke in Secs. 3121(b)(6)(B) and 3121(b)(7)(C), a fact that cast doubt on the claim that Congress intended to exempt medical residents from FICA.
Under the second Chevron step, the Court considered whether the IRS’s interpretation of the law was reasonable. The Court held that the full-time employee rule provided by the regulations “easily satisfied” this second step. The Court rejected Mayo’s arguments that the IRS was required to analyze each case separately, finding that it was reasonable to provide a bright-line rule to improve the administration of the law and to avoid wasteful litigation and continuing uncertainty. The Court also agreed with the IRS’s contention that besides administrative convenience, taxing medical residents also furthered the purpose of the Social Security Act and was consistent with the Court’s precedent.
Besides holding that the Chevron standards applied to tax regulations instead of the National Muffler standards, the Court also specifically pointed out parts of the National Muffler analysis that would no longer be relevant in an analysis of a regulation. The Court stated that agency inconsistency with respect to a regulation, the regulation’s age or contemporaneity, prior judicial decisions that conflict with the regulation, or the fact that the IRS adopted a regulation in response to litigation will not be taken into consideration in deciding whether the Chevron standards apply or if the regulation is valid under those standards.
Reflections
The Supreme Court’s rejection of the exemption from FICA for medical residents, an issue involving a large amount of money that has been the subject of extensive litigation across the country, is a big win for the IRS. However, the Supreme Court’s adoption of the Chevron standards for tax regulation analysis, which will make it much harder for a taxpayer to challenge the validity of regulations, makes this case a huge win for the IRS. As recent statements by a senior IRS official (Clarissa C. Potter, IRS deputy chief counsel (technical), speaking at the 2011 midyear meeting of the American Bar Association’s Section of Taxation) make clear, the IRS sees the Mayo opinion as greatly enhancing its power in interpreting the law through regulations (Douglas, “Potter Says ‘Mayo’ Ruling Gives Treasury, IRS More Guidance, Rulemaking Flexibility,” BNA Daily Tax Report G-4 (January 24, 2011)). If the courts strictly follow the Mayo opinion, the IRS is undoubtedly right in this belief, and taxpayers can expect the IRS to be much more aggressive in using regulations to advance its positions.
Mayo Found. for Med. Educ. and Research, Sup. Ct. Dkt. 09-837 (U.S. 1/11/11).
