Srivastava v. Commissioner

REVISED, July 21, 2000

IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT
_______________

m 99-60437
_______________

SUDHIR P. SRIVASTAVA AND ELIZABETH S. PASCUAL,

Petitioners-Appellants,

VERSUS

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

_________________________

Appeal from the United States Tax Court
_________________________
July 19, 2000

Before POLITZ, SMITH, and DENNIS, contingent fees governed by Alabama law, we
Circuit Judges. conclude that contingent fees paid according
to Texas law are also excludable.
JERRY E. SMITH, Circuit Judge:
We therefore reverse the Tax Court’s con-
This challenge to a notice of deficiency re- trary conclusion and remand for a recalculation
quires us to determine whether the portion of of the deficiency and a new determination of
a judgment or settlement payable to a taxpay- the propriety and size of any penalties. We
er’s attorney pursuant to a contingent fee find no clear error in the Tax Court’s
agreement governed by Texas law constitutes allocation of the litigation settlement between
gross income under § 61 of the Internal non-taxable items (that is, actual damages) and
Revenue Code, 26 U.S.C. § 61. Following taxable items (that is, interest and punitive
Cotnam v. Commissioner, 263 F.2d 119 (5th damages) and thus affirm on that issue.
Cir. 1959), which excluded from gross income
 I. agreement, releasing the station from liability
Petitioner Sudhir Srivastava, like his wife, in exchange for $8.5 million, to be paid by the
petitioner Elizabeth S. Pascual, is a medical station and some of the insurers. The
doctor. The KENS-TV television station aired agreement was structured to discharge divers
a series of investigative reports accusing Sri- portions of the judgment separately, in
vastava of delivering poor quality medical care accordance with the stations’ various tiers of
and committing acts that would have been coverage. The first $7 million of the award
criminal under Texas law. These reports de- was jointly discharged by Continental
stroyed Srivastava’s practice and caused sub- Casualty, contributing $2.1 million, and the
stantial financial and emotional harm to him station, contributing $1 million. The station
and his family. additionally would discharge the $7 million to
$12 million portion of the judgment, and the
Srivastava sued the station and its parent award of post-judgment interest, by paying
corporations (collectively, the “station”) in $2.4 million. Columbia Casualty and Hudson
state court for defamation and related claims. Insurance agreed to pay $3 million to settle the
The jury awarded $11.5 million in actual dam- $12 million to $22 million portion of the
ages, $17.5 million in punitive damages, and judgment. Any remaining amounts would be
pre- and post-judgment interest. The station pursued against Federal Insurance Company
appealed, then it and its insurance carriers exclusively.1
settled for $8.5 million.
II.
The station was covered by a number of A.
policies that were triggered at different tiers of Petitioners received their settlement
liability. Two of the insurers were insolvent, proceeds in 1991 but reported no gross
however, and thus afforded no protection. income therefrom, reasoning that the judgment
The station’s first $2 million of liability was constituted recovery exclusively for non-
covered by Continental Casualty and American taxable actual damages.2 To recover the tax
Casualty. Liability between $2 million and on the portion of the settlement representing
$7 million was supposed to be covered by (according to the Commissioner’s
Mission Insurance Company, but it was
insolvent. Likewise, the insurer for liability
between $7 and $12 million, Western
Employer’s Casualty, was functionally 1
Federal Insurance Company, the station’s in-
insolvent. Columbia Casualty Company and
surer for liabilities in excess of $22 million, denied
Hudson Insurance Company covered liability coverage on the ground that the station had not suf-
for the $12 million to $22 million range, and fered liability in excess of $22 million. This court
Federal Insurance Company insured the station upheld that decision. See Federal Ins. Co. v. Sri-
for liability in excess of $22 million. The vastava, 2 F.3d 98 (5th Cir. 1993).
station thus was ineffectively covered for
liability in the $2 to $7 million range, so, to
2
activate the higher levels of coverage in the For the law governing the taxable years in
absence of a negotiated settlement, it would be question, see 26 U.S.C. § 104(a)(2) (West 1988)
forced to take responsibility for that liability (excluding from gross income the “amount of any
range. damages received (whether by suit or agreement
and whether as lump sums or as periodic pay-
ments) on account of personal injuries or
The parties reached a partial settlement
sickness”).

