January 20, 2011

Medical Residents Are Employees, Not Students, for Federal Tax Purposes

Holland & Knight Alert
David J. Santeusanio

Last week, in Mayo Foundation for Medical Education Research v. United States, the United States Supreme Court ruled unanimously that medical residents are employees, not students, for purposes of Federal Insurance Contributions Act (FICA) taxes. Educational organizations nationally – including the Association of American Medical Colleges, the American Council on Education, the Association of American Universities, and the Association of Public and Land-grant Universities – urged the Court to find that medical residents are students. Although the Court’s decision is a setback for educational institutions, the decision clarifies the longstanding uncertainty about whether medical residents are students for tax purposes.

Medical Residents

The Mayo Foundation for Medical Education and Research, the Mayo Clinic and the Regents of the University of Minnesota (Mayo) offer a medical residency program that trains doctors through hands-on experience. Residents spend 50 to 80 hours per week caring for patients. Senior residents and attending physicians supervise the residents. In 2005 (the relevant year for the purposes of this case), Mayo paid its residents between $41,000 to $56,000 and provided them health insurance, malpractice insurance and paid vacation time. The program typically lasts three to five years.

Residents also participate in a structured educational program. They attend weekly lectures and conferences, read assigned textbooks and journal articles, take written exams and are evaluated by the attending faculty physicians.

The Student Exemption and Treasury’s “Full-Time Employee” Rule

FICA funds Social Security and Medicare. Employers and employees pay FICA taxes out of wages earned by employees. FICA defines “wages” as “all remuneration for employment.” “Employment” is defined as “any service, of whatever nature, performed . . . by an employee for the person employing him.” FICA exempts 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 such school, college, or university.” This is commonly referred to as the student exemption.

The U.S. Treasury Department (Treasury) is responsible for interpreting federal tax law, including the student exemption. Treasury historically interpreted the student exemption to apply to students who work for their schools “as an incident to and for the purpose of pursuing a course of study.” In 2004, it issued a rule stating that a worker’s service is “incident” to his or her studies only when “[t]he educational aspect of the relationship between the employer and the employee, as compared to the service aspect of the relationship, [is] predominant.” The rule further provides that “the services of a full-time employee” (including any employee normally scheduled to work 40 hours or more in a week) “are not incident to and for the purpose of pursuing a course of study.” In sum, medical residents – who regularly work in excess of 40 hours per week – were denied status as “students” for FICA purposes.

After Treasury issued the “full-time employee” rule, Mayo filed a lawsuit asserting that the rule was invalid. As part of the lawsuit, Mayo sought a reimbursement from Treasury for past FICA taxes that it had paid for the residents. A federal district court agreed with Mayo and granted summary judgment to Mayo. On appeal, the Court of Appeals for the Eighth Circuit reversed. Mayo appealed the decision to the Supreme Court.

Supreme Court: Treasury’s 2004 Rule Is Reasonable

The Supreme Court concluded that Treasury’s rule was valid and that the medical residents at issue were employees, not students, for purposes of FICA.

The Court began its analysis by recognizing that when Congress delegates rulemaking authority to an administrative agency, a court must give deference to that agency’s rulemaking and statutory interpretation. Consequently, the issue before the Court was whether Treasury’s rule was a “reasonable interpretation” of the FICA law.

The Court concluded that the rule was indeed a “reasonable interpretation” of the student exemption law. Mayo argued that Treasury must engage in a “case-by-case” analysis of what the individual does in the service and the purpose of his or her work, rather than adhere to a bright-line rule based on whether the individual worked 40 hours or more. The Court disagreed and noted that “[r]egulation, like legislation, often requires drawing lines.” It recognized that Treasury “reasonably sought a way to distinguish between workers who study and students who work” and “[f]ocusing on the hours an individual works and the hours he spends in studies is a perfectly sensible way of accomplishing that goal.”

In addition, the Court accepted Treasury’s rationale that the rule would “improve administrability” and avoid litigation and uncertainty that would result from the case-by-case approach to determine whether the student exemption applied.

Finally, the Court recognized that the rule was consistent with Treasury’s determination that medical residents were the type of workers who Congress intended to both contribute to and benefit from the Social Security system.

Summary and Implications

After years of uncertainty because of a split in the Courts of Appeals, the Supreme Court’s decision confirms that medical residents do not qualify for the student exemption. The government estimates that the ruling will result in a $700 million annual tax on residency programs, some of which will fall directly on educational institutions. The Court’s ruling has limited application beyond medical residents, however, as it does not affect those traditional student workers who work fewer than 40 hours per week.

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