(NOTE: The following has been modified to reflect a change regarding refunds of taxes previously paid on medical residents.  Updating is completed at 12:35 p.m.)

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Settling a 20-year legal battle between teaching hospitals and the federal tax collector and saving the Treasury some $700 million a year in future revenue, the Supreme Court ruled unanimously on Tuesday that medical students who have become doctors in training as residents are not students under federal tax law, and thus are subject to federal taxes to cover Social Security and Medicare (so-called FICA taxes).  The decision, however, will mean that the taxes are due only on residents’ stipends paid after April 1, 2005.  Earlier payments are being refunded by the Treasury’s own choice (see this news release).  Justice Elena Kagan did not take part in the decision.

In a second decision, Kagan, the newest Justice, delivered her first opinion for the Court, a ruling under bankruptcy law that an individual who owns a car but is not making loan or lease payments on it cannot take a deduction in payments under Chapter 13 for an amount needed to cover the expense of using the car.  If the debtor does not make payments on a loan or a lease, the Court decided, the Chapter 13 deduction for car ownership is not available.  The vote was 8-1, with Justice Antonin Scalia in dissent.

The Court’s ruling on taxes and medical residents came in the case of Mayo Foundation, et al., v. U.S. (09-837).

When medical students move beyond the more classroom-oriented part of their academic career, they typically become “residents” and are paid by hospitals, largely acting as doctors engaging in patient care, though under supervision.  The hospitals who employ them have argued for years that they remain “students,” for purposes of payroll taxes.  The Treasury accepted that view for some 60 years, before changing its mind in 2004.  While federal law requires employers and employees to pay payroll taxes based on wages, it provides a specific exemption for those who work for a school, college or university if the work is performed by a student “who is enrolled and regularly attending classes” at that institution.  That exemption was enacted in 1939.

The dispute over whether that covers or does not cover medical residents goes back to 1990, when federal Social Security officials decided that residents were not eligible for the student exemption, and decided to collect back payroll taxes from the University of Minnesota.  The Eighth Circuit Court, however, overturned that assessment, holding that stipends paid to medical residents were exempt under the student provision.

After the legal battle with the Minnesota institution continued in federal court, leading to claims for refunds running into the hundreds of millions of dollars, the Treasury decided in 2004 to change the view it had held since 1940, and issued a new regulation, declaring a blanket exclusion of medical residents from the payroll tax exemption.  It said candidly that it was moving to do so to overturn court rulings that had upheld the view that residents remained students.   The new regulation flatly excluded any worker from being treated as a student for payroll tax purposes if that worker is employed full time — that is, works at least 40 hours a week.  Medical residents, of course, work on onerous schedules, often running many hours beyond 40 in a workweek.

The issue finally reached the Supreme Court in appeals by the teaching hospital run by Minnesota’s famed Mayo Clinic — formally, the Mayo Foundation for Medical Education and Research — along with the hospital run by the University of Minnesota.  A long list of other teaching hospitals, along with the American Hospital Association, joined in urging the Court to resolve what they argued was a split that had developed among lower courts on the issue.   The Justice Department argued in response that there was no real conflict.

The Court resolved the issue in an opinion written by Chief Justice John G. Roberts, Jr., upholding the Treasury’s view as “a reasonable construction” of federal law.  It found that the student exemption law was ambiguous, and so opted to defer to the Treasury as the agency that carries out tax law.  “Regulation, like legislation, often requires drawing lines,” the Chief Justice wrote, and it accepted the lines the tax collector drew in 2004.

The ruling rejected the hospitals’ argument that the Treasury should not be allowed to impose payroll taxes on a categorical basis, simply because residents work more than 40 hours a week, but rather should apply the tax only on a case-by-case basis depending upon what each employee actually does.   The Treasury, the Chief Justice wrote, does not employ a rigid distinction between hands-on training and classroom instruction, but does distinguish between education and service.  “Focusing on the hours spent working and those spent in studies is a sensible way” to reach its goal of focusing on workers who study, as opposed to students who work.

As added reasons for upholding the Treasury approach, the opinion said that it eases the tax collector’s task, and assures medical residents and their families of “vital social security disability and survivorship benefits.”

While the Treasury was facing a huge file of refund claims, based upon the prior appeals court ruling overturning the exclusion of residents, the Internal Revenue Service on March 2, 2010, decided not to go on contesting the refund claims.  The agency announced that it would accept the exclusion that several appeals courts had declared, and would pay refunds rather than going on to contest them, case-by-case.  Thus, the payroll tax obligation — now that it has been upheld by the Supreme Court — will be effective across the country on stipends paid to residents after April 1, 2005.   It has been estimated that payroll taxes for medical residents are in the range of $700 million a year.

