Thomas D. Sykes

Teaching hospitals seeking a refund of FICA tax on stipends paid to medical residents should be aware of far-reaching changes in the government's position.

At a Glance

  • Recently, the IRS announced that it would cease contesting timely filed refund claims for taxable quarters before April 1, 2005, although the details that apply to its processing of those claims were not available as this article went to press.
  • The IRS will continue to contest refund claims filed for taxable quarters after March 31, 2005, so those claims will have to be litigated to a conclusion.
  • Financial officials at teaching hospitals should consult with advisers who are knowledgeable about the litigation against, and the settlement practices of, the Department of Justice.

The status of, and predicted prospects for, the long-dormant, large-dollar claims filed by teaching hospitals seeking a refund of Federal Insurance Contributions Act (FICA) tax previously paid on medical-resident stipends was the subject of an article this author wrote in late 2008 ("Recovering FICA Tax Paid on Resident Stipends: Time for a Strategic Review," hfm, January 2009, pp. 46-49). After surveying the landscape, the author urged teaching hospitals to review their strategies for resolving these claims and to consider filing a tax-refund suit as to taxable quarters before April 1, 2005.

Since that article appeared, the government's position has shifted twice. First, and contrary to its earlier position (but consistent with the author's earlier prediction), the U.S. Department of Justice (DOJ)-the IRS's attorneys in court-became willing, in April 2009, to settle tax-refund suits, brought by teaching hospitals for taxable quarters before April 1, 2005, on a basis that was very attractive. More fundamentally, on March 2, 2010, as this article went to press, the IRS threw in the towel for refund claims that were timely filed by teaching hospitals and residents for taxable quarters before April 1, 2005.

At the same time, the IRS's recent announcement makes clear that the IRS and the DOJ will continue to steadfastly refuse to make any concession at all with respect to refund claims for taxable periods after March 31, 2005-consistent with long-standing government practice respecting issues that are addressed by a regulation.

These developments warrant an updated discussion of the status of, and prospects for, teaching hospitals and medical residents to obtain refunds of FICA tax paid.

Developments in FICA Tax-Refund Issues

Over the past 15 months, there have been massive changes in the landscape, which warrant review.

The IRS's "categorically off limits" defense. The government, by agreeing to make full refunds of FICA tax that has been timely claimed for quarters before April 1, 2005, has effectively abandoned the "categorically off limits" defense that it asserted so vigorously in the courts between 2004 and 2009. That defense entailed the argument that the Student Exception from FICA is never available with respect to the activities of a medical resident, regardless of the particular facts of the situation. In early 2009, the IRS lost its fourth straight case in the federal courts of appeals-this time in the U.S. Court of Appeals for the Second Circuit. After four straight losses and with no other cases addressing the issue on the horizon, the IRS has effectively abandoned the argument by announcing, just recently, that it will no longer dispute that medical residents come within the so-called Student Exception from FICA tax for tax related to quarters before April 1, 2005, as long as a teaching hospital has on file with the IRS a timely filed claim for refund. Teaching hospitals will still be required to establish the dollar amounts of the recoveries that flow from viewing residents as coming within the Student Exception.

The IRS announcement states that it will contact the teaching hospitals with pending refund claims within 90 days of March 2, 2010. In the meantime, teaching hospitals with pending claims should consider next steps in light of the information and measures that the IRS will require to implement the refund. Most notably, the teaching hospitals will be required to provide solid dollar amounts for the tax refund sought, and to make reasonable efforts to contact the medical residents who paid employee-portion FICA tax during the quarters that are addressed by the claims, so that the residents can be offered an opportunity to participate in the refund process. The rather detailed procedures that will surround these two activities will be based upon procedures that were used in the numerous settlements of in-court cases that have occurred over the past year.

The IRS defense based upon the 2005 fighting regulation. The IRS and the DOJ have been tenacious in their defense of the Treasury Department's "fighting regulation," which became effective on April 1, 2005, for taxable periods on and after that date. That regulation (2005 regulation) basically codifies the "categorically off limits" defense for tax respecting quarters after March 31, 2005. The IRS's recent announcement makes no change to this position. The IRS and the DOJ will continue to contend that the 2005 regulation slams the door shut on efforts by teaching hospitals and residents to contend that resident stipends are not subject to FICA tax.

But that is not the end of the matter. A federal district court in St. Paul, Minn., in the Mayo Foundation/University of Minnesota case, held that the regulation was invalid and ordered a refund. The DOJ successfully took an appeal from that loss, however, last summer winning a reversal of those decisions in the U.S. Court of Appeals for the Eighth Circuit in St. Louis. In January 2010, the taxpayers filed a petition in the U.S. Supreme Court requesting that the Supreme Court agree to hear the case. Statistically speaking, the odds of the Supreme Court agreeing to hear the case are not good, notwithstanding that these teaching hospitals have support from briefs filed by other teaching hospitals and by powerful trade associations. Whether the Supreme Court will agree to hear the case will be determined later in 2010.

These two teaching hospitals emphasize the sharp differences in reasoning that appear among the opinions of the five courts of appeals that addressed cases arising under the law as it existed before the 2005 regulation was issued. Specifically, these teaching hospitals emphasize that the reasoning of the Eighth Circuit (in its 1998 Apfel opinion) is very different from the reasoning that subsequently appears in the opinions issued by the Eleventh, Seventh, Sixth, and Second Circuits-and they emphasize that the reasoning of the latter four circuit cases is correct and dictates that the 2005 regulation is invalid, as the Minnesota trial court previously held. The arguments for invalidity are powerful.

