Sixth Circuit Creates Circuit Conflict on FICA Exclusion for Severance Payments

More than two years after the appellate briefing was completed, the Sixth Circuit has finally issued its decision in Quality Stores.  (See our previous coverage here.)  The court ruled that severance payments paid to employees pursuant to an involuntary reduction in force are not “wages” for FICA tax purposes.  In so holding, the Sixth Circuit expressly declined to follow the Federal Circuit’s contrary decision in CSX Corp. v. United States, 518 F.3d 1328 (2008).

The court agreed with the taxpayer’s argument that the severance payments are not literally “wages” under the Code.  Although Code section 3402(o) provides that “supplemental unemployment compensation benefits” (which the court found to include these severance payments) should be “treated . . . as wages” for income tax withholding purposes, there is no analogous directive for FICA.  At the same time, relying on Rowan Cos. v. United States, 452 U.S. 247 (1981), the court ruled that the definition of “wages” is the same for income tax withholding and FICA purposes.  (As discussed in prior posts, the government argues that intervening legislation has made Rowan no longer good law for that proposition.)  Therefore, the court concluded, the Code does not make the severance tax payments subject to FICA taxation.

The government is likely to seek further review in this case.  Given the clear circuit conflict, and the importance to the case of the continuing vitality of the Supreme Court’s decision in Rowan, this issue is certainly a candidate for Supreme Court review down the road.

A petition for rehearing is due on October 22.  A petition for certiorari is currently due on December 6.  That date would be pushed off if the government seeks rehearing.

Quality Stores – Sixth Circuit opinion

Oral Argument Scheduled in Quality Stores

At long last, the Sixth Circuit has scheduled oral argument in the Quality Stores case for October 6, 2011.  This will be more than a year since the briefing in the case was completed.  The identity of the three-judge panel is expected to be announced on September 19.

Supreme Court Opts for Chevron Analysis of Treasury Regulations, Discarding the Traditional National Muffler Dealers Analysis

The Supreme Court this morning issued its opinion in the Mayo Foundation case, ruling unanimously that medical residents are not “students” exempt from FICA taxation.  As previously discussed several times on this blog (see here, here, and here), the Mayo case carried the potential for broad ramifications beyond its specific context because the parties had framed the question of whether deference to Treasury regulations is governed solely by general Chevron principles that supersede the deference analysis previously developed in tax cases like National Muffler Dealers.  The Court in fact addressed that question and has now endorsed use of the Chevron standard in tax cases, thereby providing the IRS with a big victory that will make it more difficult for taxpayers to prevail in court in the face of contrary regulations, even if they are “bootstrap” regulations designed primarily to influence the outcome of litigation.  And for good measure, the Court obliterated the long-held view by many in the tax world that “interpretive” regulations promulgated pursuant to Treasury’s general rulemaking authority under Code section 7805(a) are entitled to less deference than “legislative” regulations promulgated pursuant to more specific rulemaking authority.

The Court’s opinion was authored by the Chief Justice, who was the Justice who spoke out most forcefully during the oral argument in favor of the position that Chevron had superseded earlier decisions in tax cases, as noted in our previous post.  Thus, the opinion sought to be very clear on this point and to identify some of the familiar approaches to regulatory deference in tax cases that the Court was now consigning to the trash heap.  First, the Court pinpointed some of the key factors that had been identified as important under the National Muffler Dealers analysis, stating that under that analysis “a court might view an agency’s interpretation of a statute with heightened skepticism when it has not been consistent over time, when it was promulgated years after the relevant statute was enacted, or because of the way in which the regulation evolved.”  Slip op., at 8-9 (citing Muffler Dealers, 440 U.S. at 477).  The Court continued:  “Under Chevron, in contrast, deference to an agency’s interpretation of an ambiguous statute does not turn on such considerations.”  Id. at 9.

