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  • Supreme Court Requires Chevron Deference in Review of Treasury Regulations
    January 2011

    In an opinion issued on January 11, 2011, the US Supreme Court, in Mayo Foundation for Medical Education and Research v. United States,[1] upheld the validity of a U.S. Treasury regulation that defined the term "student" to exclude medical residents[2] for purposes of determining whether those individuals were employees and their wages were therefore subject to tax under the Federal Insurance Contributions Act (FICA). The opinion is significant because in reaching its decision the Supreme Court addressed an apparent conflict in its prior decisions as to the degree of deference that US courts should accord US Treasury Regulations that come before them for review.
    The Facts of the Case
    The Mayo Foundation offers medical residency programs for medical school graduates pursuing additional education in order to become certified to practice in medical specialties.  Mayo’s residency programs are usually three to five years in length and involve intensive hands-on training.  Residents in Mayo’s program typically worked between 50 and 80 hours a week, and are primarily responsible for examining and diagnosing patients, prescribing medication, recommending plans of care, and performing certain procedures.  For the years at issue, Mayo typically paid its residents an annual “stipend” between USD 41,000 and USD 56,000; Mayo also paid for the residents’ health insurance, malpractice insurance, and provided paid vacation time.
    In addition to their patient-service responsibilities, Mayo’s residents participated in what the Court referred to as “a formal and structured educational program.”  As part of this program, Mayo’s residents were given reading assignments in textbooks and medical journals and were expected to attend weekly lectures and other conferences.  Additionally, Mayo’s residents were required to take written exams, which were reviewed and evaluated by Mayo’s attending faculty physicians.   Although the Mayo residents’ educational activities were significant, the residents spent the bulk of their time with patients.
    Generally, Americans who work as employees are required pay FICA tax on their wages.  FICA was enacted by Congress to collect funds to support the U.S. Social Security system, which is a national insurance system that provides benefits to retired, disabled, and unemployed workers and their families.  FICA defines the term “wages” to includes “all remuneration for employment.”  The term “employment,” in turn, is generally defined as any services performed by an employee for an employer.  As the Court noted, although the FICA provisions broadly define the term “employment” to include “any services,” the Code provides an exception for “any services performed in the employ of… a school, college, or university…if such services are performed by a student who is enrolled and regularly attending classes at [the school].”  The Code, however, does not provide a definition of the term “student” for this purpose.
    Prior Case by Case Analysis
    Pursuant to Rev. Rul. 78-17[3] the IRS determined whether a medical resident was a student under section 3121(b)(10) on a case-by-case basis. The Social Security Administration (the “SSA”) also, pursuant to its regulations, followed a case-by-case approach with respect to a virtually identical provision that governed a worker’s eligibility for Social Security benefits. However, in practice, the SSA always held that medical residents were not students. In 1998, the Eighth Circuit Court of Appeals held that the SSA could not exclude residents from student status in all cases. Thereafter, medical residents filed more than 7000 claims seeking refund of the FICA taxes that they had paid.
    In 2004, the Treasury Department issued regulations providing that any person who is normally scheduled to work more than 40 hours per week does not provide services “incident to and for the purpose of pursuing a course of study.”  Such individuals, therefore, are not students and their wages are subject to tax under FICA.  These Treasury Regulations state that the determination is not influenced by the fact that the individual’s services contain an education-like aspect. They also included an example illustrating that a medical resident who regularly works more than 40 hours per week is not a student for FICA purposes.
    These regulations were issued under the authority of section 7805(a), which grants authority to the Secretary of the Treasury to “prescribe all needful rules and regulations for the enforcement of this Title [Title 26 or the Internal Revenue Code], including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue.” The regulations also were issued in final form after a period for notice and comment.
     Judicial Review of Administrative Regulations
    Under the U.S. Constitution, as interpreted by the Supreme Court, the judiciary is the final authority on matters of statutory construction.[4] Beginning in the 1930s Congress often has delegated to administrative agencies, which are part of the Executive branch, the authority to write regulations interpreting its statutes.  Persons affected by such regulations may bring actions in the courts disputing that a regulation is a valid interpretations of a particular statute. Although the courts regularly accept such cases, they generally defer to an administrative agency’s interpretation of a statute as embodied in an agency's regulations. However, a court’s deference is not absolute, and the Supreme Court’s cases addressing the degree of deference a court should give Treasury regulations have been difficult to reconcile.  The two principal Supreme Court cases are National Muffler Dealers Association, Inc. v. United States[5] and Chevron U.S.A. Inc. v. Natural Res. Def. Council.