2
determinations) interest and punitive damages, jury verdict (as the Commissioner had done),
both of which are taxable,3 the Commissioner the Tax Court first broke the settlement down
of Internal Revenue issued a notice of by the various tiers established by the
deficiency of $1,188,920 for tax year 1991 and settlement agreement, then matched each tier
$33,037 for tax year 1992.4 to its corresponding portion of the jury award.
That is, the portion of the settlement
The settlement agreement did not separate discharging the first $11.5 million, which the
the proceeds into the various categories of jury had awarded for actual damages, was
recovery for (non-taxable) actual damages and attributed to actual damages. In other words,
(taxable) interest and punitive damages, nor the amounts paid by Continental Casualty and
did the parties discuss any method of the station were left untaxed.
allocation. The Commissioner thus estimated
the amounts attributable to interest and The Tax Court attributed the balance of the
punitive damages by applying to the settlement station’s payment to interest, a taxable item.
agreement the proportions of the original jury The payments from Columbia Casualty and
verdict represented by interest and punitive Hudson Insurance Company, representing the
damages. The Commissioner also assessed remaining interest and punitive damages, was
penalties of $237,784 for 1991 and $6,607 for made subject to tax.
1992.
The Tax Court reduced the deficiencies and
B. penalties accordingly. It disallowed the
The petitioners challenged the deficiency assessment of penalties with respect to the
notice in the Tax Court, which rejected their amount of deficiency attributable to punitive
argument that the portion of the settlement damages, holding that the petitioners, though
payable to their attorneys under the contingent wrong in doing so, had reasonable cause for
fee agreement did not constitute gross income. not reporting taxable income arising from the
The Tax Court also rejected t heir claim that portion of the settlement representing punitive
the settlement award represented exclusively damages.5 The Tax Court left intact the
actual damages. penalties with respect to interest.

Rather than examining the settlement award III.
in its entirety, and then dividing it among ac- The petitioners contend that the portion of
tual damages, interest, and punitive damages, a judgment or litigation settlement payable to
based on the proportions found in the original their attorney pursuant to a contingent fee

3 5
See 26 U.S.C. § 61(a)(4) (including interest It was not until O’Gilvie that the Court made
within gross income); O’Gilvie v. United States, plain that punitive damages were not excludable
519 U.S. 79 (1996) (holding that punitive damages under 26 U.S.C. § 104(a)(2) and therefore were
are not awarded “on account of personal injuries or subject to tax. See Robinson v. Commissioner,
sickness” pursuant to 26 U.S.C. § 104(a)(2) and 102 T.C. 116 (1994) (holding that punitive dam-
therefore constitute gross income). ages are excludable from gross income under
26 U.S.C. § 104(a)(2)); Threlkeld v. Commis-
4
The 1992 deficiency represents the elimination sioner, 87 T.C. 1294 (1986) (same); Roemer v.
of a net operating loss carryover attributable to the Commissioner, 716 F.2d 693 (9th Cir. 1983)
settlement proceeds received in 1991. (same).

