Detroit Medical Center Not Entitled to Refund of Taxes Paid on Medical Residents’ Stipends – Sixth Circuit

Holding:

The U.S. Court of Appeals for the Sixth Circuit upheld a district court’s ruling that stipends provided by Detroit Medical Center (“DMC”) to its medical residents were wages and not scholarships or fellowships, and therefore should form part of taxable income. Citing a Supreme Court precedent, the Sixth Court held that since the medical residents were required to provide both patient care and teaching services, the stipends cannot be viewed as “no strings” educational grants, with no requirement of any substantial quid pro quo from the recipients” that characterizes “scholarships” and “fellowships.” On this basis, the Sixth Circuit concluded that amounts received by medical residents in exchange for their quid pro quo services were taxable “compensation” rather than excludable “scholarships.” The Sixth Circuit however reversed the ruling of the U.S. District Court for the Eastern District of Michigan that DMC’s medical residents could not be classified as “students,” and therefore not qualified for exemption from social security tax. On this issue, the Sixth Circuit remanded the case in order for the district court to determine whether the residents fall under that term. The Sixth Circuit reasoned that it needed to know what the residents in the program do and under what circumstances to be able to make such determination.

Detailed Summary:

Defendant-appellant DMC operates seven hospitals in the Detroit metropolitan area. It sponsors a graduate medical training and education program jointly with Wayne State University (“Wayne State”). This program provides training to medical residents in numerous areas of medicine. In Michigan, two years of post-graduate medical training are required before a doctor can take a state medical board examination.

In its federal returns for 1995 to 2003, DMC paid social security taxes on its medical residents’ stipends. In 2004, Detroit Medical sought a refund of the taxes it paid for three quarters of 2003, which the United States granted.

On further review, however, the government concluded that the refunds had been erroneous. The United States sued DMC in the district court to recover those refunds totaling more than $15 million. DMC counterclaimed for the social security taxes on the stipends it had paid for 1995 through 1997 and 2002 and 2003.

In a 30-page opinion, the district court granted the government’s motion for summary judgment, awarded the government the amounts it had refunded, and dismissed DMC’s counterclaim.

The district court first held that the stipends paid to the residents were “wages,” not “scholarships” or “fellowships” that allegedly are not subject to social security taxes. The court stated that “the residents’ stipends are given as a substantial quid pro quo for patient care” because “residents are contractually required to perform valuable patient care services.” It also ruled that because the stipends are an “all or nothing proposition,” i.e., residents are required to care for patients in order to receive the stipends, no portions of them could be excluded from taxation as attributable to the time spent in actions other than patient care.

The district court then held that the residents were not “students” “at a school, college, or university” who, under the statute, would be exempt from social security taxes.

DMC then filed this appeal.  The first issue here is whether the stipends given to DMC’s medical resident were wages and not scholarships or fellowships, and therefore not exempt from income tax.

In resolving this issue in favor of plaintiff-appellee U.S. government, the Sixth Circuit considered Section 3101 of Title 26 of the United States Code that imposes a tax on the “wages” of employees for “old-age, survivors and disability insurance and hospital insurance.” Section 3111 imposes a similar tax on employers on the “wages” they pay. “Wages” are defined in § 3121(a) as “all remuneration for employment” (with certain exceptions not here involved), and “employment” is defined in § 3121(b) as “any service, of whatever nature, performed by an employee for the person employing him …except that such terms shall not include———-.” Opinion, p. 4.

The Sixth Circuit explained that for DMC’s residents’ “stipends” to constitute “qualified scholarships” that are not part of gross income, the amounts must have been “used for qualified tuition and related expenses” and the residents must have been “candidate[s] for a degree at an educational organization” that “normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at a place where its educational activities are regularly carried on.”

The Sixth Circuit likewise considered the Supreme Court’s ruling in Bingler v. Johnson, 394 U.S. 741, 752 (1969). In Bingler, the Supreme Court ruled that the amounts received by employees for their post-graduate education in exchange for their quid pro quo services were taxable “compensation” rather than excludable “scholarships.” Id., p. 6, citing Bingler at 755-56.

Here, the residents gave Detroit Medical a quid pro quo in return for their stipends. The principal quid they furnished was the provision of patient care services. Another item was teaching and supervision of other residents or students. The Sixth Circuit found that the benefit the residents provided to DMC was substantial. If there had been no residents to provide patient care, presumably the hospitals would have been required to hire other physicians to do so. Id., citing Rockswold v. United States, 620 F.2d 166, 169 (8th Cir. 1980).

The Sixth Circuit concluded that since the medical residents were required to provide both the patient care and teaching services, the stipends cannot be viewed as “‘no strings’ educational grants, with no requirement of any substantial quid pro quo from the recipients” that characterizes “scholarships” and “fellowships.” Id., p. 7, citing Bingler, 394 U.S. at 751.

Re-stating its findings, the Sixth Circuit held that the characteristics of the stipends DMC’s residents received and the statutory provisions governing scholarships under the tax code establish that the stipends are not scholarships or fellowships under § 117 0f the IRC, and therefore not exempt from income tax.

The second issue is whether DMC’s medical residents could be classified as “students” to entitle them for exemption from social security tax.

As restated by the Sixth Circuit, the issue is “(w)hether a medical resident is a ‘student’ and whether he is employed by a ‘school, college, or university,’” which “depend on the nature of the residency program in which the medical residents participate and the status of the employer.” Id., p. 8, citing United States v. Mount Sinai Med. Ctr. of Fla., 486 F.3d 1248, 1252 (11th Cir. 2007). The Sixth Circuit vacated the district court’s ruling in favor of the U.S. government.

According to the Sixth Circuit, the statute does not define “student” but merely specifies where and how the student must be studying for the exemption to apply.  The Sixth Circuit pointed to a particular Treasury regulation says that “[a]n employee who performs services in the employ of a school, college, or university, as an incident to and for the purpose of pursuing a course of study at such school, college, or university has the status of a student in the performance of such services.” Id., p. 9, citing 26 C.F.R. § 31.3121(b)(10)-2(c) (2003).

To determine whether the doctors in DMC’s residency program were to be classified as students, the Sixth Circuit stated that it needed to know what the residents in the program do and under what circumstances.  While the meaning of “student” indeed is a legal issue, the question whether residents at the DMC come within the term is not. Thus, the Sixth Circuit ordered the district court to supplement the evidence on record to determine whether the medical residents could be classified as students, such as evidence on 1) how many hours a week does a typical resident spend at the hospital; (2) how many hours a week does a typical resident spend in the classroom; and (3) what other responsibilities does a typical resident have under the program and how much time on average do they take each week.

On the basis of the foregoing, the Sixth Circuit affirmed-in-part, vacated-in-part, and remanded-in-part.

Also See:

IRS Reminds Tax Preparers Need to File Due Diligence Checklist with All Earned Income Tax Credit Claims

IRS Provides Penalty Relief to Farmers Affected by MF Global Bankruptcy

IRS Issues Guidelines to Parents and Students on College Tax Benefits

Treasury, IRS Issue Proposed Regulations for FATCA Implementation

IRS Issues Guidance to Encourage Small Employers to Check Out Small Business Health Care Tax Credit