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Tax-free medical student loans revisited: what has changed over the past decade?

An article in the January 1999 CPA Journal set out the criteria needed for medical student loan payments to be considered tax-free (Frank M. Messina and Zoel Daughtrey, "Medical Student Loans: Making Repayments Tax-Free"). Yet when medical, dental, and nursing students are asked if they are aware of the unique ability to have their student loans paid off tax-free, the overwhelming majority still answers "no." CPAs need to be aware of the relevant changes to tax law in order to help such individuals answer these questions correctly.


Changes to IRC Section 108(f)

In the decade since that article was published, the general rule for tax-free treatment regarding medical student loans has remained intact and just about as vague. There are still no regulations and no comprehensive IRS guidance. Some additional information through various sources has been added, however, such as an expansion of applications to health professionals that took place when Congress added a new subsection to Internal Revenue Code (IRC) section 108[f][4], "Payments under National Health Service Corps Loan Repayment Program and Certain State Loan Repayment Programs" (American Jobs Creation Act of 2004, P.L. 108-357). A Tax Court summary opinion (Moloney v. Commissioner, T.C. Summary Opinion 2006-53 [4/17/06]), a revenue ruling (2008-34), and a chief counsel memorandum (INFO 2009-0126) have also been added to the literature regarding IRC section 108(f). In addition, further expansions outside tax law appear to broaden the availability of tax-free student loan forgiveness in areas of national need. It is time to revisit the issue of medical student loan payoffs and the potential benefits of IRC section 108(f).

Section 108(f) Expansion

The general rule on tax-free debt cancellation of certain student loans provides that recipients of various student loans do not have to include in gross income the discharge of such loans pursuant to a provision where the debt would be discharged if the recipient worked for certain periods of time in certain professions for any of a broad class of employers. One example of a student loan that would likely qualify for IRC section 108(f) loan cancellation exclusion would be when a doctor from a public hospital in the United States agrees to work for a certain period of time in a rural area.

Loan Forgiveness under Section 108(f)(4)

Over the last decade, the only Congressional change to IRC section 108 has been the addition of IRC section 108(f)(4), "Income from Discharge of Indebtedness," as indicated below:
  Payments under National Health Service Corps loan repayment
  program and certain State loan repayment programs. In the case of
  an individual, gross income shall not include any amount received
  under section 338B(g) of the Public Health Service Act or under a
  State program described in section 3381 of such Act.

This is a positive tax planning addition to IRC section 108(f) with regard to payments under the National Health Services Corps and state repayment programs in which loan payments made by these groups are not included in gross income. These loan payments, since they are not considered wages or compensation, are not subject to employment taxes.

Public Health Service Act Section 3381, "Grants to States for Loan Repayment Programs," states that the federal government provides grants to states to fund student loan repayment programs of health professionals in consideration of the professionals agreeing to provide primary health services in health professional shortage areas. For example, the Department of Health and Human Services maintains a website that describes the programs, eligibility, requirements, and amounts of loan forgiveness. The Exhibit provides a listing of other national healthcare loan forgiveness programs. There are increasing numbers of student loan forgiveness and service payback programs being offered by many states. (See the AAAMC link in the Exhibit.) Medical loan forgiveness opportunities are also available through the U.S. Air Force, Army, and Navy financial assistance programs.

National Need

A much broader medical-based extension applies to recipients who are working in an "unmet needs" area for certain periods of time in certain professions. According to the Joint Committee on Taxation, "General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984," the primary purpose of the IRC section 108(f) exclusion is to assist those areas that experience difficulties in attracting doctors, nurses, and teachers.

The Higher Education Opportunity Act of 2008, which amended and extended the Higher Education Act of 1965, section 428K, expanded the medical professions that may be viewed under section 108(f) to include a borrower that provides a specified length of service in an area defined as being "national need," as follows:

* Dentists,

* Nurses,

* Nutrition professionals,

* Medical specialists,

* Mental health professionals, and

* Occupational therapists.

The CRS Report for Congress on Student Loan Forgiveness Programs (updated February 1, 2005) also addressed medical student loan forgiveness for the federal Perkins loan program, through which low-interest loans are made by institutions of higher education to students in financial need. Full-time nurses or medical technicians providing health services were specifically mentioned. The report also outlined a range of loan forgiveness availability in such programs as AmeriCorps, the National Civilian Corps, and Volunteers in Service to America (VISTA) through the National and Community Service Act of 1990.