3
agreement governed by Texas law is not gross Were we ruling on a tabula rasa, we might
income. This is a question of substantial im- be inclined to include contingent fees in gross
portance, for although attorney fee expenses, income. Principles of tax neutrality, if nothing
if included within gross income, may be else, dictate that result, for when a taxpayer
deductible,6 various limitations may operate to recovers from a favorable judgment or
reduce the effectiveness of such deductions.7 litigation settlement, and compensates his
attorney on a non-contingent basis, the full
amount of the recovery may be treated as
gross income (as petitioners acknowledged
6
Attorney’s fees are potentially deductible ei- during oral argument). There is no apparent
ther as an “ordinary and necessary expense[] paid reason to treat contingent fees differently or to
or incurred . . . in carrying on any trade or bus- believe that Congress intended to subsidize
iness,” 26 U.S.C. § 162(a), or as an “ordinary and contingent fee agreements in such a fashion.
necessary expense[] paid or incurred . . . for the
production or collection of income,” 26 U.S.C. In Cotnam, however, this court excluded
§ 212(1). Determining which deduction to apply contingent fees governed by Alabama law
requires the use of the “origin of the claim” test. from the client’s gross income. Because Cot-
See United States v. Gilmore, 372 U.S. 39, 49
nam is substantially indistinguishable from this
(1963) (observing that “the origin and character of
case, we reverse the Tax Court and decide that
the claim with respect to which an expense was in-
curred . . . is the controlling basic test of whether contingent fees governed by Texas law are
the expense was ‘business’ or ‘personal’ and hence also excludable. In doing so, we acknowledge
whether [and how] it is deductible”). Because we the circuit split on this issue, with the Sixth
conclude that Srivastava’s contingent fees are ex- Circuit recently adopting Cotnam’s reasoning,8
cludable from gross income, we have no occasion and the Third,9 Ninth,10 and Federal11 Circuits
to decide which basis for a deduction would have
applied.
(...continued)
7
For example, “the miscellaneous itemized de- in the amount of tax burden that may result from
ductions for any taxable year shall be allowed only the parties’ approaches. The difference, of course,
to the extent that the aggregate of such deductions is a consequence of the plain language of sections
exceeds 2 percent of adjusted gross income.” 56, 67, and 68, so the characterization of the
26 U.S.C. § 67(a). Section 68 of the Internal attorney’s fees as excludable or deductible becomes
Revenue Code limits the total amount of itemized critical.”). (Footnote omitted.)
deductions allowed. See 26 U.S.C. § 68. Finally,
8
the alternative minimum tax also may operate to See Estate of Clarks v. United States, 202
reduce the value of a deduction. See 26 U.S.C. F.3d 854, 857 (6th Cir. 2000) (“We follow
§§ 55(b)(2), 56(b)(1)(A)(i). See also Barlow- Cotnam concluding that the majority in Cotnam
Davis v. Commissioner, 210 F.3d 1346, 1347 n.3 correctly distinguished Lucas v. Earl”).
(11th Cir. 2000) (“The deduction for attorneys’
9
fees and costs which the IRS allowed was less fa- See O’Brien v. Commissioner, 38 T.C. 707,
vorable to the taxpayer than the exclu- 712 (1962), aff’d, 319 F.2d 532 (3rd Cir. 1963)
sion-from-income approach adopted by the Tax (holding that contingent attorney fees are “gross
Court because of the operation of technical tax income to [taxpayer] under the familiar principles
rules such as the alternative minimum tax.”); of Lucas v. Earl”).
Kenseth v. Commissioner, 2000 U.S. Tax Ct.
10
LEXIS 32, at *18, 114 T.C. No. 26 (2000) (“This See Coady v. Commissioner, 213 F.3d 1187,
controversy is driven by the substantial difference ____, 2000 U.S. App. LEXIS 13692, at *10 (9th
(continued...) (continued...)

4
including contingent fees in gross income.12 A.
We also acknowledge the Tax Court’s Because the text of the Internal Revenue
objection to Cotnam13 and note that, as it Code is of little help,16 we turn to judicially-
properly has observed, in cases ultimately developed tax law principles, one of which is
appealable to this court,14 the Tax Court is that any income or gain is not taxed until it is
bound by our precedent.15 “realized.”17 In addition, to combat
“anticipatory arrangements” designed to keep
income from ever being realized by one person
(...continued) by the device of vesting, in advance of
Cir. June 14, 2000) (“We are persuaded by . . . realization, the rights to such income in
Judge Wisdom’s dissent in Cotnam.”); Brewer v. another, the Supreme Court has developed the
Commissioner, 172 F.3d 875, 1999 U.S. App. doctrine of anticipatory assignments of
LEXIS 3568, at *2 (9th Cir. 1999), aff’g without income:18
published opinion T.C. Memo. 1997-542 (“The
fact that [the taxpayer] did not actually receive the In the ordinary case the taxpayer who
gross payment and that the legal fees were paid acquires the right to receive income is
directly to counsel does not alter the fact that taxed when he receives it, regardless of
Brewer received the benefit of the full settlement
the time when his right to receive
amount.”).
payment accrued. But the rule that
11
See Baylin v. United States, 43 F.3d 1451, income is not taxable until realized has
1454-55 (Fed. Cir. 1995) (including contingent never been taken to mean that the
fees in gross income). taxpayer, . . . who has fully enjoyed the
benefit of the economic gain represented
12
The Eleventh Circuit is bound by holdings of by his right to receive income, can
the former Fifth Circuit. See Davis, 210 F.3d at escape taxation because he has not
1347 n.2. himself received payment of it from his
13
See Kenseth, 2000 U.S. Tax Ct. LEXIS 32,
at *21 (“The Cotnam holding with respect to the (...continued)
Alabama attorney lien statutes has been dis- torney’s fees are not subtracted from taxpayers’
tinguished by this Court from cases interpreting the gross income to arrive at adjusted gross income.”).
statutes of numerous other states. Significantly,
16
this Court has, for nearly 40 years, not followed See 26 U.S.C. § 61 (stating that “gross in-
Cotnam . . . .”) (collecting cases). come means all income from whatever source de-
rived”); James v. United States, 366 U.S. 213, 219
14
See 26 U.S.C. § 7482(a),(b). (1961) (noting “intention of Congress to tax all
gains except those specifically exempted,” and de-
15
See Golsen v. Commissioner, 54 T.C. 742, fining gross income broadly to include all gains
756-57 (1970), aff’d, 445 F.2d 985 (10th Cir.) from which, “when its recipient has such control
(noting that “better judicial administration requires over it . . ., as a practical matter, he derives readily
us to follow a Court of Appeals decision which is realizable economic value”) (citations and quo-
squarely in point where appeal from our decision tations omitted).
lies to that Court of Appeals and to that court
17
alone.”); Kenseth, 2000 U.S. Tax Ct. LEXIS 32, Helvering v. Horst, 311 U.S. 112, 116
at *29 (“With the exception of situations where . . . (1940) (noting “the rule that income is not taxable
we feel compelled to follow the holding of a Court until realized “).
of Appeals, we have consistently held that at-
18
(continued...) Lucas v. Earl, 281 U.S. 111, 115 (1930).

