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Student Workers Pass a Tax Test

By Albert B. Crenshaw
Sunday, December 26, 2004; Page F01

The relationship between colleges and students who work for them has long been a source of tax uncertainty.

Congress has stepped in from time to time to clear up really important issues, such as making sure no zealot at the Internal Revenue Service tries to do something like tax athletic scholarships, no matter how laughable the "scholar" part becomes. But, by and large, matters are left to the Treasury Department and IRS to work out through regulation.

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That arrangement from time to time generates some friction.

Most recently, the IRS and some universities and teaching hospitals have been trading punches over a law involving payroll taxes and certain student employees. And if you are a student, or the parent of one, it may profit you to pay attention to the scuffle.

The law generally exempts full-time students who work part time for their schools from having payroll taxes withheld from their pay, meaning no Social Security or Medicare tax is taken out, although income taxes are. The exemption applies if the student-school relationship is predominantly educational rather than predominantly one of employment. But interpretation of those parameters has led to lots of audits and even lawsuits.

The law benefits both students and schools by making on-campus employment cheaper for the college, which doesn't have to pay its share of these taxes -- and by leaving a larger share of students' gross pay in their pockets. But applied to professional fields such as medical training, the exemption can involve big bucks.

A round of audits of nonprofit institutions in the 1990s that the institutions regarded as overly aggressive triggered negotiations that led the IRS to issue "guidance" in 1998. The guidance allowed IRS agents to look at all the facts of each case -- a "facts and circumstances" test -- in determining whether the exemption applied.

The guidance did not address the situation of medical residents and some other advanced students, and shortly thereafter, the University of Minnesota and the Mayo Foundation won court cases involving millions of dollars in payroll taxes that they argued did not have to be paid for medical residents.

Last year the IRS dropped its appeal of the Mayo decision and instead, along with its parent Treasury, proposed new regulations to clarify the situation. Specifically, the rules decreed that medical interns and residents are not exempt from paying payroll taxes, and other, fairly specific, criteria were proposed for other kinds of employment.

Educational and medical groups complained at what they called the rigidity of the proposed regulations. A key argument for many was that the rules were worded in a way that might leave many graduate and even undergraduate workers subject to payroll taxes.

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