There are more than 160 million reasons why academic medical centers and teaching hospitals will be watching the outcome of a federal tax case in Florida scheduled to go to court this spring.
That's the estimated dollar amount at stake in Federal Insurance Contributions Act, or FICA, tax deductions those hospitals are seeking from the Internal Revenue Service in refunds. The IRS, in turn, is seeking the return of an undetermined number of refunds it now contends were erroneously given to some hospitals for FICA deductions paid for resident physicians.
According to a 2000 report from the General Accounting Office, as of April 2000 there were 228 institutional claims--most of which are from academic medical centers and teaching hospitals--seeking an estimated $162 million in FICA refunds. Because there are more than 400 teaching hospitals, health tax lawyers predict that figure could have grown dramatically since then. The IRS routinely declines to comment on pending litigation.
Whether those refunds are delivered likely will hinge, in part, on a case scheduled for trial in April in U.S. District Court in Miami. In that case the IRS is seeking the return of $2.3 million plus interest from the Mount Sinai Medical Center in Miami Beach, Fla., for a FICA tax refund issued in 2000 the agency now contends should not have been paid.
A high-stakes issue
The FICA law, which was passed in 1939, came four years after passage of the Social Security Act to finance that program. The tax has been revised several times and is now 15.3% of annual wages or salary. The law requires employers to deduct the employee's portion, match it and pay both amounts in the form of taxes to the IRS. Of that 15.3% deduction, 12.4% of wages and salary goes to Social Security and 2.9% funds Medicare, with both employers and employees paying equal shares of the total amount.
At issue is whether resident physicians performing their training at academic medical centers and teaching hospitals should be categorized for tax purposes as students or employees. If they are judged to be students, then they would not be required to pay FICA taxes on their earnings and their hospital employers would not have to withhold the money from the physicians' paychecks or pay the matching employer share of the tax. If they are considered employees, the residents' employers would have to repay any FICA refunds and both employers and employees would be required to pay FICA in the future.
"There's a lot at stake here," says Lucille White, a healthcare tax lawyer with the Chicago office of Ernst & Young. "This represents to the IRS a potential loss of hundreds of millions of revenue to Social Security and Medicare, now and in the future. The amounts are astronomical. Everyone's watching the Mount Sinai case to see if they should litigate their claims as well."
White says the imbroglio started after a 1997 victory by the University of Minnesota in U.S. District Court in Minneapolis that was affirmed the following year by the 8th U.S. Circuit Court of Appeals in St. Louis. In that case, which was litigated by the Social Security Administration, the court determined that the residents were students and exempt from FICA because, while they did provide patient care and were paid, it was a necessary part of their medical education.
Citing the University of Minnesota case, a number of university medical centers and teaching hospitals began filing for refunds. The IRS established a task force on the medical resident FICA issue and ordered a halt to the refunds, but apparently notice didn't spread to field service offices in time and an unknown number of refunds were issued. In 2000 and 2001, the IRS began demanding the return of that money, saying those refunds had been sent erroneously. The IRS filed suit against at least three hospitals for the return of refunds already paid.
Last year, the Rochester, Minn.-based Mayo Clinic Foundation prevailed in a case before the same federal district court, a case that the government did not appeal. The U.S. District Court in Minneapolis held that the student exception to the FICA tax on wages and salaries applies to stipends paid by a medical foundation to physician residents participating in its residency program.
The Mayo Clinic filed refund claims of $12 million for 1994 through 1996 and in 1999 received a refund of $4 million for 1995 alone. The government sued the following year, seeking a return of that refund plus interest.
The district court ruled that Mayo and its residents also can recover FICA taxes paid for 1994 and 1996 and added interest on the 1995 refund. Mayo Senior Counsel Robert Moore says the clinic is pleased with the result of its case and awaits the return of its money. "It's been a long process," Moore says.
Although the IRS and Social Security Administration jointly share jurisdiction over FICA, the IRS did not participate in the University of Minnesota case. But it did lead the Mayo litigation and is now leading the Mount Sinai case and other FICA refund challenges. The IRS has long held in its guidance that medical residents would qualify for the FICA exemption only if they were full-time students in the employ of a college, school or university.
While the Mayo Clinic and University of Minnesota clearly qualify in the category of colleges, schools or universities, 756-bed Mount Sinai is none of the above. That and its location in a different federal circuit make it a case with wide-ranging implications for other teaching hospitals.
"What the IRS is saying is that these aren't students, but employees, and doesn't want to entitle them to this exemption," White says. "That's where the battle lines are drawn. In the Mayo case the court held that the Mayo Foundation meets the guidelines of being a university or university-controlled affiliate. But the IRS has said just because it lost in (the Mayo case), the game is not over by any means. Many teaching hospitals have arrangements with universities but aren't themselves universities, schools or colleges. They pay residents through an established residency program, but will they qualify?"
The two Minnesota cases, while viewed as important because the courts rejected portions of the narrow IRS definitions, are not yet considered the law of the land, partly because they occurred in the same federal circuit. That's why the Mount Sinai case, which involves a not-for-profit teaching hospital not owned by a university, is being carefully watched for its potentially broader impact.
In that case the U.S. Justice Department, on behalf of the IRS, is seeking to recover FICA refunds for 1996 through 1999. Mount Sinai originally paid the FICA tax on its residents' wages, but in 2000 and 2001 filed refund claims alleging that the fellowship grants paid to residents were not payments for services, but stipends, and that student exemptions applied. The IRS paid those refunds but later sought their return. The agency stated the refunds had been paid erroneously because the residents did not qualify under its definition of students.
