Stipends paid to medical residents may be exempt from FICA tax, so teaching hospitals should review their strategic plans for getting this refund.

For almost a decade now, most of the teaching hospitals in the United States have had tax refund claims pending with the Internal Revenue Service (IRS) that seek many millions of dollars in Federal Insurance Contributions Act (FICA) tax paid on stipends provided to their medical residents. The pending claims typically reach back to tax quarters in 1995 and address both the employer’s and the employees’ shares of FICA.

The IRS has refused to take any administrative action on the claims—refusing to grant, deny or settle them. A few teaching hospitals brought suit in federal courts, on behalf of themselves and their residents, to recover tax refunds, while the government brought suit against a few teaching hospitals that had managed to obtain refunds. In these suits, the teaching hospitals won two early battles. In 2005 and 2006, the IRS won three non-final decisions before federal district court judges, starting with a victory in Miami. But since then, taxpayers have racked up a very impressive string of victories, with the result that of the last 12 substantive decisions issued by the federal courts, nine have gone in favor of the teaching hospitals.

A key taxpayer victory was handed down in September 2008 by the U.S. Court of Appeals for the Seventh Circuit in Chicago. In The University of Chicago Hospitals case, a unanimous Court of Appeals rejected the IRS’s argument that the Student Exception from FICA tax, upon which the teaching hospitals and their residents rely, is “categorically off limits” to medical residents. The Seventh Circuit lined up with the U.S. Court of Appeals for the 11th Circuit in Atlanta, which in 2007 unanimously issued a similar ruling in United States v. Mt. Sinai Medical Center of Florida, Inc. After its appellate victory, Mount Sinai Medical Center defeated the IRS at trial, with the court finding that Mount Sinai’s residents were students and Mount Sinai a school for purposes of the Student Exception. More recently, a federal district judge in Boston followed the Seventh Circuit’s decision in The University of Chicago Hospitals case, reiterating that residents at teaching hospitals were eligible to assert the Student Exception to FICA.

Since early in the current decade, teaching hospitals and their current and former residents have been hoping the IRS would make a broad-based settlement offer for these types of claims. On September 11, 2008, a senior IRS chief counsel attorney stated at a tax conference that the IRS does not foresee making any broad-based settlement offer. More recently, however, the U.S. Department of Justice’s Tax Division (which handles all of these types of cases in court for the IRS) indicated a willingness to consider some case-specific settlements, but only to the extent that a case addresses quarters before the second quarter of 2005, when a regulation went into effect that purports to resolve the dispute in favor of the IRS. The 2005 regulation, however, has already been held invalid by one federal judge, in a decision that is now under review by the U.S. Court of Appeals for the Eighth Circuit in St. Louis.

A confluence of factors—among others, the very positive trends seen in the string of recent court decisions; the decade-long declination of the IRS to offer any broad-based settlement; the emerging willingness of the U.S. Department of Justice (DOJ) to discuss, on a case-by-case basis, a possible settlement of pending suits that address quarters before the second quarter of 2005; and the unwillingness of DOJ (and the IRS) to even consider a settlement as to quarters after the first quarter of 2005—suggest that hospital officials holding responsibility for these large-dollar, long-dormant tax claims should promptly undertake a fresh review of a hospital’s going-forward strategy for perfecting and moving refund claims (whether they address claims for tax in quarters before or after the effective date of the 2005 regulation) forward to a prompt and successful result. This strategic review should be undertaken with advisors that include tax-litigation counsel experienced in dealing with DOJ in the litigation of these types of cases.

An article discussing these developments in more detail, authored by McDermott partner Tom Sykes, appears in the January 2009 issue of hfm Magazine.