5
 obligor. The rule [of realization], case, the taxpayer had contracted with his wife
founded on administrative conven- for her to receive half of any of his future in-
ience, is only one of postponement come. The Court concluded that such an ar-
of the tax to the final event of rangement constituted an anticipatory
enjoyment of the income, usually assignment of income and attributed all of the
the receipt of it by the taxpayer, income to the husband. Id. at 113-15.
and not one of exemption from
taxation where the enjoyment is Similarly, in Horst, the taxpayer, a holder of
consummated by some event other a coupon bond, had made a gift of interest
than the taxpayer’s personal receipt coupons while retaining title to the bond. The
of money or property. This may Court again held that such an arrangement
occur when he has made such use constituted an anticipatory assignment of in-
or disposition of his power to come. See Horst, 311 U.S. at 119-20. In both
receive or control the income as to cases, the taxpayer kept control of the asset or
procure in its place other income source and merely committed future
satisfactions which are of economic income streams to another. Such
worth. . . . arrangements cannot be used to evade tax.

[Under the anticipatory assignment of On the other hand, the doctrine does not
income doctrine,] income is ‘realized’ by apply to a taxpayer who transfers, sells, or
the assignor because he, who owns or otherwise relinquishes an asset or income
controls the source of the income, also source to another, because the taxpayer ceases
controls the disposition of that which he to receive any income from that asset
could have received himself and diverts (excepting, of course, any gain realized from
the payment from himself to others as the sale). After all, a taxpayer no longer
the means of procuring the satisfaction enjoys the fruits of a tree he no longer owns,
of his wants. The taxpayer has equally just as a taxpayer does not receive income
enjoyed the fruits of his labor or from “[t]he rent from a lease or a crop raised
investment and obtained the satisfaction on a farm after the leasehold or the farm had
of his desires whether he collects and been given away.” Id. at 119 (citing Blair v.
uses the income to procure those Commissioner, 300 U.S. 5, 12-13 (1937)).
satisfactions, or whether he disposes of Thus, where a stockholder had assigned to a
his right to collect it as the means of corporation his entire interest in a claim of
procuring them. uncertain value against the government, this
court held that the anticipatory assignment of
Horst, 311 U.S. at 115-17 (citations omitted). income doctrine did not apply, because the
The doctrine does not allow a taxpayer to stockholder had fully divested himself of the
evade tax through an “arrangement by which claim and thus no longer received any income
the fruits are attributed to a different tree from from that asset. See Jones v. Commissioner,
that on which they grew.” Earl, 281 U.S. 306 F.3d 292 (5th Cir. 1962).
at 115.
B.
In other words, what is taxed is not The question, therefore, is one of
exclusively the receipt of funds, but rather any characterization, and, as we have recognized,
enjoyment of gain, whether monetary or non- is not always easy to apply in particular
monetary. For example, in the landmark Earl

