TaxTrends
Recent Cases
and Rulings
Employment Taxes
Amended Regulations on the Student Exception from FICA Are Invalid
The Mayo Clinic (Mayo) and Mayo Foundation for Medical Education & Research (MFMER) are nonprofit corporations in Minnesota. MFMER acts as Mayo’s agent for purposes of paying withholding and FICA taxes for Mayo’s employees.Mayo operates graduate medical education programs for medical residents and fellows (residents). Most of these programs are formally reviewed and approved by national accreditation bodies. Residents are enrolled in the programs, register for courses, attend lectures, perform research, and participate in teaching rounds and patient care. They also receive grades or written evaluations for their performance in each course and may be terminated from the programs for failing to satisfy academic standards. Finally, they receive formal certification on completion of the programs. Mayo pays a stipend to the residents to provide a minimum level of financial support during their enrollment.
Mayo I
MFMER and Mayo sought a refund of FICA taxes paid on the residents’ stipends in the years 1994– 1996, which Mayo believed were exempt from FICA under the student employment exception. Under Sec. 3121( b)(10), a student enrolled at a school, college, or university is exempt from FICA on wages paid for services performed for that school, college, or university. Prior to 2003, the IRS maintained that, as a matter of law, the student exception could never apply to medical residents. In addition, although the existing regulations ( Regs. Sec. 31.3121( b)(10)-2) specifically stated that the term “school, college, or university” was to be taken in its commonly and generally accepted sense for purposes of the student exception, the Service argued that an institution qualified for the exception only if its primary purpose was to serve as a school, college, or university ( the primary purpose test ).
The IRS refused the refund request, and MFMER and Mayo filed a refund claim in district court. In 2003, in Mayo Foundation for Medical Education and Research, 282 FSupp2d 997 (D. Minn. 2003) (Mayo I ), a district court held that, as a matter of law, a medical resident could be considered a student for purposes of the exception and that the IRS’s primary purpose test was invalid. Instead, the court held that the term “school, college, or university” should be taken, as the regulations stated, in its commonly or generally accepted sense and that the determination of whether the exception applied should be made on a case-bycase basis. After reviewing the evidence, the court found that in the commonly and generally accepted sense of the term, Mayo was a school, college, or university. It also found that under the standards set out in the regulations, Mayo’s residents qualified as students. Therefore, the court held that the stipends Mayo paid to its medical residents were not subject to FICA.
Mayo II
In order to avoid the problems it encountered in Mayo I caused by the existing regulations’ language, the Service proposed regulations in 2003, which were finalized in April 2005, that amended the existing regulations to specifically incorporate the primary purpose test into the determination of whether an institution was a school, college, or university. In addition, although it did not attribute the change to the Mayo I decision, the IRS added a rule in the amended regulations that an employee whose normal work schedule is more than 40 hours a week cannot be a student for purposes of the student exception.
After the amended regulations were finalized, MFMER resumed paying FICA on the resident’s stipends and later requested a refund of those taxes. The IRS refused the request, and MFMER and Mayo filed a refund suit in district court. The district court again held in favor of Mayo and ruled that the amended regulations were invalid.
The court looked to the statute’s plain meaning and found that the language of Sec. 3121 was unambiguous and that therefore the terms “school, college, or university” and “student” should be interpreted in their ordinary, everyday senses. The court also reviewed the amended regulations under the general standard for the review of interpretive regulations set out in National Muffler Dealers Association, Inc., 440 US 472 (1979), and found that they did not meet this standard. Because the primary purpose test and the 40-hour work week exception in the amended regulations departed from the ordinary, everyday sense of the terms in Sec. 3121 and because the regulations did not meet the general standards for interpretive regulations, the district court found the regulations inconsistent with the statute’s plain meaning and therefore invalid. It further held that under the plain meaning of the statute, Mayo’s residents were covered by the student exception and their stipends were not subject to FICA.
Reflections
This case is the first test in the courts of the amended regulations under Sec. 3121( b)(10). Despite the poor results for the IRS, it is likely to continue pursuing this issue. Although the Eleventh Circuit and a number of district courts, in cases involving tax years before the amended regulations were finalized, have sided with the court in Mayo I and Mayo II and held that the plain meaning of Sec. 3121 ( b)(10) allows the student exception to apply to medical residents, a number of other district courts have held that it does not. These courts have held that the issue must be viewed in the overall context of Social Security law and that, in this context, the law is ambiguous. Finding the law ambiguous, the courts have looked at various expressions of congressional intent about Social Security coverage and have come to the conclusion that Congress intended medical residents to be subject to FICA. Therefore, according to these courts, they are subject to FICA as a matter of law.
