IRS Loses (Again) on Taxes for Medical Residents

A U.S. appeals court -- the fourth to do so -- rules that future doctors are not automatically ineligible for student exemption from payroll taxes.
March 26, 2009

Four times, the U.S. Justice Department, on behalf of the Internal Revenue Service, has made the case to a federal appeals court that federal tax law, and the legislative history behind the law, make medical doctors-in-training categorically ineligible for the broad exemption students have from paying Social Security taxes. And four times, as of Wednesday, the government has lost, making some tax experts wonder when federal officials will give up and take a different tack.

"This is another nail in the coffin for the government," Bertrand M. Harding, a Washington tax lawyer who advises colleges and other nonprofit entities on tax issues, said of Wednesday's ruling by the U.S. Court of Appeals for the Second Circuit, which came in a joint case involving two teaching hospitals, Albany Medical Center and Memorial Sloan-Kettering Cancer Center.

At issue in this case, as in the others, is the Internal Revenue Service's push to force teaching hospitals and academic medical centers to pay tens (if not hundreds) of millions of dollars in back taxes that the government argues should have been paid by young doctors on the wages they earn in the several years they are trained in medical residencies. The IRS position is that the Federal Insurance Contributions Act, which governs Social Security taxes, unequivocally dictates that medical residents should not qualify for the exemption given to students because the duties they perform are clearly work rather than studies.

Teaching hospitals and the universities that operate medical centers have argued over and over that residents should qualify for the student exemption, and, alternatively, that an independent, case-by-case assessment must be made about any particular group of medical residents based on the facts at a given teaching hospital or residency program.

The IRS has long fought such an approach, Harding asserted, because agency officials "don't want to spend weeks of trial time to go through each medical residency program trying to prove that it exists primarily to provide services as opposed to being educational." He added: "The government doesn't want to go through the horrendous job of litigating these cases, so it's been trying this alternative approach" of seeking a sweeping, one-size-fits-all legal judgment.

The Second Circuit court became the latest appeals court -- joining the Sixth, Seventh and 11th Circuits -- to reject the government's arguments, overturning decisions made in both the separate Albany and Sloan Kettering cases by lower federal courts. "Because the student exception is unambiguous, both district courts erred in ruling that medical residents are ineligible for the exception as a matter of law," a three-judge panel of the Second Circuit said in its ruling.

"We agree with the Eleventh Circuit that '[w]hether a medical resident is a "student" and whether he is employed by a "school, college, or university" are separate factual inquiries that depend on the nature of the residency program in which the medical residents participate and the status of the employer.' ... Accordingly, both cases must be remanded for 'a particularized review of whether [the Hospitals’] medical residents qualify for the student exclusion.”

So while the Second Circuit ruling isn't an outright victory for the two teaching hospitals in question, which must now go back and prove that their own particular residents deserve the student exemption, Harding and others hope the mounting rulings against the IRS will prompt the government to alter its approach. He suggests the possibility of a settlement or compromise that might allow universities to recoup some of the back taxes they and their residents have already paid, and/or agree that, going forward, the first two years of a medical residency are considered exempt but successive years are not, as the duties become more service-like.

But given that there are hundreds of millions, if not billions, of dollars in outstanding claims seeking FICA refunds, Harding acknowledged, the government might remain reluctant to shift its stance.

A spokesman for the Internal Revenue Service said the agency typically does not comment on litigation.


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