The Court amplified its rejection of the Muffler Dealers analysis by citing a series of non-tax decisions under Chevron that decline to attribute significance to these considerations.  Thus, the Court remarked that it had “repeatedly held that ‘[a]gency inconsistency is not a basis for declining to analyze the agency’s interpretation under the Chevron framework’” (quoting National Cable & Telecommunications Assn. v. Brand X Internet Services, 545 U.S. 967, 981 (2005)); “that ‘neither antiquity nor contemporaneity with [a] statute is a condition of [a regulation’s] validity’” (quoting Smiley v. Citibank, N.A., 517 U.S. 735, 740 (1996)); and that it is “immaterial to our analysis that a ‘regulation was prompted by litigation’” (quoting Smiley, 517 U.S. at 741).  Trying to link these decisions to its tax law jurisprudence, the Court then observed that in United Dominion Industries, Inc. v. United States, 532 U.S. 822, 838 (2001) (which involved the calculation of product liability losses for affiliated entities under Code section 172(j)), it had “expressly invited the Treasury Department to ‘amend its regulations’ if troubled by the consequences of our resolution of the case.”  Mayo slip op., at 9.  The Court emphasized that it saw no good reason “to carve out an approach to administrative review good for tax law only.”  Id.  Thus, the Court concluded:  “We see no reason why our review of tax regulations should not be guided by agency expertise pursuant to Chevron to the same extent as our review of other regulations.”  Id. at 10.

Second, the Court moved to squash another area where it discerned a difference between Chevron principles and those developed in tax cases – even though the parties had not focused on that point.  Pointing to an amicus brief filed by Professor Carlton Smith arguing for reduced deference because the regulations in Mayo were “interpretive” regulations promulgated pursuant to Treasury’s general rulemaking authority under 26 U.S.C. § 7805(a), the Court acknowledged that there is pre-Chevron authority for the proposition that courts “‘owe the [Treasury Department’s] interpretation less deference’ when it is contained in a rule adopted under that ‘general authority’ than when it is ‘issued under a specific grant of authority to define a statutory term or prescribe a method of executing a statutory provision’” (slip op., at 10-11 (quoting Rowan Cos. v. United States, 452 U.S. 247, 253 (1981)).  The Court tossed that precedent aside as well, ruling that the Rowan statement was not compatible with the current approach to administrative deference, which is unaffected by “whether Congress’s delegation of authority was general or specific.”  Slip op., at 11.

With the Chevron analytical framework in place, the Court made short work of the FICA issue before it.  It reasonably concluded that the statutory text did not unambiguously resolve whether medical residents qualify for the FICA student objection.  Hence, the Court moved to “Chevron stage two” – namely, whether the regulation was a “reasonable interpretation” of the statute.  Observing that “[r]egulation, like legislation, often requires drawing lines” (slip op., at 13), the Court held that it was reasonable for Treasury to establish a rule that anyone who works a 40-hour week, even a medical resident, is not a “student” for purposes of the FICA student exception.

In sum, the Court’s decision in Mayo resolves the deference issues that have recently divided the lower courts in a way that is extremely favorable to the government.  Treasury likely will be emboldened to issue regulations that seek directly to overturn cases that the government loses in court on statutory interpretation issues, or to issue regulations even earlier to sway the outcome of pending litigation before the courts interpret the statute in the first place.  Of course, we have seen that phenomenon already in the Mayo case itself, with respect to the statute of limitations issue litigated in Intermountain and a host of other cases (see here and here), and in other settings.  The Mayo decision will further encourage the Treasury Department to issue such regulations and will make it tougher for taxpayers to prevail in court in the face of those regulations.

 Mayo Foundation – Supreme Cout opinion

Mayo Foundation Oral Argument Tilts Towards the Government and Raises Doubts About the Continuing Vitality of National Muffler Dealers

At oral argument on November 8, several Supreme Court Justices expressed skepticism regarding the claim that medical residents fall within the “student exemption” from FICA taxation.  Although it is always hazardous to predict the outcome of a case from the questions asked at oral argument, it is difficult to envision the taxpayer getting the five votes needed to overturn the court of appeals’ rejection of the exemption.

The Justices’ objections to the taxpayer’s position came from a variety of angles.  Justice Sotomayor focused on the essence of what a medical resident does, suggesting that a person working unsupervised for more than 40 hours per week, and for significant remuneration, is “really not a student.”  Justice Ginsburg focused more on Congress’s intent, suggesting that the exemption seemed directed at “the typical work/study program in a college.”  Chief Justice Roberts observed that the line between student and worker is a difficult one to draw and suggested that it was therefore appropriate to let the IRS draw the line in a categorical way and then defer to the IRS’s interpretation.  Justice Breyer took a different tack, arguing that the IRS’s position was a valid interpretation of a requirement that had been in the regulations for a long time – namely, that the employment has to be “incident” to the study.  Full-time employment, he suggested, would not be “incident” to the study because it is “so big in comparison to the study.”