6
cases.19 There are, to be sure, “distinct and retains control over the tree, while handing out
identifiable principles which have been its fruits, is in fact continuing to enjoy the
developed in tax jurisprudence which serve to benefits of both. By contrast, a taxpayer who
guide . . . courts.” Id. at 296. As we shall see, has divested all dominion and control over a
however, contingent fee contracts defy easy tree cannot be said to enjoy gain from its
categorization, standing as they do somewhere subsequent fruits.
in between the two polesSSon the one hand, an
obvious scheme to evade taxation through Application of the taxpayer-dominion-and-
diversion of future income streams to another, control principle to the case of contingent at-
and on the other hand, full and complete torney’s fees yields no obvious answer,
divestment of an income source. however. We need not explore the entire
realm of attorney-client relations or articulate
1. all of their respective rights, duties, and
The most widely-applied principle for im- obligations to recognize that, when a client
plementing the anticipatory assignment of in- hires an attorney to prosecute a claim on his
come doctrine is that a taxpayer who makes an behalf, control over that claimSSthe income
assignment of future income streams but re- source or “tree”SSis neither fully divested to
tains ownership and control over the source of the attorney nor fully retained by the taxpayer-
those funds has effected an anticipatory client. Rather, the claim is subject to a sort of
assignment of income.20 The principle rests on virtual co-ownershipSS“[l]ike an interest in a
the sound inference that a taxpayer who partnership agreement or joint venture.”
Clarks, 202 F.3d at 857.21

To put it another way, contingent fee
19
See Jones, 306 F.2d at 296 (stating that arrangements, to be sure, assign a percentage
anticipatory assignment of income cases “are not of the proceeds of any judgment or settlement
easy to decide. In seeking to reconcile the im- agreementSSthe “fruit” of the treeSSto the at-
plications of the infinite variety of facts presented torney, thereby avoiding realization by the cli-
by the decided cases and all that has been said ent of that portion of income. But attorney re-
about the subject of anticipatory assignment of tainer agreements accompanied by contingent
income, one is likely to be displeased with his own fee provisions assign more than just the
wits; and may find his mind teetering between con-
fruitSSand yet divest clients of something less
flicting conclusions. . . . ‘Drawing the line’ is a re-
than the entire tree. Contingent fees are thus
current difficulty in those fields of the law where
differences in degree produce ultimate differences in a sense
in kind.”).
more like a division of property than an
20
See Horst, 311 U.S. at 119 (“We have held assignment of income. Here the client
without deviation that where the donor retains as assignor has transferred some of the
control of the trust property the income is taxable trees in his orchard, not merely the fruit
to him although paid to the donee.”); Com-
missioner v. First Sec. Bank, 405 U.S. 394, 403
(1972) (“In cases dealing with the concept of in-
21
come, it has been assumed that the person to whom But see Kenseth, 2000 U.S. Tax Ct. LEXIS
the income was attributed could have received it. 32, at *31 (“Attorneys represent the interests of
The underlying assumption always has been that in clients in a fiduciary capacity. It is difficult, in
order to be taxed for income, a taxpayer must have theory or fact, to convert that relationship into a
complete dominion over it.”). joint venture or partnership.”).

7
 from the trees. The lawyer has contingent fee agreement, by contrast, is an
become a tenant in common of the arm’s-length commercial transaction; we are
orchard owner and must cultivate hard-pressed to imagine a client who would
and care for and harvest the fruit of offer his attorney a pure gratuity.
the entire tract.
The anticipatory assignment of income doc-
Id. at 857-58. trine does not recognize such distinctions,
however, for the purpose of the doctrine is
The control test thus leaves us in a simply to capture the taxpayer who diverts a
quandary. In light of this ambiguity, a number stream of income to achieve gain in non-
of other factors might be considered. monetary form and to prevent him from
evading taxation through such an arrangement.
2.
It might be urged, for example, that, unlike
the assignees in Earl and Horst, an attorney “[I]ncome is ‘realized’ by the assignor
must perform to reap the benefits of the because he, who owns or controls the
contingent fee agreement.22 Certainly, a client source of the income, also controls the
contemplates that an attorney will work to disposition of that which he could have
earn his contingent share of any award. received himself and diverts the payment
Indeed, the Sixth Circuit has so noted: from himself to others as the means of
procuring the satisfaction of his wants.
Here the lawyer’s income is the result of The taxpayer has equally enjoyed the
his own personal skill and judgment, not fruits of his labor or investment and ob-
the skill or largess of a family member tained the satisfaction of his desires
who wants to split his income to avoid whether he collects and uses the income
taxation. The income should be charged to procure those satisfactions, or wheth-
to the one who earned it and received it, er he disposes of his right to collect it as
not as under the government’s theory of the means of procuring them.”
the case, to one who neither received it
nor earned it. Horst, 311 U.S. at 117.