    National Muffler
    National Muffler involved a trade association for automotive muffler dealers affiliated with a particular commercial franchise that sought exemption from income tax as a “business league” under section 501(c)(6).[6]   The regulations issued under section 501(c)(6) excluded the trade association from the definition of business league.[7]  After its request for exemption was denied a second time, the trade association filed tax returns as a taxable entity and then brought action in the courts seeking a refund of income taxes claiming that it was exempt from tax under section 501(c)(6) as business league. The lower courts held for the IRS and the trade association appealed to the Supreme Court.
    In holding for the government the Supreme Court stated that when a statutory term is “so general as to render an interpretive regulation appropriate,” such a regulation will be upheld if it is found to “implement the congressional mandate in some reasonable manner.” The choice among reasonable interpretations is for the Commissioner [of the IRS], not the courts.”
    The Court then set out the following test for determining the validity of a regulation issued under section 7805(a):
    In determining whether a particular regulation carries out the congressional mandate in a proper manner, we look to see whether the regulation harmonizes with the plain language of the statute, its origin, and its purpose. A regulation may have particular force if it is a substantially contemporaneous construction of the statute by those presumed to have been aware of congressional intent. If the regulation dates from a later period, the manner in which it evolved merits inquiry. Other relevant considerations are the length of time the regulation has been in effect, the reliance placed upon it, the consistency of the Commissioner's interpretation, and the degree of scrutiny Congress has devoted to the regulation during subsequent re-enactments of the statute.
    In Chevron various environmental groups sought the Supreme Court’s review of a lower court’s judgment that set aside a certain regulation issued by the Environmental Protection Agency (the “EPA”).  The particular regulation, which was promulgated to implement section 172(b)(6) of the Clean Air Act Amendments of 1977, allowed states to treat all pollution-emitting devices within the same industrial grouping (such as a plant that contains more than one pollution emitting device) as though they were encased within a single bubble.  Under the single bubble concept, a plant could install or modify a pollution-emitting device without meeting a state’s permit program so long as such modification or alteration did not increase the plant’s emissions of pollution.  According to the lower court, the single-bubble concept was inappropriate for programs enacted to improve air quality.
    In reversing the lower court’s judgment, the Supreme Court determined that the EPA regulation under consideration was based on a reasonable construction of the term “stationary source,” a term that appears in section 172(b)(6) of the Clean Air Act Amendments of 1977.  In reaching this decision, the Supreme Court set forth a framework that involves a two-step analysis for addressing the substantive validity of regulations. 
    Step one of the Chevron analysis considers whether Congress has directly spoken to the precise question at issue.  If the statute under consideration is neither silent nor ambiguous with respect to the issue under consideration, the Supreme Court states that “that is the end of the matter, for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress.”[8]  The second step of the analysis, which becomes relevant only if the first step of the analysis is not answered affirmatively, considers whether an administrative interpretation of the statute is based on a permissible construction of the statute.  If the administrative interpretation is based on a permissible construction of the statute, then the Chevron framework requires a court to defer to such administrative interpretation.  This is the case even if the court believes the administrative interpretation is not the best interpretation of the statute under consideration.
    The Supreme Court also stated in Chevron:
    ‘The power of an administrative agency to administer a congressionally created ... program necessarily requires the formulation of policy and the making of rules to fill any gap left, implicitly or explicitly, by Congress.’ [citation omitted] If Congress has explicitly left a gap for the agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation. Such legislative regulations are given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute. [footnote omitted] Sometimes the legislative delegation to an agency on a particular question is implicit rather than explicit. In such a case, a court may not substitute its own construction of a statutory provision for a reasonable interpretation made by the administrator of an agency.[9]
    The Mayo Court’s Reasoning
    The Court began its analysis by applying the first step in the two-step Chevron analysis, and determining that the Code neither directly defined the term “student” nor addressed whether medical residents were subject to tax under FICA.  In doing so, the Court dismissed Mayo’s argument that the common dictionary definition of the term “student” was in conflict with the Treasury Regulations’ 40-hour rule,[10] because the Court determined the common dictionary definition did not eliminate the Code’s ambiguity.  For example, the Court noted that the application of the common dictionary definition of the term “student,” could encompass full-time employees who take evening classes.