Justice Alito seemed the most sympathetic to the taxpayer.  He rose to the taxpayer’s defense by offering an alternative reading of word “incident.”  Later, he challenged the government’s counsel to explain why medical residents should not be eligible for the exemption when law students who write briefs are eligible, arguing that the medical residents should be treated as students if their primary motivation is to complete a course of study rather than to earn money.  Justice Ginsburg and the Chief Justice also questioned government counsel, though not as sharply as they had questioned the taxpayer’s counsel.  Justices Scalia and Kennedy were uncharacteristically silent during the argument.  In accordance with his usual practice, Justice Thomas did not speak.  Justice Kagan is recused in the case because of her prior involvement when she was Solicitor General.

In our prior posts on this case (see here, here, and here), we discussed the possibility that this case could be a vehicle for the Supreme Court to address the correct standard for deference to Treasury regulations – that is, whether the more generic Chevron analysis has superseded the more specific, and in some respects less deferential, approach set forth in National Muffler Dealers Ass’n v. United States, 440 U.S. 472 (1979).  The Justices did not exhibit any independent interest in this issue, as their questions focused on the meaning of the statute, not on deference to the regulation.  At one point in his opening argument, taxpayer’s counsel noted that the new regulation was issued only after the government had repeatedly lost in court (a fact that would argue for less deference under the National Muffler Dealers approach), but that point did not elicit any reaction from the Justices.

Thus, the oral argument did not touch on the Chevron/National Muffler Dealers issue until the very end when taxpayer’s counsel affirmatively raised it during his few minutes of rebuttal time.  Counsel sought again to persuade the Court that the government’s position is suspect because it is a recent invention that seeks to overturn a series of adverse court decisions, and this time phrased the argument explicitly in terms of the standard for deferring to a regulation.  Taxpayer’s counsel argued that deference to the new Treasury Regulation is inappropriate under “[t]he National Muffler standards, which we understand still to be appropriate to evaluate deference given to an IRS regulation,” because the regulation “is not a contemporaneous regulation.”  Justice Sotomayor quickly objected, asserting that the Court has “said that agencies can clarify situations that have been litigated and positions that they have lost on.”  (She was referring here not to tax cases, but to decisions that apply the Chevron analysis.).  Shortly thereafter, Chief Justice Roberts zeroed in on the issue, asking:

Why are we talking about National Muffler?  I thought the whole point of Chevron was to get away from that kind of multifactor ad hoc balancing?

Taxpayer’s counsel tried to respond by arguing that the National Muffler Dealers factors were “sensible factors” that the Court should continue to apply in the case of a “regulation that pops up 65 years of the enactment of the statute, after the government has lost five cases.”  But the Chief Justice was dismissive, stating simply:  “If Chevron applies, those considerations are irrelevant, right?”

The outlook for the case therefore is that the Court will likely affirm the Eighth Circuit’s ruling that medical residents do not come within the student exemption from FICA.  Such a decision would not necessarily require a discussion of deference to Treasury regulations, but if there is such a discussion, the Court may well be ready to conduct the analysis explicitly in the Chevron framework and consign National Muffler Dealers to the dustbin of history.  As noted in our previous post, that would in some respects be an unfortunate outcome – giving too much deference to regulations that may well be unduly influenced by the IRS’s narrow interest in maximizing tax revenues rather than a neutral effort to implement the will of Congress.

Attached below are links to the taxpayer’s reply brief and to the transcript of the oral argument.  A decision is expected in the next few months.

Taxpayer Reply Brief in Mayo Foundation

Transcript of Oral Argument in Mayo Foundation

Briefing Completed in Quality Stores

As we previously reported, a district court in Michigan disagreed with the Federal Circuit’s decision in CSX Corp. v. United States, 518 F.3d 1328 (2008) (opinion linked here), and held that severance payments paid to employees pursuant to an involuntary reduction in force are not “wages” for FICA tax purposes.  The employer, Quality Stores, has now filed its answering brief in the Sixth Circuit defending the district court opinion and addressing the arguments made by the government in its opening brief, and the government has filed its reply brief.  (The briefs are attached below.)

