April 7, 2005

IRS Issues Final Regulations and Other Guidance Regarding the Student Exception From Employment Taxes

Holland & Knight Newsletter
Harold Bucholtz
Federal Insurance Contribution Act (FICA) taxes are imposed on employers and employees to fund Social Security and Medicare. FICA taxes are imposed as a percentage of the wages received by an individual with respect to employment. However, since 1950, the statutory rules governing FICA taxes have included an exception for students if a two-part test is met: (1) the employer must be a school, college or university; and (2) the employee must be a student who is enrolled in, and regularly attends classes, at that school, college, or university. The Federal Unemployment Tax Act (FUTA) imposes an additional employment tax on employers. The statutory rules governing the FUTA tax include a similar exception for students.


Over the last several years, the Internal Revenue Service and various institutions engaged in educational activities have contested the scope of the student exceptions from FICA taxes and the FUTA tax. The IRS asserted that the exception was not available in situations where, in its view, the employment aspects of the student-employee’s relationship to the school, college or university predominated over the student aspects. This issue has been litigated in three recent cases involving the employment tax status of medical residents employed by, and simultaneously receiving training at, teaching hospitals: Minnesota v. Apfel, 151 F.3rd 742 (5th Cir. 1998); United States v. Mayo Foundation, 282 F. Supp. 2d 997 (D.Minn. 2003); United States v. Mount Sinai Medical Center, Case No. 02-22715-CIV (S.D.Fla. 2005).

In addition, the IRS previously issued guidance in the form of Revenue Procedure 98-16, 1998-1 C.B. 403, for distinguishing between career employees of an institution of higher learning and employees who are half-time undergraduate students or half-time graduate or professional students. Revenue Procedure 98-16 also provides guidelines for applying the student exception to half-time students.

In response to the growing controversy over the breadth of the student exceptions from FICA taxes and the FUTA tax, on December 20, 2004, the IRS issued final regulations regarding those exceptions. The final regulations will apply to services performed on or after April 1, 2005. At the same time, the IRS replaced Revenue Procedure 98-16 with Revenue Procedure 2005-11, 2005-2 I.R.B. 307, in order to conform its safe harbor standards for half-time undergraduate students and half-time graduate or professional students to the rules contained in the final regulations. Rev. Proc. 2005-11 will be applicable to services performed on or after April 1, 2005.

Summary of the Final Regulations

The final regulations provide guidance on when an employer is considered a “school, college or university” and when an employee is considered a “student” for purposes of the student exceptions from FICA taxes and the FUTA tax. Under the final regulations, the exception will be available only where education is the primary function of the organization. Further, the individual’s predominant relationship with the organization must be as a student rather than an employee for the exception to apply.

School, College or University

An organization will be treated as a school, college or university for purposes of the student exception from FICA and FUTA taxes if the “primary function” of the organization is to carry on educational activities. It is not sufficient that the organization perform educational activities in addition to non-educational activities. For example, a teaching hospital that is an unincorporated division of a university would be treated as a school, college or university because the university’s primary function is education. However, a separate teaching hospital that has a division or function that carries on educational activities would not qualify because its primary function is health care.

Determining When an Employee Is Considered a Student

The employee must be enrolled and regularly attending classes in pursuit of an educational credential. A “class” is an instructional activity led by a faculty member, an adjunct faculty member, graduate assistant or other qualified individual following an established curriculum. An “educational credential” is a degree, certificate or other recognized educational credential granted by a school, college or university.

Full-time employees are not students and are not eligible for the student exception from FICA and FUTA taxes. A “full-time employee” is an employee who is classified as such by the employer or whose normal work schedule is 40 hours or more per week. An employee’s normal work schedule is determined at the start of the academic term based upon expectations at that time. An employee’s normal work schedule is generally not determined based upon the actual number of hours worked during the term unless the employee changes positions during the academic term or there is some other significant change in the employee’s employment relationship with the employer. An employee’s normal work schedule is separately determined each academic term.

The employee’s primary relationship with the organization must be as a student and secondarily as an employee. If an employee is not a “full-time employee,” then whether the employee qualifies as a student depends on all the relevant facts and circumstances. An individual is a student if education, not employment, is the predominant aspect of the employee’s relationship with the organization. The final regulations include a nonexclusive list of factors to consider in evaluating the educational or service aspects of the employee’s relationship with the organization, including (1) the employee’s course workload; (2) the employee’s normal work schedule or actual number of hours worked; (3) whether the employee has the status of a professional employee (as defined by the final regulations); (4) whether the employee is a licensed professional employee; and (5) whether the employee receives one or more employment benefits. The regulations clarify, however, that a student employee’s eligibility to receive health insurance benefits is not considered in determining whether the service aspect of the relationship is predominant and that eligibility for benefits mandated by state or local law is given reduced weight. Because none of the listed factors are absolutely determinative of whether the service aspect of the relationship is predominant, graduate research or teaching assistants who are not full-time employees are not automatically ineligible for the student exception.

The amount of compensation paid to an employee, the type of services performed by the employee, and the place where services are performed are immaterial for purposes of the student exception from FICA and FUTA taxes.

For more information, e-mail Harold Bucholtz or Diana Imholtz at harold.bucholtz@hklaw.com or diana.imholtz@hklaw.com, respectively, or call toll free, 1.888.688.8500.

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