With the significantly increased amount of student loan debt in recent years, this expansion of "national need" medical professions has opened up opportunities for these categories of taxpayers who may now take advantage of IRC section 108(f) by working in an unmet-needs area. In a footnote to Moloney v. Comm'r, the Tax Court stated in 2006 (before the passing of the Higher Education Opportunity Act of 2008) that the "certain professions" to which IRC section 108(f)(1) applies are medicine, nursing, and teaching (Porten v. Comm'r, T.C. Memo. 1993-73, n.1, citing Staff of Joint Committee on Taxation, "General Explanation of the Revenue Provisions of The Deficit Reduction Act of 1984"). It seems that the particular medical professions that are providing health services discussed above would fall under the category of "medicine." It is not clear whether the IRS and courts will agree with this assessment as well.

Primary Authority

Over the last decade, there has been very little additional activity regarding primary tax authority for IRC section 108(f). There have been one court case and one revenue ruling--both dealing with lawyers, not medical professionals--that addressed section 108(f). The following is a summary of the decision in Moloney:

Melissa L. Moloney had received federal Stafford loans to attend law school in 1996-1999. After graduation, she worked for the Baltimore County State Attorney's Office, which qualified her as a public servant. In 2002, she received $4,372 from the Janet L. Hoffman Loan Assistance Repayment Program (LARP) administered through the Maryland Higher Education Commission. The LARP provides funds to repay student loans for "Maryland residents who provide public service in Maryland State or local government or nonprofit agencies in Maryland." The funds were distributed in a check payable to both the graduate and the lender. Moloney argued that the $4,372 was not required to be included in gross income under IRC section 108(f).

Relying on the language of IRC section 108(f) and the award letter from the LARP, Moloney stated that she met the requirements in that she, the person receiving the financial award, worked in specified employment as a full-time employee with a state or local government or non-profit organization. She also relied on the CCH explanation of section 108(f) for further guidance of intent, which stated that "in order to ensure the professional participation in public service activities, many educational organizations sponsor programs which offer students an opportunity to be discharged (partially or completely) from their student loans, by working for a period of time in a public serviced organization" ("CCH Standard Federal Tax Reporter," paragraph 7002).

It was Moloney's position that the award received through the LARP should be treated as a discharge of indebtedness and as such not taxable income. IRC section 108(f) exists to encourage professionals to participate in public service employment instead of working in the private sector. Moloney acknowledged at trial that her law school loan did not contain provisions "under which all or part of the indebtedness of the individual would be discharged if the individual worked for a certain period of time in certain professions for any of a broad class of employers."

The IRS disagreed with Moloney's view of IRC section 108(f). It viewed the LARP payment as an award and not a discharge of indebtedness which should not be excludible from income under section 108(f) under the plain language of the statute that must be followed. The argument of intent by Moloney was incorrect according to the reading of section 108(f).

The Tax Court agreed with the IRS. The court stated that the $4,372 was an award and not a discharge of indebtedness even though the award was to be, and was, used by Moloney to repay a portion of her law school loan. In a footnote, the court noted that her reliance on the CCH explanation of IRC section 108(f) also was misplaced and that a secondary source was not binding on the court--it only represents the views of the publisher. In conclusion, the court noted:
  We turn finally to petitioner's argument that the Court should be
  guided by not only the letter but also the spirit of section
  108(f)(1). The Court must follow the law as written by Congress.

Unlike a decade ago, and based on this court decision, it appears that the IRS may narrowly interpret the application of IRC section 108(f). There does appear to be some clarification by the IRS with regard to loan repayment assistance programs, however. Revenue Ruling 2008-34 clarifies the definition of a law school student loan that satisfies the requirements of IRC section 108(f) made under a Loan Repayment Assistance Program (LRAP). Student loan debt that was forgiven was considered a discharge of indebtedness and not taxable because the former student completed a period of service following graduation under a repayment assistance program that qualified under section 108(f). A key point is to ensure consistent treatment (even if a refinancing of the debt occurs) so as to make sure that the LRAP itself has met the qualifying conditions.

National Information on Medical Student Loan Forgiveness Programs

Organization           Program                         Purpose

National Institutes    Medical and health researchers  To attract
of Health (NIH)        and professionals can apply     researchers to
                       for student loan forgiveness    the NIH. In
                       via the National institutes of  exchange for
                       Health, which runs several      repayment of up
                       programs.                       to $70,000 of
                                                       education debt,
                                                       the student
                                                       commits to
                                                       working at least
                                                       20 hours a week
                                                       for two years.