Mount Sinai General Counsel Arnie Jaffee says the hospital had always paid FICA taxes for residents before filing for its refunds in April 2000 and March 2001 after hearing of the Minnesota cases. In September 2002, the IRS sued for the return of the refund after unsuccessfully demanding repayment in a letter several months earlier.
"Our case tests the question at the heart of the Mayo and the University of Minnesota cases: Are medical residents enrolled in residency programs students? The courts seem to be saying they are," Jaffee says. "The core issues are exactly the same. In Mayo, clearly the court says medical residents in a residency program are subject to the student exemption. The government's position seems to be that this is on-the-job training."
Jaffee concedes that Mount Sinai is not part of a university.
"But we are a teaching hospital and have affiliations with various universities," he says. "Most teaching hospitals believe that if students are enrolled in recognized residency programs in teaching hospitals they should qualify for student exemption under FICA."
$3,000 per resident
Attorneys involved in the case say the average medical resident pays about $3,000 per year in FICA taxes. He says if the government prevails, Mount Sinai will then decide whether to appeal the ruling to the 11th U.S. Circuit Court of Appeals in Atlanta or return the funds to the government.
"This has been heard in federal court twice and twice federal courts have analyzed the student exemptions and twice stated that residents are students under FICA," he says. "We think we present the issue clearly and have a strong likelihood of success based on the merits of the case."
Jaffee says a Mount Sinai loss would create a split in the federal circuits, which is often grounds for appeal to the U.S. Supreme Court.
"And if we were to win, it would present a fairly good indication that the courts in a more geographically dispersed area have all ruled in the same way that the IRS position is incorrect," Jaffee says.
Ivy Baer, regulatory counsel for the Association of American Medical Colleges, says the organization is participating in a coalition of 42 teaching hospitals, medical schools and industry associations, such as the National Association of College and University Business Officers. The coalition, led by accounting firm KPMG, is pooling legal resources to address the FICA issue.
"We believe that residents are students and therefore should be able to be counted as students and what they receive (be regarded) as stipends, not salaries, that should not be subject to FICA," Baer says. "For many reasons the IRS wants to see limits on this."
Baer says the IRS has stated that the purpose of a teaching hospital is patient care and those employed by teaching hospitals can't take advantage of the Minnesota or Mayo decisions. "It's still an open issue," she says.
Richard Speizman, a tax partner with KPMG's national exempt organizations practice in Washington and paid adviser to the Medical Resident FICA Coalition, says the coalition was formed to work out an industrywide solution to the issue with the IRS, focusing on the administrators of the law, not the courts. Although the coalition has submitted comments to the IRS, it is not a party to the litigation. He says the IRS position remains unclear.
"Which means the IRS is still deciding what to do," he says.
Speizman says medical residents present an interesting dilemma to the student exception. He says both the residents' clinical and didactic training are integral to becoming doctors.
"But the government seemed to feel that only the didactic time spent counts towards student time and everything else should be considered as working time. And that just doesn't work," Speizman says. "It's impossible to separate those activities out. Residents, relatively speaking, don't spend much of their time in the classroom, but classroom time is not their only learning time. Everything they do every day is part of the learning process of becoming doctors, and that's why they should qualify."
He says that while medical residency programs may differ in the amount of classroom time and whether the residents' employers are universities, medical colleges or teaching hospitals, most programs are accredited by the American College of Graduate Medical Education or the American Osteopathic Association.
"Standards have to be met. And in that sense, despite the different shapes and sizes, they are fundamentally very similar because of the accreditation standards," Speizman says. "For accredited residency programs all these details about who sponsors what shouldn't matter. What matters is all residents are in residency programs."
Larry Abowitz, a healthcare tax lawyer with Ernst & Young in Iselin, N.J., says the FICA case's impact could extend to dental and veterinary residents but will likely have little impact outside of healthcare. Abowitz says the University of Minnesota case "upset the apple cart. Prior to that it had been well-accepted that medical residents, for tax purposes, were employees," he explains, saying that other professions typically don't require residency programs to practice.
Abowitz says some physician residents have begun filing for refunds on their own. He says that amount could be staggering. He estimates that the average resident has roughly $2,000 to $3,000 deducted annually in FICA over a four-year period, multiplied by thousands of residents, current and former.
"They can do a lot with that money; help pay off loans," he says. "It's a highly emotional issue to them."
Abowitz contends the IRS is afraid of the revenue impact of the FICA issue on the Treasury Department. "They don't want to open the floodgates to hundreds of millions of dollars leaving Social Security and Medicare," he says.
David Flynn, a healthcare tax lawyer with the Philadelphia law office of Duane Morris, says that on the advice of tax advisers, lawyers and accounting firms, 110 to 115 organizations filed claims for actual refunds and another 100 filed what are called protective refund claims. Protective claims preserve the statute of limitations to allow taxpayers to file refund claims later.
Flynn, a former attorney-adviser to the Tax Legislative Counsel of the U.S. Treasury Department, says he believes the FICA issue holds a high priority at the IRS, which established an internal task force to examine 18 different test cases.
"These cases are based on refunds for past amounts paid," Flynn says. "If taxpayers are successful and this becomes law, teaching hospitals and academic medical centers in the future won't be paying taxes for those residents and there will be a future government revenue loss. In most cases, we're talking about refunds for taxes already paid. This represents a huge future revenue loss, but it's not going to affect the future training of physicians."
Flynn says that if the hospitals continue to win, the government likely will be compelled to seek legislative remedies to recoup the revenue losses.
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