Board of Education of Muhlenberg County, Kentucky v. United States

Citations: 920 F.2d 370; 67 A.F.T.R.2d (RIA) 334; 1990 U.S. App. LEXIS 20867; 1990 WL 188793Docket: 90-5131

Court: Court of Appeals for the Sixth Circuit; December 3, 1990; Federal Appellate Court

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An appeal was made by the Board of Education of Muhlenberg County, Kentucky, and 108 teachers against the United States regarding the improper collection of Medicare taxes by the IRS. The case centers on the 1986 Act that extended Social Security and Medicare to state and local government employees. The key issue is whether the teachers from three consolidated school systems lost their exemption from Medicare taxes following the consolidation into a single district.

The District Court had ruled in favor of the United States, affirming the tax collection. However, the Court of Appeals reversed this decision. Prior to the consolidation on July 1, 1986, the three school districts—Muhlenberg County, Central City Independent, and Greenville Independent—merged into one district governed by the Muhlenberg County Board of Education, which assumed all assets and liabilities while maintaining the federal employee identification number of the old district. 

The teachers retained their employment status, accumulated sick leave, and contractual rights without interruption. The IRS, however, viewed the consolidation in a way that treated teachers from the Greenville and Central City schools as newly hired employees, thus subjecting them to Medicare taxes, while those from the old Muhlenberg system were considered continuing employees and exempt from the tax. This distinction led to the legal challenge regarding the tax obligation post-consolidation.

Before 1986, Social Security coverage for state and local government employees was limited to voluntary agreements. In 1986, Congress extended Medicare coverage to these employees, imposing taxes on both employees and employers. To address concerns about the financial burden of mandatory coverage, Congress established a continuing employment exception for individuals employed before April 1, 1986, who maintained their employment relationship after that date.

The continuing employment exception stipulates that service performed by individuals who were bona fide employees before April 1, 1986, and whose employment was not established solely to meet the exception's requirements, would not be considered as employment for tax purposes. Additionally, the statute outlines criteria for determining when entities are treated as separate employers, indicating that agencies and instrumentalities of a State or the District of Columbia are treated as a single employer, while those of political subdivisions are treated differently.

The House Report indicated that employees transitioning between different jobs within a State government would be viewed as continuously employed, whereas those moving between State and local government positions would be regarded as newly hired. The central issue is whether the plaintiff teachers, following a consolidation, are classified as newly hired by a different employer, thus subjecting them and the school board to the Medicare tax, or if they qualify for the continuing employment exception, thereby exempting them from the tax obligations.

Plaintiffs contend that teachers qualify for the continuing employment exception under Kentucky law, asserting that boards of education are state agencies, thereby treating all boards in Kentucky as a single employer. This argument is based on Sec. 3121(u)(2)(D), which allows employee mobility without termination when moving between units of state or local government. They also reference Sec. 3121(u)(2)(C), which requires that employees must have substantial work for an employer before April 1, 1986, and must have been bona fide employees as of March 31, 1986, without any interruption in the employment relationship post that date.

In an alternative argument, plaintiffs assert that even if school boards are not state agencies, the consolidation of school districts did not create a new employer or terminate the teachers' employment, thus fulfilling the continuing employment exception's criteria without needing to invoke Sec. 3121(u)(2)(D).

The Government counters that school boards are independent political subdivisions, each acting as separate employers. Therefore, teachers transitioned from one political subdivision to another, disqualifying them from the continuing employment exception. The Government argues that the consolidation preserved the identity of the Muhlenberg County School District but dissolved the prior Greenville and Central City districts, indicating that the teachers are now employed by a different employer, the Muhlenberg County Board.

The District Court merged the two arguments and focused solely on whether school boards qualify as state agencies, ultimately ruling they do not, and classified the Muhlenberg County Board as a new employer under Sec. 3121(u)(2)(C), concluding that the teachers are not eligible for the continuing employment exception.