MAYO FOUNDATION FOR MEDICAL EDUCATION & RESEARCH, D. MINN., 8/3/07
Gross Income
Third Circuit Holds That Advance Payments of Trade Discounts Are Income on Receipt
Karns Prime & Fancy Food, Ltd. (Karns), is a Pennsylvania corporation that operates grocery stores in the Harrisburg, Pennsylvania,area. In 1998,Karns’s management determined that the company required $1.5 million for capital improvements to its stores. Karns approached its primary supplier, Super Rite, Inc., about borrowing funds from it to make the improvements. In 1999, Super Rite agreed to make $1.5 million immediately available to Karns; in return, Karns executed a promissory note to Super Rite and signed a supply agreement as required by Super Rite.
The supply agreement provided that Super Rite would be the principal wholesaler for all of Karns’s purchased products and that Karns would purchase $16 million worth of productsannually from Super Rite.The promissory note was interest bearing and was to be repaid in six annual payments of $250,000.However, the supply agreement provided that if Karns met the supply requirement for the previous calendar year by purchasing the stipulated amount of Super Rite products, Super Rite would forgive the $250,000 note payment due and owing for that year. If Karns fell short of its total purchase requirements for a year, Super Rite would forgive a portion of the payment based on the amount of purchases Karns made.
Karns recorded the $1.5 million advance as notes payable and treated it as a loan. In the years 2000–2003, Karns either fully or partially met its purchase requirements, and Super Rite forgave all or a large portion of the payment due under the note for those years. Karns reported the amount of the payment that was forgiven each year as other income on its income tax return for that year.
The IRS disagreed with Karns’s treatment of the Super Rite advance, contending that it was not a loan and that the full $1.5 million was includible in income in 1999 when it was received. Therefore, the Service sent Karns a notice of deficiency for 1999 for tax on the full amount of the advance. Karns challenged the IRS’s determination in the Tax Court, which held that the full amount of the advance was includible in income in 1999.Karns appealed theTax Court’s decision to the Third Circuit Court of Appeals.
Third Circuit’s Analysis
The Third Circuit affirmed the Tax Court and held that the full amount of Super Rite’s advance to Karns was includible in Karns’s income in 1999. The Third Circuit’s holding was based on Indianapolis Power & Light Co., 493 US 203 (1990). In that case, the taxpayer, an electric utility company, required some of its customers to pay security deposits, which the company was not entitled to keep unless the customer actually purchased electricity and subsequently did not pay for it. The Supreme Court held that the deposits were not includible in income when they were received. According to the Court, the determination of whether a payment is a deposit,which does not have to be included in income when received, or an advance payment, which does have to be included in income when received, depends on which party controls the ultimate disposition of the payment. If the payor’s actions control whether or not the payee can retain the payment, it is a deposit. If the payee’s actions control (i.e., if the payee lives up to the terms of the agreement, it can keep the payment), it is an advance payment. According to the court, the customers controlled whether or not the company kept the security deposits, so they were deposits, not advance payments.
In its analysis, the Third Circuit treated the note payable and the supply agreement as one unified agreement because the facts indicated that the parties had treated them as one agreement. The court found that although Karns had an absolute obligation to pay back the Super Rite advance under the note payable, under the supply agreement Karns was in control of whether or not it would actually have to pay the advance back, because Karns controlled whether or not it made the purchases necessary to meet the requirements under the supply agreement for forgiveness of the payments due under the note. Therefore, applying the precedent in Indianapolis Power, the court found that the Super Rite advance was an advance payment that was includible in income on receipt because Karns controlled whether or not it had to repay the advance.
Reflections
The IRS’s win in Karns is tempered by the fact that it announced its acquiescence to the Ninth Circuit’s holding in Westpac Pacific Food, 451 F3d 970 (6th Cir. 2006), before the Third Circuit filed its decision in the case. In Westpac, the Ninth Circuit held that advance payments of trade discounts by a supplier are equivalent to loans and are not includible in income when received. As the Third Circuit did in Karns, the Ninth Circuit purported to base its holding on the Supreme Court’s Indianapolis Power opinion; however, for the reasons discussed by the Third Circuit, the Ninth Circuit fundamentally misinterpreted the Indianapolis Power holding in Westpac. Given the similarity of the facts in Karns to those in Erickson Post Acquisitions, TC Memo 2003-218, a case to which the Service issued a nonacquiescence in 2006, further challenges on this issue may well be forthcoming from the IRS despite its acquiescence in Westpac. See Shevak, “Retail Cash Advances: Loans or Income?”; and Auclair, “Westpac Pacific Food: Advance Trade Discounts Are Not Income,” Tax Clinic, The Tax Adviser (February 2007), pp. 78 and 80, for a further discussion of Erickson Post Acquisitions and Westpac.
KARNS PRIME & FANCY FOOD, 3D CIR., 7/20/2007
