Academic medical centers and teaching hospitals had a nice little winning streak going in the federal courts this decade when they went toe-to-toe with the Internal Revenue Service over whether the annual stipends paid to medical residents (doctors-in-training) should be subject to payroll taxes.
But in late 2004, amid a series of courtroom defeats for the federal government’s position, the Treasury Department literally changed the rules of engagement, issuing new regulations that declared medical residents to be employees rather than students and mandated that they and their institutions pay Social Security tax on their stipends. The rules took effect fully in April 2005.
Friday, the IRS’s strategy paid off, as the U.S. Court of Appeals for the Eighth Circuit, citing and upholding the validity of the new rules, declared that the University of Minnesota and the Mayo Foundation for Medical Education and Research must pay such taxes for their medical residents.
The appeals court's decision completely changes the dynamic of the long-running legal fight between the government and academic medicine, and the dispute is far from academic, as there are hundreds of millions of dollars at stake.
"If the court's finding that the rule is valid stands, there's no way a resident could be declared a student," said Ivy S. Baer, director & regulatory counsel at the Association of American Medical Colleges.
The same appeals court’s 2003 decision siding with Minnesota and Mayo over the IRS was the first of several that have “exploded” in recent years, in the words of Friday’s Eighth Circuit ruling. In the years since, four other federal appeals courts, the Second, Sixth, Seventh and 11th Circuits, joined the Eighth Circuit in declaring that, based on the Treasury Department’s pre-2005 rules, medical residents qualified under the “student exception” in the Federal Insurance Contributions Act, which governs Social Security.
But in direct response to those unfavorable court rulings, the IRS acknowledged in the “need for regulations” section of its 2004 Notice of Proposed Rulemaking, the government issued new rules specifically noting that the student exception could not apply, the Eighth Circuit wrote in its ruling, to “a person employed by a university to provide patient care services at an affiliated teaching hospital if an employee works at least forty hours per week, even if the services have an educational or training aspect. Such services are not excluded, the regulations explain, because the person is a full time employee and therefore his services ‘are not incident to and for the purpose of pursuing a course of study.’ “
When Mayo and Minnesota sued the IRS in 2005 to challenge the government’s assertion that they owed taxes on their stipend payments to residents, a federal district court judge in 2007 declared the new regulations to be invalid, on the grounds that the new rules clashed with the “plain meaning” of the underlying FICA statute as Congress had passed it. Applying the pre-2004 rules, then, it reached the same conclusion the other courts had previously -- that the institutions’ payments to residents were excluded under the student exception.
But this time, when the IRS appealed to the Eighth Circuit, it reached a different result. The FICA statute is “silent or ambiguous on the question of whether a medical resident working for the school full-time is a ‘student who is enrolled and regularly attending classes,’ " and the Treasury Department’s revised interpretation of the law is “reasonable” and “consistent with the origin and purpose of the student exception” as lawmakers crafted and expanded it, the three-judge appellate panel wrote.
“We do not doubt -- indeed we applaud -- the educational benefits of the medical residency programs offered by Mayo and by the university," the Eighth Circuit panel wrote. "We do not rule that medical residents are not 'students' or are not 'enrolled' or are not 'regularly attending classes' for other purposes. But we conclude that the full-time employee regulation is a permissible interpretation of the statutory student exception and therefore, in the tax periods in question, the residents’ compensation for health care and patient services was subject to FICA taxes."
Officials at Minnesota and tax experts who follow the FICA issue were surprised and dismayed by the appeals court’s ruling. William P. Donohue, deputy general counsel at the University of Minnesota, said the university was weighing its options and would decide whether to appeal to the full Eighth Circuit court or the U.S. Supreme Court. The university has been paying taxes on its stipends to medical residents since the IRS released its 2004 regulations, so the ruling would, if upheld, mean that the government would not have to reimburse Minnesota for what it has already paid.
But with scores of medical schools and teaching hospitals in similar disputes with the IRS over the taxability of residents' payments, the Eighth Circuit's decision will resonate far beyond the Twin Cities.
"If every time the IRS lost cases in court, it could simply amend its regulations setting out its new positions," isn't that unfair? wondered Bertrand M. Harding, a tax lawyer who works with colleges on FICA issues.
But the Eighth Circuit seemed to anticipate that complaint in its ruling in the Minnesota case, noting that "[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."
And Friday's ruling may bode particularly badly for teaching hospitals because, as Harding notes, the Eighth Circuit is widely seen as the "most favorable circuit for taxpayers."