National Institutes    The NHSC has both a student     To encourage
of Health (NIH)        loan forgiveness program and a  health
                       service payback program.        professionals to
                                                       work as primary
                                                       health providers
                                                       in areas where
                                                       are in short
                                                       supply. The NHSC
                                                       will pay
                                                       up to $50,000 in
                                                       student loans in
                                                       exchange for two
                                                       years of
                                                       recipients need
                                                       to sign a
                                                       to provide two
                                                       years of
                                                       service in one
                                                       of the

Health Resources and   The Nurse Reinvestment Act      In exchange for
Services               established a service payback   two years of
Administration--       program that provides a         service,
Nursing Education      scholarship to nursing          participants
Loan Repayment         students in addition to a loan  receive 60% of
Program                forgiveness program. Nurses     their total
                       must agree to work in a         qualifying
                       nursing facility for a          nursing
                       pre-determined period of        education
                       time.                           loan balance.
                                                       For an
                                                       optional third
                                                       year of service,
                                                       participants may
                                                       receive 25% of
                                                       their original
                                                       total qualifying
                                                       also receive
                                                       salary and
                                                       benefits from
                                                       their employing

Indian Health Service  The IHS LRP offers healthcare   To encourage
Loan Repayment         professionals the opportunity   health
Program (IHS LRP)      to lighten qualified student    professionals to
                       loan debts and help IHS meet    work in
                       the staffing needs of Indian    facilities
                       health programs.                serving American
                                                       Indians and
                                                       Alaska Natives
                                                       for a minimum
                                                       two-year service
                                                       obligation. As
                                                       part of the LRP,
                                                       loan repayments
                                                       are made to
                                                       recipients in
                                                       addition to
                                                       their salary.
                                                       The initial
                                                       begins when
                                                       the contract
                                                       is signed. Award
                                                       amounts vary.

Health Resources and   Award recipients are required   To assist
Services               to annually provide             eligible
Administration--       documentation demonstrating     entities
Disadvantaged Health   that funds were used to repay   in increasing
Professions Faculty    educational loans.              the number of
Loan Repayment                                         underrepresented
Program                                                minority faculty
                                                       at health

Association of         State and federal repayment,    To provide a
American Colleges      loan, and scholarship           partial listing
(AAMC)                 searchable database.            of many medical
                                                       loan forgiveness
                                                       throughtout the
                                                       United States.

Organization           Website

National Institutes
of Health (NIH)

National Institutes
of Health (NIH)

Health Resources and
Nursing Education
Loan Repayment

Indian Health Service
Loan Repayment
Program (IHS LRP)

Health Resources and
Services               professions-faculty-loan-repayment-and-
Administration--       fellowship-program.html
Disadvantaged Health
Professions Faculty
Loan Repayment

Association of
American Colleges

The importance to medical professionals of this recent primary authority lies in the proper implementation of IRC section 108(f) as it relates to any potential medical discharge of indebtedness. It is essential for a tax professional to work with medical professionals in making sure the Loan Repayment Assistance Program (LRAP) meets the qualifications under IRC section 108(f).

Another source of tax authority related to IRC section 108(f) is Chief Counsel Memorandum INFO 2009-0126, which addresses the tax consequences of student loan discharges under the Higher Education Act for public service (not the medical profession). However, this memorandum does provide a good generic explanatory trail of the tax consequences of student loan discharges. It notes that the term "student loan" includes any loan made by an educational organization described in section 170(b)(1)(A)(ii) or by an organization exempt from tax under IRC section 501(a) to refinance a loan to an individual to assist the individual in attending any such educational organization, but only if the refinancing loan is pursuant to a program of the refinancing organization. Additionally, the memorandum notes that loan forgiveness is conditional on the borrower working for a certain period of time in a qualifying needs area.

Importance of Tax-Free Loans

In a tough economic climate where medical students are facing rising loan debt, it is important to look to IRC section 108(f) for the potential discharge of student loan indebtedness. Over the last decade, IRC section 108(f) and related laws have been expanded to address both national need and greater opportunities for medical loan forgiveness. Particular care should be used in tax planning for student loan payoffs to qualify for tax-free treatment. Such knowledge is critical for a tax advisor handling student loan forgiveness agreements in order to avoid harmful and possibly inadvertent tax consequences.

Frank M. Messina, DBA, CPA, is a professor at the University of Alabama at Birmingham and tax scholar-in-residence at Carr, Riggs & Ingram.
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Title Annotation:personal financial planning
Author:Messina, Frank M.
Publication:The CPA Journal
Geographic Code:1USA
Date:Jul 1, 2010
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