Last year, numerous hospitals filed claims for refunds for FICA taxes on stipends paid to medical residents based on the rationale used by the Eighth Circuit Court of Appeals in the case of Minnesota v. Apfel. While some hospitals protected their claims by merely filing inexpensive protective claims for refund, others paid hundreds of thousands of dollars in consulting fees to collect reams of unnecessary data for the purpose of filing their claims. As the April filing deadline to file protective refund claims for calendar year 1996 rapidly approaches, many hospitals, again, are faced with the decision to file simple and inexpensive protective refund claims or to spend significantly more money in filing full refund claims which provide no greater protection to the hospital.
Even though a year has passed since those first refund claims were filed, numerous questions remain regarding the propriety, procedures, status and costs associated with these types of refund claims. Nonetheless, two points are clear from the developments since those first refund claims were filed: (1) the Internal Revenue Service (IRS) is challenging the refund claims although it acknowledges that some refund claims and adjustments have "slipped" through; and (2) there is sufficient basis to these arguments that all hospitals that train medical residents should spend the few hundred dollars and the hour or two necessary to file a protective refund claim and preserve their rights and those of the affected medical residents.
Although easily and inexpensively filed, these refund claims must be filed by no later than April 17, 2000 (Note: April 15th falls on a Saturday this year), the date on which the employment tax statute of limitations generally expires for refund claims on 1996 stipends. The failure to file a timely protective refund claim means that the rights to any and all refunds on the 1996 stipends evaporate. The statute of limitations for post-1996 years do not expire until after 2000. This Health Law Update briefly describes the Eighth Circuit opinion that is the foundation for these refund claims and outlines an inexpensive and noncontroversial alternative to pursuing a traditional employment tax refund claim.
The Minnesota Case
In 1998, the United States Court of Appeals for the Eighth Circuit determined that the State of Minnesota was not liable for FICA taxes on the stipend amounts paid to medical residents in the University of Minnesota’s graduate medical program. That case, Minnesota v. Apfel, 151 F.3d 742, involved an assessment by the Social Security Administration (SSA) against the State for FICA taxes allegedly owed on stipends paid to medical residents. States and state instrumentalities were originally viewed as exempt from the Social Security system, but could extend Social Security protection to their workers under Section 218 of the Social Security Act by executing voluntary agreements with the SSA commonly referred to as "Section 218 Agreements." These voluntary agreements establish the boundaries under which a state is responsible for FICA taxes on payments to its workers, including workers employed by state instrumentalities such as a state university and its teaching hospitals.
Minnesota's Section 218 Agreement was executed in 1955 and it specifically excluded from taxable services any "services performed by students." Consequently, for the next 30 years, Minnesota did not withhold or pay FICA taxes on stipends paid to medical residents. In 1989, SSA initiated an investigation and assessed FICA taxes on the stipends paid to medical residents for the years 1985 and 1986. The district court granted summary judgment in favor of the State on the alternative grounds that (i) the medical residents were not "employees" under the Section 218 Agreement, and (ii) even if the residents were employees under the Section 218 Agreement's terms, they were excluded from coverage under the agreement’s "student exclusion." The Eighth Circuit affirmed both alternative grounds.
Reaction by Hospitals and Tax Advisors
Based on this novel decision, both private and public hospitals have been inundated with literature indicating that they may be due significant employment tax refunds on amounts previously paid with regard to the hospital’s medical residents. Some consultants have interpreted Minnesota v. Apfel as having broad applicability outside of a specific Section 218 Agreement to all hospitals and their relationships with medical residents. They are recommending that hospitals file refund claims for all FICA taxes previously withheld on payments to medical residents. Some hospitals have even considered applying this position on a prospective basis to future stipend payments.
While it is not clear that Minnesota v. Apfel has the broad applicability currently being touted, the interpretation is not meritless, especially due to the broad analysis under the Eighth Circuit's alternative argument. However, since these claims were first filed last year, it has become clear that both the IRS and SSA will challenge traditional refund claims that are filed based solely on this decision. Nonetheless, all hospitals should strongly consider filing what is known as a "protective refund claim" for prior years because the potential tax refunds on this issue may range in the millions of dollars.