The IRS defense asserting that the particular facts of a case do not meet the requirements of the Student Exception. The author's January 2009 article noted that the IRS and the DOJ, after numerous courtroom defeats, had largely lost their appetite for litigating the fact-bound questions about whether a resident is a "student" "employed by" a "school, college, or university." The very recent IRS announcement confirms this point, making clear that the IRS will no longer dispute that medical residents come within the Student Exception.

The IRS's "Medicare offset" defense. By ceasing to contest that teaching hospitals and residents come within the Student Exception for quarters before April 1, 2005, the IRS is apparently abandoning its "Medicare offset" defense, at least as to those quarters.

Prospects for case-specific settlement in court. As noted, the IRS and the DOJ will no longer dispute that stipends paid to medical residents during taxable quarters before April 1, 2005, are exempt from FICA tax under the Student Exception; refunds on timely filed claims for those quarters will be processed, and those cases that are pending in court will be dismissed by agreement.

At the same time, IRS and the DOJ will, as previously predicted, refuse to make any refund with respect to stipends paid during taxable quarters beginning on and after April 1, 2005. The IRS's recent announcement draws a line in the sand at that date. The reason for this line is the 2005 regulation, which took effect on April 1, 2005. Historically, the IRS and the DOJ have been tenacious in their defense of regulations that are issued to "fix" a specific problem, and as a policy matter, these agencies do not undercut the operation of regulations like this by engaging in piecemeal settlements, instead preferring to have the courts make an up-or-down decision-exactly the pattern seen in the Mayo Foundation/University of Minnesota (which were even preceded by in-court victories by these taxpayers with respect to quarters before the effective date of the 2005 regulation). Basically, a teaching hospital must file suit if it wishes to obtain a recovery for quarters after March 31, 2005.

Accordingly, teaching hospitals should:

  • Continue to pay FICA on stipends to the IRS with its Forms 941
  • Promptly file claims for refund (Forms 941X and 8275-R) seeking to recover that FICA, with the claims setting out in some detail the grounds for viewing the 2005 regulation as invalid (keeping in mind that the deadline for filing claims for quarters in 2006 is April 15, 2010)
  • Put in place administrative measures preserving all payroll records, whether for before April 1, 2005, or after March 31, 2005, that are necessary to determine the amount of the stipends paid to individual residents and the FICA tax paid on those stipends
  • Seriously consider commencing suit to obtain a tax refund for quarters after March 31, 2005, in consultation with tax-litigation counsel experienced with handling contested FICA- refund cases in both the federal trial and appellate courts (As noted, the IRS and the DOJ will be tenacious in their opposition, so the case will surely proceed through the trial court and at least to a federal court of appeals.)

Prospects for a legislative "fix" favoring the IRS. Last year's article emphasized that if the 2005 regulation were widely invalidated by the courts, the Department of the Treasury would likely seek corrective legislation. The Senate Finance Committee, in May 2009, issued a discussion paper that listed a legislative "fix" of the medical resident FICA issue as one of many options available to fund the Obama administration's healthcare reform agenda. But the healthcare bills subsequently passed by the House and Senate did not include any "fix" provision. It is not at all far-fetched to believe that if teaching hospitals bring suit and get a recovery, Congress would respond with corrective legislation, especially given that roughly $700 million in tax per year is up for grabs. How long it would take for the Treasury Department to offer a proposal like this, or for Congress to respond, is difficult to predict.

In sum, the developments occurring during 2009 and 2010 were hugely favorable for teaching hospitals and medical residents. Surely it is satisfying that, after a decade of waiting for something to happen on their mounting claims, teaching hospitals are able to recover upon timely pending claims for tax paid for quarters before April 1, 2005. But the battle is not over. Large amounts of tax (as much as $30 million in employer-portion tax for some of the largest teaching hospitals) have been paid already for quarters after March 31, 2005-and the 2005 regulation that is the basis for the IRS's intransigence respecting those quarters is viewed as highly vulnerable. Accordingly, teaching hospitals should continue to report and pay FICA tax on stipends; promptly file claims for refund with respect to that tax, without allowing any claim-filing deadlines to expire; and promptly evaluate strategies for pursuing a recovery upon those claims in the federal courts, mindful of the fact that the cases challenging the IRS's position with regard to FICA tax paid for quarters before April 1, 2005, were astonishingly successful.

Action Steps for Teaching Hospitals

Financial officials at teaching hospitals should promptly consult with advisers who are knowledgeable about the litigation and settlement practices of the DOJ (which controls the settlement and litigation of tax-refund suits). Refunds will soon be available for taxable quarters before April 1, 2005, but litigation will be required to obtain any recovery for subsequent taxable quarters. Care should be taken in selecting a litigation strategy and counsel to handle the case; in prior cases in this area that were litigated, the obstacles faced by teaching hospitals varied widely from case to case. Because meeting the IRS's recent announcement that it will make refunds will require extensive back-office activities, a teaching hospital would be wise to hire advisers who can carefully choreograph these activities so that they move along to the satisfaction of all involved.

With regard to the tax periods purportedly governed by the 2005 regulation, teaching hospitals with substantial tax at stake should seriously consider whether and when to bring suit on those periods with a view to proceeding to a final judgment-and how to coordinate that suit with the resolution of the recovery of a refund for earlier periods. Taxpayers should focus tightly upon whether a legislative fix that jeopardizes their claims is down the road, and whether any steps can be taken to head off that risk.

Thomas D. Sykes, JD, is a partner, McDermott Will & Emery LLP, Chicago.  

Publication Date: Thursday, April 01, 2010

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