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January 26, 2011

On January 11, 2011, the U.S. Supreme Court decided Mayo Foundation for Medical Education and Research, et al. v. U.S., upholding a Treasury regulation that classifies medical residents who work more than 40 hours per week as full-time employees and thus ineligible for the “student” Federal Insurance Contributions Act (FICA) tax exemption. However, beyond its precise holding against these particular medical students, the Court used this decision to clarify a point of administrative law and dealt a severe, if not fatal, blow to taxpayers seeking to overturn “interpretative” Treasury regulations promulgated under Internal Revenue Code (IRC) Section 7805(a).

As discussed below, Mayo is the culmination of three decades of agency administrative law review decisions by the Supreme Court. Mayo is the end result of increasing judicial deference to IRS and other federal agency regulations. The decision could have broad implications not just for taxpayers dealing with IRS regulations, but for the entire field of administrative law.

Treasury Regulations: Legislative v. Interpretive
Briefly, the Treasury Department and one of its divisions, the Internal Revenue Service (IRS), are the administrative agencies responsible for overseeing tax laws enacted by Congress. The Treasury Department issues regulations to provide guidance in applying new legislation and to address uncertainty that arises with respect to existing IRC sections. Such regulations are intended to interpret and provide directions on complying with the law enacted by Congress. Treasury Department regulations are referred to as either legislative or interpretative:

  • Legislative regulations establish substantive law and are issued pursuant to a specific grant of authority from Congress. Normally, when such authority is granted, the statute provides that “the Secretary shall provide such regulations as may be necessary or appropriate to carry out the provisions of this section.” Before the Treasury can issue regulations, the Administrative Procedure Act requires that certain rulemaking procedures be conducted, such as giving public notice and a period during which the public can comment on the regulations.
  • Interpretative regulations do not establish substantive law. Instead, they clarify enacted law. These regulations are issued under the general authority of IRC Section 7805(a), which empowers the Treasury Secretary to “prescribe all needful rules and regulations” to enforce the IRC.

Treasury Regulations: National Muffler or Chevron Standard of Review?
Before the Mayo decision, the two main standards of review used to evaluate the validity of agency regulations were established by the Supreme Court in National Muffler and Chevron. According to the Court’s analysis in these cases, the authoritative weight of a final Treasury regulation (and the judicial deference to such regulation) depended on whether the regulation was legislative or interpretative.

Interpretative regulations generally receive less judicial deference than legislative regulations and do not have the same force and effect of law. Most courts follow interpretative regulations as long as they meet the standard of review established by National Muffler. Under National Muffler, which addressed certain IRC Section 501(c) regulations, the Supreme Court found that courts should defer to interpretative regulations as long as they implement the Congressional mandate in a reasonable manner and harmonize with the plain language of the statute, its origin and its purpose. In determining whether a regulation meets this standard, courts may consider several factors, including whether the regulation was contemporaneous with the statute, the length of time the regulation has been in effect, the reliance placed on it, the consistency of the Commissioner’s interpretation and the degree of scrutiny Congress has devoted to the regulation during subsequent reenactments of the statute.

Legislative regulations, in contrast, have the force and effect of law, because Treasury issues them pursuant to specific delegations by Congress to fill statutory gaps. In general, courts should follow legislative regulations if they are within the scope of authority delegated by Congress. In Chevron, addressing regulations issued by the Environmental Protection Agency, the Supreme Court set out a two-step analysis for courts to follow when reviewing an agency regulation:

  1. If Congressional intent is clear, courts must give effect to the unambiguously expressed intent of Congress (in other words, if the underlying statute is unambiguous, the regulation is invalid only if it conflicts with the clear language of the statute); and
  2. If the statute is silent or ambiguous as to a specific issue, the question for a court is whether the agency’s answer is based on a permissible construction of the statute. An agency’s regulations are given controlling weight (i.e., the courts should defer to the regulation) unless they are “arbitrary, capricious, and manifestly contrary to the statute.”

Under the Chevron standard, courts show deference to agency regulations if they satisfy the two-part test, regardless of whether they are legislative or interpretative. Since Chevron was decided in 1984, there has been a question as to whether the National Muffler standard still applies to interpretative Treasury regulations. With the Mayo decision, the Supreme Court took clear aim at the less deferential standard of National Muffler and emphatically answered the question of whether this standard still applies to interpretative IRS regulations with a resounding “no!”

Facts and Implications of Mayo
Mayo addressed the validity of a 2004 interpretive regulation under which all persons who work more than 40 hours per week for an employer are treated as employees for purposes of FICA tax withholding (the “full-time employee” rule).

After the full-time employee regulation was issued, the IRS changed its decades-long practice of classifying individuals for FICA tax purposes on a case-by-case basis and classified all Mayo medical residents working more than 40 hours per week as full-time employees. Thus, these residents became subject to the FICA tax. The Mayo Foundation argued that its medical residents, who typically spend 50 to 80 hours per week caring for patients, were “students” under IRC Section 3121 and, therefore, were exempt from FICA taxes. Mayo asserted that Section 3121 is unambiguous and that the IRS should continue a case-by-case determination as to whether individuals qualify for the student exemption under Section 3121. In reviewing the statute, Mayo asked the court to apply the less deferential National Muffler multi-factor analysis.