    After determining the first step in the Chevron analysis had been met, the Court next turned to step two, that is, the determination of whether the Treasury Regulation was “arbitrary or capricious in substance, or manifestly contrary to the statute.”  The Court disagreed with Mayo’s argument that the National Muffler standard should be used to determine whether a Treasury Regulation met this step. 
    Rather, the Court agreed with the government that Chevron deference should be applied and, thus, the Treasury Regulation should be upheld if it was “a permissible construction of the statute.”
    The Court noted that U.S. law and administrative landscape had evolved since its earlier decisions regarding agency deference, and determined that Mayo did not provide any additional justification for not applying Chevron deference to Treasury Regulations.  The Court found it proper to apply Chevron deference to all administrative agency regulations, including Treasury Regulations, because the Court found it important to “maintain a uniform approach to judicial review for administrative action.” 
    Finally, the Court dismissed the notion that the Treasury Regulations at issue should be afforded less deference because they were issued under the general grant of authority of section 7805(a) and not a specific grant of authority.   In fact, the Court found section 7805(a) to be an “express congressional authorization to engage in the process of rule-making” and, therefore, was a “very good indicator of delegation meriting Chevron deference.”  Additionally, the Court noted that the Treasury Regulation at hand was promulgated only after notice-and-comment procedures, another indication that Chevron deference was appropriate.
    After determining Chevron deference was the applicable standard, the Court determined that the Treasury Regulation’s 40-hour rule was a “reasonable interpretation” of the Code and, thus, upheld the Treasury Regulation as valid.  The Court also noted that 40-hour rule improved administrability and avoided wasteful litigation that would inevitably result from adopting Mayo’s case-by-case approach.
    The Court’s holding in Mayo Foundation provides much-needed clarity on the topic of judicial deference due Treasury Regulations after many years of uncertainty. The opinion is noteworthy not only because it adopts the more deferential Chevron standard of review for a Treasury Regulation, but because it applies Chevron deference to a regulation issued under the general regulatory authority of section 7805(a) (rather than pursuant to a specific grant a regulatory authority by Congress) and to a regulation that was issued to counter a judicial decision adverse to the IRS. As might be expected, the chief counsel of the IRS has publicly expressed great delight in the decision.
    [1] 2011 WL 66433 (U.S.).
    [2] A "medical resident" is a recent medical school graduate engaged in a work-study program at a hospital or other similar medical care facility.
    [3] 1978-1 C.B. 307.
    [4]  Chevron U.S.A. Inc. v. Natural Res. Def. Council, 467 U.S. 837, 843 fn. 9.
    [5] 440 U.S. 472 (1979).
    [6] Section 501(c)(6) refers to “Business leagues, chambers of commerce, real-estate boards, boards of trade, or professional football leagues (whether or not administering a pension fund for football players), not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual.”
    [7] Reg. § 1.501(c)(6)-1 provides in part:
    A business league is an association of persons having some common business interest, the purpose of which is to promote such common interest and not to engage in a regular business of a kind ordinarily carried on for profit. It is an organization of the same general class as a chamber of commerce or board of trade.  . .  An organization whose purpose is to engage in a regular business of a kind ordinarily carried on for profit, even though the business is conducted on a cooperative basis or produces only sufficient income to be self-sustaining, is not a business league
    [8] Chevron, 467 U.S. at 842-843.
    [9] Chevron, 467 U.S. at 843
    [10] Mayo used the definition of the term “student” set forth in the Third Edition of the Oxford Universal Dictionary, which was “one who engages in ‘study’ by applying the mind ‘to the acquisition of learning, whether by means of books, observation, or experiment.”
    KEYWORD: Judicial Review