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Sunday, March 23, 2003


Ralph W. Emerson and Suzanne O. Emerson attempted to exclude proceeds from a settlement of a law suit against Ralph�s former employers clients from their income. Ralph was a biochemical researcher hired by ProGuard to develop safer chemistries to be used on food supplies. In exchange for transferring all intellectual property rights in the results to ProGuard, Ralph was to receive $10,000 per month and 15% of the profits from the patents developed for ProGuard. While Ralph was working with them, ProGuard (or an agent of theirs that Ralph reported to) loaned him $128,424.60.

After several years, the business relationship between ProGuard and Ralph ended, and Ralph filed suit against ProGuard. The complaint and amended complaint described the history of the business relationship between Ralph and ProGuard, and listed as causes of action many claims arising from contract, and several claims arising from tort, such as slander, intentional infliction of emotional distress, and fraud. Of the sixteen causes of action, none involved personal injury or physical sickness. The dispute was taken to mediation. The mediator, retired California State Superior Court Judge Richard Gilbert suggested that Ralph include a personal injury claim to facilitate settlement.

The resultant settlement agreement, stipulation to amend complaint, and stipulation to dismiss were prepared and signed by both sides as a package. The settlement agreement referenced breach of contract and several tort claims, including infliction of emotional distress and personal injury. The second amended complaint included a cause of action for negligence, based on stressful working conditions that exacerbated his diabetes. The request for dismissal was filed four minutes after the amended complaint. Defendants never reported a personal injury claim to their insurers for reimbursement. The terms of settlement included monetary payments and debt relief.

The Emersons left the payments and debt relief off of their tax return. Tax Court referenced in the opinion someone named �Stevenson� whom they do not further identify but who appears to have been the tax preparer. Despite Ralph�s testimony regarding the toxins he worked with while at ProGuard, Tax Court was not convinced that ProGuard intended to compensate for physical injury of sickness in the settlement. Tax Court referenced a letter from Ralph�s attorney to ProGuard�s attorney stating that the second amended complaint had no operable effect on the settlement. Also a representative of ProGuard testified at the trial in Tax Court that the entire mediation discussion revolved around the contractual dispute and there was no mention of a claim for personal injury. ProGuard claimed it wanted to have clear title on the patents to secure marketing opportunities. Therefore, Tax Court ruled that the entire settlement proceeds should be included in taxable income. Tax Court also determined that both the cash payments and the debt forgiveness were compensation for non-employee services, and that the Emersons therefore owe self-employment taxes on the proceeds. Fortunately, however, Tax Court spared the Emersons from the accuracy penalty imposed by the IRS. Tax Court determined that the Emersons had been mislead by Judge Gilbert and their tax advisors.

As a fledgling mediator, I was taken somewhat aback by the description of the testimony regarding the contents of the mediation. Mediations in California are supposed to be confidential. We mediators tell disputants that nothing said in mediation can be brought out in testimony in court. But that is based on the California evidence code. I honestly have not considered the admissibility of mediation discussions in Federal Courts, such as Tax Court. I will obviously have to investigate this, and possibly give considerably more narrow confidentiality assurances to my mediation clients.

I should also point out how this case obviously serves as an example of the dangerousness of directive mediation, where experts invent creative solutions and hand them to the disputants, rather than helping the disputants solve the problem themselves. Judge Gilbert was an expert, he came up with a creative opinion, and he used it notch another settlement on his belt. And his clients got screwed.

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