The employer’s main argument is a textual one, based on the interplay between the FICA and income tax withholding provisions of the Code.  Asserting that “wages” should mean the same thing in both sets of provisions, the employer relies on Code section 3402(o), which states that “supplemental unemployment compensation benefits” should be “treated as . . . wages.”  Implicit in this provision, the employer asserts, is the proposition that such “SUB pay” would not otherwise be wages.  Since the severance payments are encompassed within “SUB pay,” it follows that they are not “wages” for FICA purposes.  (FICA does not contain a provision analogous to section 3402(o)).

The Federal Circuit in CSX had rejected the logic of this argument, reasoning that section 3402(o) might imply that some SUB pay is not “wages,” but not that all SUB pay is not “wages.”  In addition to that relatively narrow argument, the government has suggested more broadly that the meaning of “wages” in the income tax withholding context “has no bearing” on its meaning in the FICA context.  The Federal Circuit did not fully embrace that suggestion in CSX, stating that “we disagree with the government’s argument that after 1983, the term ‘wages’ in FICA must be interpreted without reference to the same term in the income tax withholding statutes.”  In its reply brief in Quality Stores, the government focuses primarily on a narrower argument that accords with the Federal Circuit’s approach, contending that section 3402(o) was addressed only to the subset of SUB pay that had been exempted from withholding by certain Revenue Rulings.  Because the payments in this case would not fall within those Rulings, the government reasons, section 3402(o) is irrelevant.

The employer also argues that the Sixth Circuit is bound by the Supreme Court’s decision in Rowan Cos. v. United States, 452 U.S. 247 (1981), to treat SUB pay the same for income tax withholding and FICA purposes.  The government responds that Rowan cannot have that precedential effect after Congress overruled it and passed the “decoupling provision.”

With the briefing now concluded, the parties await the assignment of a date for oral argument, which will likely occur in the winter.  The briefs are complex, and it remains to be seen whether the Sixth Circuit will immerse itself deeply in the issue or, instead, give considerable deference to the decision of its sister circuit in CSX.

Quality Stores – Taxpayer’s Answering Brief

Quality Stores – US Reply Brief

Mayo Foundation Oral Argument Scheduled for November 8

The Supreme Court has released the oral argument schedule for its November session.  The argument in Mayo Foundation is scheduled as the second case on Monday November 8, meaning it will begin around 11:00.  A decision is expected to issue in the spring, almost certainly no later than June 2011.  We will provide a report on the argument in November.

Taxpayers’ Brief Filed in Mayo Foundation

The taxpayers have filed their opening brief in Mayo Foundation, a copy of which is attached.  They argue primarily that the statutory language of the exemption unambiguously includes medical residents, and therefore there is no occasion to consider the reasonableness of the IRS regulation.  Secondarily, they argue that the regulation is in any event arbitrary and unreasonable. 

With respect to the question of the correct deference analysis discussed in our previous post, the brief relies heavily on the National Muffler Dealers factors.  It identifies five factors that militate against the reasonableness of the regulation:  (1) does not harmonize with the origin and purpose of the statute; (2) not contemporaneous; (3) did not “evolve in an authoritative manner” because it was designed to overturn adverse judicial decisions; (4) has not been in effect for long; and (5) the government’s position has been inconsistent.  Although the first factor is basic to any analysis of the reasonableness of a regulation, the other four all come from National Muffler Dealers and are not commonly associated with the Chevron deference analysis applied to non-tax statutes. 

The taxpayers have not asked the Court to choose between Chevron and Muffler Dealers.  To the contrary, they have finessed the possible tension between two lines of cases by purporting to examine “the factors that indicate the reasonableness of a tax regulation under this Court’s decisions in Chevron and National Muffler” and observing that the “Court has given special consideration to several factors identified in National Muffler” “in determining the reasonableness of a regulation interpreting a revenue statute.”  As discussed in our previous post, this approach is entirely consistent with the way the Supreme Court has approached this issue in recent years – that is, citing to the National Muffler Dealers factors in tax cases without addressing whether the analysis is fully consistent with Chevron.  But the courts of appeals have begun to question whether the two approaches are compatible.  It will be interesting to see whether the government’s brief challenges the continuing vitality of the National Muffler Dealers analytical framework.  That brief is due on September 27.

