United States: IRS Developments Impact The FICA Tax Treatment of Medical Residents

Two important IRS developments face hospitals regarding the U.S. Federal Insurance Contributions Act (FICA) tax treatment of stipends paid to medical residents. First, proposed regulations were released that dramatically expand the scope of FICA taxation. Second, an IRS settlement program will be formally announced that may offer significant refund opportunities for properly positioned hospitals. Hospitals should carefully analyze both of these developments to determine how best to address past and future years and to maximize any FICA tax savings.

After losing two cases involving the FICA tax treatment of medical residents, the IRS is now seeking to bypass the judicial process by issuing proposed regulations that would tax the stipend payments to residents, effective February 25, 2004. Under the regulations, medical residents are not students if they regularly perform patient services for more than 40 hours per week or are eligible to receive certain specified employee benefits. In addition, hospitals will not be considered educational institutions. By issuing the proposed regulations, the IRS seeks to override the FICA tax exemption recognized by the courts.

Proposed regulations do not carry the force of either final or temporary regulations. Proposed regulations are typically issued when additional input is required before the IRS can adopt a final position. Interested parties, such as hospitals, on their own behalf (as well as on behalf of their residents) must be given an opportunity to participate in the rulemaking process through the submission of written views, comments and arguments. The proposed regulations establish a comment deadline of May 25, 2004, and a public hearing date of June 16, 2004.

The IRS has also stated that it will establish a settlement program for the medical resident FICA issue. The specifics of this program are still in the developmental stage and remain fluid. However, the IRS has committed to a release date that corresponds to the close of the regulatory comment period. It is anticipated that the settlement program will consist of a closing agreement that will provide a cash settlement in exchange for settling outstanding refund claims and future compliance. The amount of any settlement will likely vary depending on the facts of the specific hospital, inclusion or exclusion of the medical residents in the closing agreement, the amount and type of stipends previously paid, the open FICA tax years and other variables.

Whether and how a hospital should enter into any settlement program is a decision that each hospital should carefully consider based on its own specific facts. Since medical residents are mandatory stakeholders under the FICA tax provisions, hospitals must also be positioned to knowledgeably respond to expected inquiries from residents about the settlement process and to demonstrate to residents that the proper consideration and resources were devoted to the hospital’s ultimate decision. Whatever the settlement decision, each medical resident will still be free to independently pursue individual claims for overpaid FICA taxes.

Hospitals should consider responding to the IRS developments from two different approaches. First, each hospital should carefully consider efforts to influence the shape of the proposed regulations or limit the extent of their adverse impact. Actively participating in the rulemaking process by submitting formal comments can serve dual purposes: attempting to influence the substance of the regulations and demonstrating to a hospital’s medical residents that the hospital actively sought to protect their interests.

Second, it is also important that hospitals keep abreast of the anticipated settlement guidelines and become properly positioned to maximize any settlement offers. As indicated, the IRS has informed us that the settlement program is fluid at this stage, but it is anticipated that significant settlements will be offered to some, but not all hospitals. Although likely unfounded, there are some concerns expressed by consulting firms that the settlement program will only be available to hospitals that have filed actual or protective refund claims for all open FICA tax periods. Nonetheless, it is imperative that hospitals take immediate action by filing refund claims or taking FICA tax adjustments.

McDermott is a recognized leader in the areas of health law and payroll taxes. One of our unique features and major strengths is that our payroll tax group is led by tax lawyers who formerly directed the IRS’ payroll tax efforts prior to joining the Firm. Furthermore, McDermott is litigating the only medical resident FICA tax issues currently before the courts—Mount Sinai Medical Center of Florida (Case No. 02-22715 Dist. Ct. S.D. Fla.)—and another soon-to-be filed refund suit. McDermott is also preparing comments and plans to testify at the June hearing on these proposed regulations. Due to this unique background, we are familiar with the medical resident issue and the IRS' approach to it.