Id. It therefore may be true that gratuitous
transfers are particularly good opportunities
Similarly, some courts have noted that Earl for a taxpayer to enjoy his fruits in advance of
and Horst involved gratuitous transfers.23 A realization by, for example, giving them away
to loved ones, as in Earl, involving a transfer
between spouses. There is nothing about
arm’s-length transactions that need preclude
22
See Clarks, 202 F.3d at 857 (distinguishing anticipatory assignments in that context,
Earl and Horst on the ground that “[t]he assignee however. To the contrary, a taxpayer who
[in those cases] performed no services in order to anticipatorily assigns future streams of income
receive the income”). to obtain services in return has quite obviously
23
See Jones, 306 F.2d at 302 (“No gra-
tuity or gift is involved here as has been involved in (...continued)
numerous other cases. So far as the record dis- closes, the assignment contract was an arm’s length
transaction.”).
(continued...)

8
procured a benefit.24 because a future income stream (or “harvest,”
if you will) is of uncertain value does not mean
Thus, where a medical partnership arranged a taxpayer cannot achieve gain from anticipa-
for its patient group to fund a separate torily assigning it to another. The taxpayer in
retirement trust for the benefit of the Earl, after all, was taxed on the portion of his
partnership’s physicians, without ever vesting future salary anticipatorily assigned to his
those funds in the partnership, the Supreme spouse; that there was some degree of inherent
Court applied the anticipatory assignment of uncertainty in his future income stream went
income doctrine and required the partnership without comment and did not preclude
to pay tax on the funds deposited into the application of the doctrine. See Earl, 281 U.S.
retirement trust. See United States v. Basye, at 113-15.27
410 U.S. 441, 448-53 (1973). That the
payment was made at arm’s length, rather than 4.
as a gratuity, was of no significance. The main reason for a client to sign a

3.
Nor, as some courts have suggested, does (...continued)
are rarely certain and free of doubt. Experienced
uncertainty as to the valueSSindeed, not even
lawyers have long since learned that it is unwise
uncertainty as to the factSSof a contingent fee
and indeed, ultra foolish to predict the results of
preclude application of the anticipatory litigation. . . . When this assignment was made
assignment doctrine.25 There is no questioning over five months before the Court of Claims an-
the fact that the value of a claim is often nounced its decision, over nine months before the
uncertain and difficult to predict.26 But just decision became final, and over fourteen months
before payment was received, the ‘tree’ appeared to
be blighted and almost devoid of life. It had borne
‘no fruit’ and to a layman . . ., while hopeful and
24
See Kenseth, 2000 U.S. Tax Ct. LEXIS 32, confident because he believed in the justice of his
at *26 n.4 (“[T]he transfer of trees in and of itself claim, certainly he could not be said to have
could be consideration in kind and result in gains to sufficient insight reasonably to speculate what the
the taxpayer. More significantly, if the trees are United States Court of Claims would ultimately
analogous to the taxpayer’s chose in action or com- decide.”); Cotnam, 263 F.2d at 125 (Rives and
pensatory rights, then the transfer represents a Brown, JJ., concurring) (noting that taxpayer who
classic anticipatory assignment of income.”). merely had a claim to pursue in court was “a long
way from having the equivalent of cash. Her claim
25
See First Sec. Bank, 405 U.S. at 403-04 had no fair market value, and it was doubtful and
(noting that “the assignment-of-income doctrine uncertain as to whether it had any value.”).
assumes that the income would have been received
27
by the taxpayer had he not arranged for it to be See also Baylin, 43 F.3d at 1455 (noting that
paid to another”); Jones, 306 F.2d at 301 (“We the “temporarily uncertain magnitude of the legal
believe it appropriate to point out that the claim . . . fees under such an arrangement and the vehicle of
was at the time of assignment . . . uncertain, an assignment cannot dictate the income tax treat-
doubtful and contingent.”); Clarks, 202 F.3d ment of those fees.”); Kenseth, 2000 U.S. Tax Ct.
at 857 (noting that, in Earl and Horst, “the income LEXIS 32, at *30-*31 (“Despite characterizing
assigned to the assignee was already earned, vest- petitioner’s right to recovery as speculative, his
ed, and relatively certain”). cause of action had value in the very beginning;
otherwise, it is unlikely that [his attorneys] would
26
See Jones, 306 F.2d at 301 (“Indeed, lawsuits have agreed to represent petitioner on a contingent
(continued...) basis.”).