Mayo Foundation – Taxpayers’ Opening Merits Brief

Supreme Court to Address Deference Owed to Regulation Governing FICA Taxation of Medical Residents

In Mayo Foundation, et al. v. United States, No. 09-837, the Supreme Court will consider whether medical residents are exempt from FICA taxation, with the decision likely to turn on the level of deference the Court is willing to accord to a recent regulatory change.  Although the issue may seem obscure, there are 8,000 residency programs in the United States, and the government estimates that $700 million in taxes per year is at stake, with $2.1 billion in refund claims pending.  

The issue involves the meaning of the “student exemption” to FICA, which excludes from the definition of “employment” “service performed in the employ of a school” by a “student who is enrolled and regularly attending classes at such school.”  I.R.C. § 3121(b)(10).  The regulations implementing that statute long provided that “student” status depends on the relationship between the employee and the institution and that when the services are performed “incident to and for the purpose of pursuing a course of study,” the employee can qualify for the student exemption.  Beginning in the late 1990s, there have been several cases addressing whether this exception applies to medical residents, who work more than full-time and earn a $40,000-$60,000 stipend, but perform their duties as part of an educational process in which they also attend classes.

In 2003, a federal district court in Minnesota ruled that the Mayo Clinic’s residents qualified for the student exception under the statute and existing regulations.  The government responded by amending the regulations, effective April 1, 2005, to provide a bright-line rule that does not allow full-time employees to qualify for the exception.  Thereafter, four other courts of appeals ruled against the government, stating that the residents fell within the terms of the statutory exception.  All four of those cases, however, involved pre-2005 periods, and therefore the courts did not directly consider the impact of the amended regulation.   In this case, the first to address the new regulation, the Eighth Circuit held that it owed Chevron deference to the new regulation as a reasonable interpretation of an ambiguous statute.  Thus, contrary to the other four circuits, it sided with the government and held that the residents are subject to FICA taxation.

Most tax cases reach the Supreme Court on the strength of a request for further review by the government, but in this case the Court granted a petition filed by the taxpayers over the government’s opposition.  The taxpayers predictably argued that the circuit conflict, and dollars at stake, necessitated Supreme Court review.  In situations like this, the government often acquiesces in certiorari, because the IRS likes to get circuit conflicts resolved to promote its own institutional interest in uniformity.  In this case, however, the government sought to avoid taking its chances in the Supreme Court by arguing that there was no genuine circuit conflict, because the other four circuits had not considered the new regulation.  Evidently, the government hoped that it could build on this decision and use it to get the other circuits to retreat from their prior decisions and adopt a rule going forward under the new regulation that would subject medical residents to FICA taxation.  The Court, however, was apparently persuaded by the taxpayers that the new regulation is unlikely to lead to a different result in those circuits — because they had already indicated a view that medical residents qualify for the exception under the unambiguous statutory language, which would leave no room for Chevron deference to the new regulation.  

A decision by the Court will, of course, resolve the question of FICA taxation of medical residents — unless Congress steps in.  But the decision could have a much broader impact because it implicates the general topic of deference to IRS regulations, particularly the question whether Chevron deference principles have superseded the more specialized analysis developed over the years in tax cases dating back to National Muffler Dealers Ass’n v. United States, 440 U.S. 472 (1979).  In recent years, courts of appeals have begun to trend towards applying standard Chevron analysis in tax cases, but the Tax Court has resisted.  See, e.g., Swallows Holding Ltd. v. Commissioner, 126 T.C. 96 (2006), rev’d, 515 F.3d 162 (3d Cir. 2008).  The Supreme Court has not specifically addressed the issue.

There is not a huge difference in the two deference approaches, and, in most cases, choosing between them is not likely to affect the outcome.  Like Swallows Holding, however, this case could be an exception.  Among the factors listed in Muffler Dealers for determining deference that have been oft-applied in later cases are whether the regulation is contemporaneous with the statute and “the consistency of the Commissioner’s interpretation.”  440 U.S. at 477; see also, e.g., United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 220 (2001); Cottage Savings Ass’n v. Commissioner, 499 U.S. 554, 561 (1991).  In this case, those factors support the taxpayers’ rejection of the regulation, as the government is arguing for reliance on a new regulatory approach that departs from a 65-year old regulation.  Contemporaneity and consistency, however, play no role in the Chevron analysis, which does not penalize the agency for inconsistency or for promulgating new regulations designed to overturn adverse court decisions.  Indeed, the Court has specifically ruled that prior contrary judicial constructions of a statute do not foreclose owing Chevron deference to a subsequent regulation, unless the court decision had determined that the statute is unambiguous.  National Cable & Telecommunications Ass’n v. Brand X Internet Services, 545 U.S. 967, 982-86 (2005).

