United States: Internal Revenue Service Issues Proposed Regulations to Exclude Medical Residents from Student FICA Tax Exception

After being unsuccessful in its recent attempts to convince courts to accept its long held position that medical residents are, in fact, employees and not students,¹ the Service has turned to the regulatory process to achieve its goals. In proposed regulations promulgated on February 25, 2004, the Service has attempted to remove any question that, at least after that date, medical residents are 2003). not exempt from FICA or FUTA. The proposed regulations seek to clarify sections 3121(b)(10) and 3306(c)(10)(b) under the Internal Revenue Code of 1986, as amended (the "Code").

The proposed regulations provide that the primary function of an institution is the primary determinant as to whether that institution qualifies as a "school, college or university." Simply carrying on educational activities is not, under the proposed regulations, enough to qualify. The commentary accompanying the regulations indicates that this test is to be applied to the institution as a whole, having a division or department that is primarily involved in education and teaching is insufficient. The commentary contends that the "primary function" test is consistent with the "commonly or generally accepted sense" standard contained in the existing regulations. For example, according to the commentary, the term "hospital" is commonly accepted to mean an entity in which its primary purpose is providing patient care, not education.

Under the current regulations² an employee will be given the status of a "student" if the services performed by that employee are performed "incident to and for the purpose of pursuing a course of study" at the institution. According to the commentary accompanying the proposed regulations, the intent of the new regulation is to provide clarification in three respects with regard to the definition of a student.

First, in order to be considered "enrolled and regularly attending classes," an individual’s activities must present the opportunity to acquire new skills and knowledge, and those activities must be led by a knowledgeable faculty member. Essential elements of these activities include faculty leadership, a set curriculum and a prescribed time frame.

Secondly, in order to be pursing a "course of study" under the proposed regulations, an individual must be involved in courses that upon completion will entitle that individual to receive an educational credential granted by the institution.

Finally, the proposed regulations provide that the test for whether or not services performed are "incident to and for the purpose of pursuing a course of study" is a facts and circumstances based test. The determination is made by comparing the educational purposes of the relationship against the service purposes of the relationship. Factors that will be relevant include:

• Hours worked – individuals serving full- time hours (40 hours or more) will typically be considered employees and not students;

• Status as a "professional employee" – individuals whose service requires knowledge of an advanced type in a field requiring substantial exercise of discretion and judgment are typically considered employees;

• Terms of employment – any of the enumerated terms, such as vacation and sick pay, retirement plan participation, tuition reduction plans, and other benefits associated with full-time employment will signify a career employee relationship; and

• Whether the individual is required to be licensed – an individual is a career employee if that individual is required to be licensed under state or local law to work in the field.

In connection with the issuance of the proposed regulations, the Service also suspended the safe harbor guidance for the student FICA exception contained in Revenue Procedure 98-16 and issued a new proposed Revenue Procedure³ that is consistent with the proposed regulations.

Additionally, the Service announced that a new settlement program will be developed to allow hospitals and residents to obtain FICA refunds for periods prior to the February 25, 2004 effective date of the proposed regulations. The guidance provided by the Service indicates that this settlement program should be fully developed and announced concurrently with the close of the comment period on the proposed regulations.

It is clear that, if adopted, these proposed regulations will, put and end to the question of whether academic medical centers and other institutions operating residency programs are required to withhold and pay FICA taxes for all services performed by their residents. Under the new regulations all such services rendered after February 25, 2004 will, without question, be subject to these taxes. However, these regulations should not have any impact on the applicability of FICA and FUTA to residents for services provided prior to that date.

It will be important for institutions that have paid FICA and FUTA for resident services rendered prior to February 25, 2004 to pay close attention to the settlement program and consider the best strategy for participating in that program.

Additionally, all interested parties should carefully consider the benefits of providing comments on the proposed regulations. Comments on the proposed regulations must be received on or before May 25, 2004, and a public hearing on the regulations is scheduled for June 16, 2004. It is expected that the Service will issue a final revenue procedure after the regulations are finalized.

Gardner Carton & Douglas LLP will be following this issue closely and will keep you informed of new developments. We will also be providing comments on the proposed regulations prior to the due date.

Copyright 2004 Gardner Carton & Douglas

This article is not intended as legal advice, which may often turn on specific facts. Readers should seek specific legal advice before acting with regard to the subjects mentioned here.