In a technical legal sense, Tuesday’s ruling relied upon the analysis that the Court spelled out in its 1984 decision in Chevron v. Natural Resources Defense Council, focusing on what an administering agency thinks about the scope of a federal law that is ambiguous.   “The principles underlying our decision in Chevron apply with full force in the tax context,” Roberts wrote.

The Court thus disagreed with a federal judge who had ruled in favor of the teaching hospitals’ plea for student exemption for residents.  The judge had relied upon a 1979 Supreme Court ruling, National Muffler Dealers Association v. U.S., which laid out a multiple-factor analysis used in interpreting a tax regulation — an analysis that Mayo argued that the Supreme Court should apply in its case.

The National Muffler test, the Chief Justice conceded, has been relied upon by the Court, along with the Chevron approach, in analyzing Treasury regulations.  The Chevron analysis, the opinion said, does not depend on whether a federal agency has been consistent in its view of the scope of a tax provision, while the National Muffler test does use that as a key factor.  But, the Court concluded, agency inconsistency is not a basis for declining to use the Chevron test.  The Treasury thus is entitled to the wider deference that the Chevron precedent provides, the Court said.

Justice Kagan’s initial opinion as a member of the Court came in the case of Ransom v. FIA Card Services N.A. (09-907).

The decision rejected the claim of Jason M. Ransom, a Nevada debtor.  He owns his car, a 2004 model Toyota Camry valued at $14,000, free of any debt.  It was his claim to a deduction based on the operating expenses for that car that the Court rejected Tuesday.

Under federal bankruptcy law, an individual who files for bankruptcy under Chapter 13 is allowed to create a plan to work that person’s way out of debt by paying off as much as possible to creditors who do not have security to cover what they are owed.  A bankruptcy court cannot approve such a plan if the holder of some of the unsecured debt objects.  That objection, however, can be overcome if the debtor shows that the plan will use all of the “disposable income” that the debtor expects to receive to make payments on the debt under the plan.

“Disposable income” is the amount of current monthly income, minus any amounts the debtor needs to support himself or herself above the median, which is a figure that is set differently, depending on where the debtor lives geographically.  The monthly expenses that the debtor may claim, thus reducing disposable income, depends upon whether the expense is an actual one, or is one covered by a specialized set of Internal Revenue Service standards.  The law specifies that the debtor may not claim as an expense any amounts being paid on existing debt.

Under the IRS standards, expenses can include transportation expenses — such as public transit tokens, or costs of ownership of a vehicle.  The issue in Jason Ransom’s case was whether the debtor can include as an offset to disposable income an expense for a car, if the debt is not making payments on it — either for a car loan or for a lease package — but rather owns it outright.   Ransom wanted to claim a deduction of $471 a month as a car ownership expense.  The lender objecting, contending that Ransom had claimed $471 too much because he owned the car.  The difference would actually work out to about $28,000 over the 60 months — five years — of his Chapter 13 plan.

The Ninth Circuit Court turned down Ransom’s claim, concluding that an ownership cost is not an expense if there is no cost of ownership.  The Supreme Court agreed to hear Ransom’s appeal, because other courts had disagreed on whether owing a debt or making lease payments was necessary in order to claim the ownership deduction from “disposable income.”

Justice Kagan’s opinion, analyzing whether Ransom’s car-operating expenses fit within the bankruptcy code for the ownership exemption, said the answer depends upon the debtor’s actual financial circumstances — that is, a debtor’s ability to afford the payments to be made to creditors under the Chapter 13 plan.  What, specifically, does the IRS standards cover for car ownership? Kagan asked, and concluded that it covers only financing costs — that is, a loan or lease payment.

The Court rejected Ransom’s argument that a ruling against him on that point would send the wrong message: that is, that it is better to be deeply in debt on car loans, rather than pay them off.  The opinion answered: “The choice here is not between thrifty savers and profligate borrowers, as Ransom would have it.  Money is fungible.  The $14,000 that Ransom spent to purchase his Camry outright was money he did not devote to paying down his credit card debt, and Congress did not express a preference for one use of these funds over the other….The car-ownership allowance thus safeguards a debtor’s ability to retain a car throughout the plan period.  If the debtor already owns a car outright, he has no need for this protection.”

Posted in Mayo Foundation v. U.S., Ransom v. FIA Card Services, Featured, Merits Cases

Recommended Citation: Lyle Denniston, Court: Medical residents not students, SCOTUSblog (Jan. 11, 2011, 10:21 AM), http://www.scotusblog.com/2011/01/court-medical-residents-not-students/