The parties did not tee up this potential issue in the briefs filed at the certiorari stage.  The court of appeals’ opinion straddled the fence, purporting to apply Chevron but also stating that the Muffler Dealers factors were “instructive” on the second part of the Chevron inquiry – whether the regulation is a reasonable interpretation of the statute.  The certiorari petition focused mostly on the circuit conflict.  To the extent it discussed the merits of the case, it argued that the Eighth Circuit’s decision was inconsistent with Chevron and and did not cite the Muffler Dealers line of cases.  (The petition argued that the Eighth Circuit had “effectively eliminate[d]” the first step of Chevron analysis in tax cases when it stated that, when common words are found in “a provision of the Internal Revenue Code, a Treasury Regulation interpreting the words is nearly always appropriate.”)  The government’s brief was happy to embrace the notion that Chevron governs the deference inquiry.  It will be interesting to see whether the taxpayers try to get more mileage out of Muffler Dealers and its progeny at the merits stage.

The parties will be briefing the case over the summer, with the taxpayers’ opening brief currently due on August 6, 2010.  Oral argument is expected to be scheduled for November or December.  One important note is that this is one of the cases in which Elena Kagan has stated her intent to recuse because she participated in the case as Solicitor General.  That means the case will be decided by an eight-Justice Court, with the possibility of a 4-4 split.  If that occurs, the Court would issue a one-line order affirming the Eighth Circuit’s decision by an equally divided court.  The government’s victory in this case would stand, but the decision would have no precedential value, and the issue would remain in play outside the Eighth Circuit.

The opinion of the Eighth Circuit and the parties’ briefs at the certiorari stage are linked below.  We will provide the briefs on the merits after they are filed.

Mayo Foundation – 8th circuit opinion

Mayo Foundation – cert petition

Mayo Foundation – US brief in opposition

Mayo Foundation – Taxpayers’ reply brief at certiorari stage

U.S. Opening Brief Filed in Quality Stores

On July 13, 2010, the government filed its opening brief in the Sixth Circuit in In re Quality Stores, Inc:  United States v. Quality Stores, Inc., No. 10-1563.  In that case, the government is appealing the district court’s surprising decision holding that severance payments made to employees pursuant to an involuntary reduction in force are not “wages” for FICA tax purposes if they qualify for exclusion from income tax withholding as “supplemental unemployment compensation benefits” (“SUB pay”) under Code section 3402(o)(2).  As the district court acknowledged, its decision directly conflicts with the Federal Circuit’s ruling in CSX Corporation v. United States, 518 F.3d 1328 (2008), which had appeared to resolve this issue definitively in favor of the IRS.  (This Miller and Chevalier Tax and Employee Benefits Alert contains a fuller discussion of the district court’s opinion and the steps that companies can take to protect their rights pending the outcome of the appeal.)

Although the government’s opening brief  relies extensively on CSX, it also addresses the issues comprehensively as if the Sixth Circuit were the first circuit court to consider the issue.  Primarily, the government argues that the case is controlled by Code section 3121, which broadly defines wages as “all remuneration for employment” — a definition that encompasses severance pay.  The government criticizes the district court’s reliance on Code section 3402(o) both because that section relates to income tax withholding, rather than FICA taxes, and because its terms in any event do not dictate that SUB pay is not “wages.”  With respect to the district court’s reliance on Rowan Cos. v. United States, 452 U.S. 247 (1981), the government argues that Rowan does not support exempting SUB pay from FICA taxation and, in any event, Congress’s enactment of the “decoupling provision” in the wake of Rowan eliminates any possible support that the case could lend to the companies’ position.

The answering brief for Quality Stores is currently due September 8, 2010.   Links to the government’s brief and the district court opinion are attached.

US opening brief in Quality Stores

District Court opinion in Quality Stores

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