Although we believe all hospitals should file protective refund claims, we also believe state university hospitals have the most advantageous technical and procedural basis for filing such protective refund claims. Likewise, the Eighth Circuit’s alternative position regarding the student FICA exception provides a significant argument for all hospitals to file protective refund claims since the court determined that the student exclusion applies (citing general FICA provisions) if the main purpose of the relationship with the employer "is pursuing a course of study rather than pursing a livelihood." Under those conditions, the court will "consider [the resident] to be a student and [his/her] work is not considered employment." Accordingly, if a hospital is to take advantage of this Court of Appeals decision, it must file a claim for refund (or adjustment), or file a protective claim for refund of the employment taxes previously paid. We believe that filing a protective refund claim is by far the most appropriate course for hospitals seeking to preserve their rights to reclaim previously paid FICA taxes.
We continue to monitor the developments regarding the potential for significant refunds to hospitals on this basis. As indicated above, it is clear that the IRS will challenge almost all of the refunds and has notified the Service Centers accordingly. It is important to note that it likely will take several years for this issue to conclusively be resolved. The parties to the anticipated litigation and refund challenges easily may spend in excess of several hundred thousand dollars in litigation, consulting and administrative costs. In the meantime, the statute of limitations will expire on many potentially valid refund claims without some action on your part by no later than April 17, 2000. Filing a "protective refund claim" will suspend your statute of limitations for a minimum of two years while other parties undertake the lengthy and costly task of defending this position in court. Despite the short time frame to file a formal refund claim, a protective refund claim can easily be filed by April 17th because it should take no more than a few hours to prepare and file such a claim, rather than exhausting a potentially endless number of precious administrative hours and the tens of thousands of dollars in consulting fees collecting data that is unnecessary to file the protective refund claim.
Protective Refund Claims
In a formal FICA tax refund claim or FICA tax adjustment, several mandatory procedural steps exist (i.e.,data collection, worker consents, etc.) that would make taking such actions difficult, if not impossible, to complete by April 17th. In addition, because the IRS has indicated that it generally will challenge refund claims that rely on the Minnesota v. Apfel decision, we believe that filing such a formal refund claim is likely to result in an expensive and time consuming IRS administrative challenge. Ultimately, there is no guarantee that after exhausting significant resources filing and defending the claim that the hospital will realize a dime in recovered taxes. Equally, there are troubling issues raised by seeking FICA adjustments that actually may place the hospitals in the position of actually paying out additional FICA tax dollars.
In sharp contrast to a traditional refund claim, a protective refund claim is a simple and inexpensive method to preserve all of your rights while other organizations pursue a costly defense of this legal position. A protective refund claim specifically recognizes that the law may not be settled on a particular issue, and yet, an organization may be facing an expiring statute of limitations beyond which any claim for refund would be time barred. In these circumstances, an organization may file a protective refund claim with the IRS to prevent the statute of limitations from barring the claim. In essence, a protective refund claim allows a taxpayer the luxury of preserving a claim potentially worth millions of dollars while expending very minimal administrative and monetary resources. Rather than incurring significant costs in attempting to claim a refund, an organization simply files a protective refund claim and, in essence, allows the cost of litigation be borne by another entity. If the other entity is successful, the organization that filed the protective refund claim simply will need to amend its claim to provide the information necessary to justify the amount of the refund claimed. Contrary to the advice being given by numerous tax advisors, this information is not required to be supplied with the protective refund claim. In addition, this procedure still allows the organization the ability to contribute to a test case effort if it chooses without actually being the test case itself.
Under the circumstances presented and especially in light of the IRS' informal comments, protective refund claims by hospitals seem particularly compelling rather than actual refunds or adjustments. If the Minnesota v. Apfel decision is ultimately given broader application by either the IRS, SSA or the courts, then the protective refund claim can be perfected by the hospital to act as an actual refund claim. Assuming appropriate procedures are followed, such a protective refund claim will keep the statute open for a minimum of two additional years. In the event that the government successfully challenges these positions, then the hospital only will have incurred very minor costs. There are other practical reasons for asserting a protective refund claim in lieu of either a prospective position or a formal refund claim. These should be discussed with your tax advisors.