General Rule

IRC section 108(f) provides that recipients of various student loans do not have to include in income the discharge of such loans pursuant to a provision under which the debt would be discharged if the recipient worked for certain periods of time in certain professions (specifically, medicine, nursing, and teaching) for any of a broad class of employers. An example of a broad class of employers is any public hospital in a rural area of the United States. As stated in the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, the primary purpose of the exclusion is to assist those areas that experience difficulties in attracting doctors, nurses, and teachers.

Student loans consist of money borrowed to assist the individual in attending an educational institution that maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where the educational activities are regularly carried on. To qualify under IRC section 108(f), the loan must be made by--

* the United States or an agency thereof;

* a state or territory, or possession of the United States or any political subdivision thereof;

* a public benefit corporation that is tax-exempt under code section 501(c)(3) (i.e., a religious or charitable organization), has assumed control over a state, county, or municipal hospital, and whose employees have been deemed to be public employees under state law; or,

* any educational institution pursuant to an agreement with any entity described above under which the funds for the loan were provided to that educational institution.

The Taxpayer Relief Act of 1997 expands the student loan exclusion to those made by tax-exempt charitable organizations such as private foundations. Specifically, for loans sponsored by tax-exempt organizations, the student or former student must work in an area or occupation with unmet needs, and the work must be performed for or under the direction of a tax-exempt charitable organization or governmental entity. Also, the student whose loan is forgiven cannot be employed by the lender organization.

The debt cancellation provision can apply to direct or indirect loans. A main condition for IRC section 108(f) exclusion is that the recipient and institution do not have an employer-employee relationship. Specifically, the requirement that the services be performed for one or a few specified employers (e.g., for one hospital) results in disqualification for the IRC section 108(f) exclusion.

An example of a medical student loan that would likely qualify for IRC section 108(f) loan cancellation exclusion would be a student loan to a doctor or nurse from a public hospital in any rural area of the United States, with the agreement that after medical school, the physician would work for a certain period of time in that rural area, but not as an employee of the hospital. Various organizations offer student medical loan payoff provisions to attract doctors to needed areas. Programs like the National Health Plan pay medical student loans of doctors who agree to spend at least six years working in geriatric clinics in Minnesota. Also, the Osteopathic Medical Student Loan-for-Service Program makes annual awards to students who promise to serve as osteopathic physicians or physician assistants in a designated health professional shortage area of New Mexico.

Some Issues

Examination of a typical physician/hospital loan agreement helps address many of the issues related to IRC section 108(f) concerning student loan payoffs. For example, suppose a physician/hospital student loan agreement states that the physician must move to the area of a rural, tax-exempt public benefit hospital upon completion of medical school and engage in the practice of medicine for a certain period of time. Also, the agreement further provides that the physician maintains the hospital as his or her primary admitting hospital as long as the hospital, in his or her judgment, is capable of providing quality services for patients. In this example, arguments can be made for both tax inclusion and tax exclusion of the student loan payoff. These arguments will vary dependent on the particular facts and circumstances of each case.

Argument for Taxable Status. Since the agreement specifies that, to achieve the cancellation of the debt, the physician must move to the rural area and maintain the hospital as the primary admitting hospital, this clause of the agreement could be interpreted as requiring the physician to perform services for one or a few specified employers. As a result, the debt cancellation would not qualify for the exclusion.

Argument for Nontaxable Status. Since the agreement does not specifically bind the physician to the hospital if, in the physician's judgment, an alternate facility is the preferred provider, an argument can be made that the physician is not performing services for one or a few specified employers and the debt cancellation would not be taxable income. Other reasoning could be established that there is not an employer-employee relationship between the hospital and physician. It then follows that the physician is not performing services for one employer.

Refinancing an Existing Student Loan and Subsequent Payoff

What if an IRC section 108(f) qualifying tax-exempt hospital pays off a physician's student loans after the doctor has completed medical school and chosen to work in that area, but has had no prior medical loan agreement with the hospital? As noted previously, with the passage of the Taxpayer Relief Act of 1997, a major enhancement now allows for refinancing and payoff of outstanding student loans by those organizations after August 5, 1997. Under old tax law, because of the prior wording of the code that the loan must be made by an IRC section 108(f) qualifying entity, in most cases a physician would have had taxable income if a tax-exempt public benefit hospital provided the funds to the physician to repay the student loans or if the hospital repaid the loans directly.

One suggested approach in meeting the rules of IRC section 108(f) for refinancing would be for the tax-exempt public benefit hospital or charitable organization to make a loan to the physician. The loan agreement should stipulate that the loan proceeds are to be used only to pay for educational expenses represented by the original student loans, and such proceeds will be used specifically to repay the original student loans. Under the interest tracing rules, it would be desirable to set up a separate bank account to document without question the path of the loan funds directly from the hospital to the physician and thence to the student loan repayment. The physician would then have a loan from the hospital (a qualified entity), which would be canceled as the physician performed services over the agreed upon time period. The IRC is silent as to the required timing of the loans and payoffs.

Taxable Student Loan Payoff of a Physician/Employee

If the physician is an employee of the hospital, there should be no question that the loan payoff is taxable, but there are ways to manage the student loan payoff process.

For example, the hospital could do the following:

* Pay off a portion of the physician's loan debts as time progresses on the contract. If the contract agreement is to work for the hospital for three years, an option would be to have the loan paid off equally over the three-year period.

Advantages: The tax liability will not be due all at once.

Disadvantages: Monthly payoffs will be considered wages and subject to FICA, Medicare, and income tax withholdings.

* Pay off the physician's loan immediately and then set up a loan receivable from the physician (employee).

Advantages: The tax liability will not be due at once.

Disadvantages: Imputed interest may need to be calculated on the loan. Also, the IRS may attempt to classify the loan as disguised income that would trigger FICA, Medicare, and income tax implications. For this not to happen, the physician must pay the loan back in cash to the hospital or do as in the first suggestion.

Reporting of Debt Cancellation

There does not appear to be any reporting on the part of the entity paying off the physician's medical student loan. The specific instructions to Form 1099-C, Cancellation of Debt, do not address any reporting requirement to student loan payoffs for the creditor. However, debtors who exclude amounts from gross income relative to IRC section 108(f) are required to fill out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, even if the discharge is excludable from gross income.

No Court Guidance

An interesting note to tax-free student loan payoffs is that there have been no court cases on debt cancellation of medical student loans. In fact, there is only one reported Tax Court case (Porten, TC Memo 1993-73) where IRC section 108(f) was an issue, and the case provides no true guidance or clarification of the requirements for student loan debt cancellation. It appears that the IRS has not aggressively tried to limit the application of IRC section 108(f). This code section was enacted in its current form in 1984, so it is noteworthy that there has been almost complete absence of activity regarding disputes involving this application. *

Zoel Daughtrey, PhD, CPA, is a professor at Mississippi State University. Frank M. Messina, DBA, CPA, is an assistant professor at the University of Alabama at Birmingham.