IRS sues hospitals to get FICA refunds back

Medical residents are considered employees, not students.

By Myrle Croasdale — Posted Aug. 22, 2005

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The Internal Revenue Service appears to be going after teaching hospitals to reclaim social security tax refunds it made in recent years. If the courts find in favor of the IRS, the impact on the individual hospitals involved could be significant, legal experts said.

The University Hospital in Cincinnati is facing the possibility of having to repay, with interest, $5 million in Federal Insurance Contributions Act tax refunds it was awarded in 2003. With an annual budget of $450 million, that won't be easy, said Gail Myers, vice president of public relations and marketing for Health Alliance, which represents five hospitals, including University Hospital.

"Paying back the tax refund would have a significant impact," Myers said. "We're a not-for-profit, and money is put straight back into teaching and technology."

It's unclear how many schools or hospitals may be sued, but the IRS confirmed that it has filed complaints against three hospitals so far. The amounts it is seeking range from $2.5 million to $16 million.

The debate over whether medical residents are employees or students has gone on for at least 40 years. The Social Security Act was signed into law in 1935, and by 1939, students, medical interns and self-employed physicians were exempt from the tax. Residents were not. In 1964, when this distinction between interns and residents was challenged, Congress responded by expanding Social Security to include interns and self-employed physicians.

Then came Minnesota v. Apfel in 1998. Because employees of the state of Minnesota were exempt from paying Social Security taxes, the University of Minnesota had not been paying FICA for its medical residents. When the Social Security Administration decided that the University of Minnesota's medical residents should be taxed, the university sued and won in the 8th U.S. Circuit Court of Appeals.

"After Minnesota, accounting firms invited institutions to jump on the bandwagon," said Mark Levy, executive director of the Committee for Interns and Residents. "We got calls from all over."

In 2003, in United States v. Mayo Foundation, the foundation also won tax relief when the federal district court decided its residents qualified for the student exemption. According to court documents, what followed was a flood of 7,000 claims made to the IRS, seeking refunds of more than $1.135 billion in Social Security taxes.

The Dept. of Justice declined to comment on how many institutions received FICA refunds, but the consensus within the industry is that the number is probably in the hundreds, not thousands.

The IRS ended the debate when it issued a regulation in December 2004, clearly stating that residents are employees and do not qualify for the student exemption from FICA taxation.

While the regulation defined residents as employees from April 1 on, the debate over money rebated earlier could continue to play out.

In January, the IRS won a complaint against Mount Sinai Medical Center of Florida for $2.5 million in FICA taxes previously refunded.

Federal Court Judge Alan S. Gold, in his summary judgment, ruled that the IRS regulation was not retroactive but that Congress never intended to exempt residents from Social Security taxes. He said the Minnesota and Mayo decisions were wrong in giving residents the student exemption.

Arnie Jaffee, vice president and general counsel for Mount Sinai Medical Center, said forcing teaching hospitals to pay back these refunds will ultimately hurt patient care.

"Teaching hospitals don't put their assets where there's the largest return, but where there's the greatest community need," Jaffee said. "What it means is we'll lose money that we'd put into heart monitors, nursing ratios, things that truly save peoples' lives. It's not money that goes to shareholders. When a significant amount of money like this gets pulled out of a hospital, people die."

Jaffee said hospitals like Mount Sinai applied for the refund because they believed they were on firm ground based on settled law following the rulings in Minnesota and Mayo.

"Our summary judgment is out of line with the law," he said. "We believe the opinion is fatally flawed and should be overturned on appeal," which Mount Sinai plans to file.

Since the Florida decision in January, the IRS has filed at least two other complaints regarding FICA refunds. In April the IRS filed against the Detroit Medical Center for nearly $16 million, and in June the IRS filed against University Hospital in Cincinnati seeking $5 million.

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Exempt or not exempt?

Whether hospitals should be forced to pay Social Security taxes on residents has been debated from the moment Social Security was created.

1935: Social Security Act signed into law.

1939: Students, medical interns and self-employed physicians exempted from Social Security tax.

1965: Medical intern and self-employed physician exemptions end.

1998: Minnesota v. Apfel finds residents qualify for the exemption, sparking more institutions to seek the FICA tax break.

2003: United States v. Mayo Foundation also finds medical residents may be excluded from FICA taxation under the student exception.

January: United States v. Mount Sinai Medical Center of Florida finds that medical residents are not exempt and $2.5 million in FICA tax refunds must be returned to the IRS.

April: In United States v. Detroit Medical Center, the IRS seeks $16 million in past FICA refunds.

June: In United States v. University Hospital, the IRS seeks $5 million in FICA refunds for medical residents at the Cincinnati facility.Source: Various court documents

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