The summary concludes that the two questions—whether school boards are state agencies and the impact of consolidation on employment—should be treated as distinct, suggesting that the case could be more effectively resolved through an analysis of the statute and the legislative intent behind the continuing employment exception.

The statutory provision in question, Sec. 3121(u)(2)(C)(ii) and (iii), includes criteria for an employment exemption related to current employment post-consolidation. Subsection (ii) specifies that an individual must have been performing substantial work for the employer before April 1, 1986, must have been a bona fide employee on March 31, 1986, and must not have entered the employment relationship to circumvent the provision. Subsection (iii) states that the employment relationship must not have been terminated after March 31, 1986. The critical issue is whether the term "that employer" includes the consolidated entity, the Muhlenberg County Board of Education. A narrow interpretation suggests the plaintiffs do not qualify for the exemption as they were previously employed by separate districts. However, a broader interpretation raises the possibility that the plaintiffs are still employed by the same entity under a different name. The statute’s language is clear in typical employment scenarios but does not explicitly address consolidation events. Consequently, both parties find support for their interpretations in the statutory language, which ultimately does not provide a definitive answer regarding the employment status of the teachers post-consolidation. Legislative history and the policy underlying the continuing employment exception must be examined to clarify this issue.

The House Report identified a problem with Medicare funds being drained by individuals eligible for hospitalization benefits without significant contributions. To address this, the statute mandated Medicare coverage and taxation for previously exempt state and local government employees, who numbered over 13 million, including many teachers. Recognizing the financial burden this could impose on government entities due to the requirement for employer contributions, Congress opted for a gradual inclusion approach, applying the statute only to newly hired employees. The report clarified that employees included in the mandatory coverage were those newly hired, while those exempt were those not separated from prior excluded employment. It emphasized scrutiny to ensure the legitimacy of qualifying employment and noted that internal transfers within state government units would not constitute a discontinuation of employment, while transfers between state and local entities would.

The legislative history reflects Congress's intent to alleviate the financial impact of mandatory Medicare coverage on state and local governments by incorporating a continuing employment exception. This exception indicates that Congress did not intend for mergers or consolidations to be treated as creating a new employer, as that would counteract the purpose of the exception. The report suggests a focus on gradual inclusion rather than deterring consolidations aimed at efficiency. Additionally, the Government's argument that consolidation creates a new employer is undermined by its concession that the old Muhlenberg school system retains its exemption. The distinction among the consolidated districts appears illogical and misaligned with congressional intent, indicating support for maintaining the exemption across all three districts rather than just one.

The plaintiffs argue that the Government inconsistently treats consolidations as creating a new employer for tax purposes in some contexts but not in others. They reference 26 U.S.C. Sec. 402, which addresses tax-exempt employee benefit plan distributions, noting that lump sum distributions upon employee separation are eligible for preferential tax treatment. According to Rev.Rul. 79-336, employees are not deemed separated if a merger or consolidation results in their employment with a new entity. The plaintiffs contend that a similar interpretation should apply under 26 U.S.C. Sec. 3121(u)(2)(C) concerning mergers or consolidations.

The conclusion reached is that the Muhlenberg County Board of Education is the same employer as the former Central City, Greenville, and Muhlenberg County School Districts for the purposes of Sec. 3121(u)(2)(C). Consequently, the plaintiff teachers and school system qualify for an exception from the Medicare tax, and the United States has improperly collected this tax from them. The case is remanded to the District Court for refund proceedings.

The Court also examined whether the plaintiffs were sufficiently designated in the Notice of Appeal, ultimately determining they were properly before the Court, as the Notice includes the school board's name and indicates "the other 107 named Plaintiffs," referencing their names in the Complaint. Under Kentucky law, employment status is preserved in consolidations and when teachers move between districts. The status of local school boards as state agencies for sovereign immunity purposes was established in Clevinger v. Board of Educ. of Pike County, affirming local school boards as agencies of state government. Lastly, the House Report acknowledged challenges in defining "newly hired" and called for Treasury regulations, which have not yet been issued.