In 2007, a Minnesota district court initially found for Mayo Foundation, applying the National Muffler standard in finding that the “full-time employee” regulation was inconsistent with IRC Section 3121’s unambiguous language. In 2009, the Eighth Circuit Court of Appeals overturned the district court, relying on the more deferential Chevron standard in holding that the regulation, which limits the student exemption to students who are not full-time employees, is a valid interpretation of an ambiguous statute.

The Supreme Court concluded that the Treasury’s full-time employee rule included in the 2004 amendment is a reasonable construction of IRC Section 3121. Although the Mayo Foundation asked the Supreme Court to apply the National Muffler standard, because the regulation at issue was an interpretative Treasury regulation, the Court declined and, affirming the Court of Appeals, applied the less deferential Chevron standard.

Chief Justice John Roberts explained in detail the Court’s rationale for Chevron being the appropriate standard of review for analyzing an interpretative Treasury regulation:

“Aside from our past citation of National Muffler, Mayo has not advanced any justification for applying a less deferential standard of review to Treasury Department regulations than we apply to the rules of any other agency. In the absence of such justification, we are not inclined to carve out an approach to administrative review good for tax law only. To the contrary, we have expressly ‘recognized the importance of maintaining a uniform approach to judicial review of administrative action.’

The principles underlying our decision in Chevron apply with full force in the tax context. Filling gaps in the Internal Revenue Code plainly requires the Treasury Department to make interpretative choices for statutory implementation at least as complex as the ones other agencies must make in administering their statutes. 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.”

In further discussing why the National Muffler standard is no longer applicable when courts review interpretative Treasury regulations, the Court explained that although it had stated in “two decisions predating Chevron that ‘we owe the Treasury Department’s interpretation less deference’ when it is contained in a rule adopted under the general authority of Section 7805(a), 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,’ that the “administrative landscape has changed significantly” since those two decisions. Although Chief Justice Roberts did not state how or why the “administrative landscape” has changed significantly during the last 30 years, he did state that the Court’s analysis of an agency regulation “does not turn on whether Congress’s delegation of authority was general or specific.”

The Court held that Section 3121 is ambiguous under Chevron’s first step, because it does not define the term “student,” nor does it specifically address whether medical residents are subject to FICA. The Court then held that the full-time employee rule “easily satisfies the second step of Chevron, which asks whether the Department’s rule is a reasonable interpretation of the enacted text . . . and the Department reasonably concluded that its full-time employee rule would improve administrability and it thereby has avoided the wasteful litigation and continuing uncertainty that would inevitably accompany any purely case-by-case approach like the one Mayo advocates.” The Court concluded that because Congress has not directly spoken to the issue of whether Mayo’s medical residents are “students” under Section 3121, and because the Treasury regulation is a reasonable construction of what Congress has said, the medical residents were properly classified as full-time employees for FICA tax purposes.

Thus, Mayo reinforces the Chevron standard of review regarding judicial deference to federal agency administrative rulemaking and expands this standard to cases involving interpretative Treasury regulations.

Unsurprisingly, on January 21, Clarissa C. Potter, IRS deputy chief counsel (technical), commented positively on the Mayo decision in a luncheon speech at the 2011 Midyear Meeting of the American Bar Association’s Section of Taxation. Stating that Mayo “likely would change the ‘environment’ regarding rulemaking and guidance on tax issues, the ruling also means Treasury now has greater capability to issue guidance.” She also mentioned that although many in the private sector will not like the decision because it cuts down on opportunities to challenge Treasury regulations, “I think it emphasizes our need to include all stakeholders in the process in a full discussion of the issues and solutions to issues.”

Alvarez & Marsal Taxand Says:
While it may be true that Chevron’s two-step analysis is simpler to apply than National Muffler’s multi-factor analysis, Chevron’s requirement that an agency’s regulations be given deference unless they are “arbitrary, capricious, and manifestly contrary to the statute” will be a difficult if not an impossible standard to meet for many taxpayers challenging interpretative Treasury regulations. Thus, in light of the Supreme Court’s decision, it will be difficult for taxpayers to convince most courts that inconsistent or overreaching IRS interpretative regulations satisfy this high threshold and therefore should be found invalid. By affirming that courts must use the Chevron two-step analysis when reviewing both legislative and interpretative Treasury regulations, the Supreme Court appears to have completely eliminated the importance of the factors enumerated in National Muffler that have been part of the judicial analysis of interpretative Treasury regulations over the past 30 years.

Thus, the Mayo decision, and the corresponding increased deference that the IRS will argue should be given to interpretative, as well as legislative Treasury regulations, will make it much more difficult for taxpayers to successfully challenge interpretative IRS regulations that do not reflect Congressional intent or are inconsistent with the statute to which they relate.

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