9
contingent fee contract, presumably, is not to it.29 That gainSSno less than the non-monetary
avoid taxation by anticipatorily assigning fu- gains recognized as income in Earl, Horst, and
ture streams of income to others in exchange their progenySSis not to be excluded from
for non-monetary benefits. More likely, he gross income solely on the basis that the mon-
signs it to secure the services of an attorney ey is diverted to, and realized by, the tax-
without having to put any capital at risk, and payer’s assignee.
to encourage the attorney to perform well by
offering a personal stake in the claim. That is to say, if there were no contingent
fee arrangement, Srivastava presumably would
A taxpayer who enters into the contract re- have had to compensate counsel out of his
cognizes that, to realize and maximize the val- own pocket, rather than rely wholly on the
ue of his claim, he must necessarily obtain the income stream arising from his claim. He
resources and expertise of counsel.28 But of ought not receive preferential tax treatment
course, the same is true of a client who retains from the simple fortuity that he hired counsel
counsel on a non-contingent fee basis. The on a contingent basis,30 for his attorney’s me-
fact that a contingent fee arrangement has the thod of compensation did not meaningfully
added benefits of risk-shifting and realignment affect the gain he was able to enjoy from a
of incentives does not alter the economic re- favorable resolution of the litigation.
ality. Such an arrangement diverts a portion of
the litigation proceeds from the client to the C.
attorney, thereby accruing to the client non- Thus, were we to decide this case as an
monetary gain from enjoying the assistance of original matter, we might apply the
counsel without otherwise having to pay for anticipatory assignment doctrine to hold that
contingent fees are gross income to the client.
We do not, however, decide this case on a

28
See Cotnam, 263 F.2d at 125-26 (Rives and
29
Brown, JJ., concurring) (“The only economic ben- See Old Colony Trust Co. v. Commissioner,
efit she could then derive from her claim was to use 279 U.S. 716, 729 (1929) (“The discharge by a
a part of it in helping her to collect the remain- third person of an obligation to him is equivalent to
der. . . . [Her] claim . . . was worthless without the receipt by the person taxed.”); Baylin, 43 F.3d
aid of skillful attorneys. At the time that she en- at 1545 (reasoning that “although the partnership
tered into the contingent fee contract, she had rea- did not take actual possession of the funds it paid
lized no income from the claim, and the only use to its attorney, opting instead to pay him directly
she could make of it was to transfer a part so that out of its eventual recovery, it is evident that the
she might have some hope of ultimately enjoying partnership received the benefit of those funds in
the remainder. . . . [S]he could never have col- that the funds served to discharge the obligation of
lected anything or have enjoyed any economic ben- the partnership owing to the attorney as a result of
efit unless she had employed attorneys . . . .”); the attorney’s efforts to increase the settlement
Clarks, 202 F.3d at 857 (“[T]he value of tax- amount”).
payer’s lawsuit was entirely speculative and de-
30
pendent on the services of counsel. The claim sim- See Kenseth, 2000 U.S. Tax Ct. LEXIS 32,
ply amounted to an intangible, contingent expec- at *26 (observing that “taxable recoveries in law-
tancy. The only economic benefit Clarks could suits are gross income in their entirety to the party-
derive from his claim against the defendant in state client and . . . associated legal feesSScontingent or
court was to use the contingent part of it to help otherwiseSSare to be treated as deductions”) (foot-
him collect the remainder.”). note omitted).

10
clean slate, but must follow the contrary attorneys a greater degree of power to enforce
approach endorsed in Cotnam. their rights than does Texas.32

Cotnam dealt with a contingent fee These distinctions, however, should not af-
agreement governed by Alabama law. A fect the analysis required by the anticipatory
majority of that panel held that contingent assignment of income doctrine, which looks to
attorney’s fees are not subject to tax under the the taxpayer’s degree of control and dominion
anticipatory assignment of income doctrine. over the asset. As we have said, a taxpayer
The majority reasoned that, before judgment who enters into a contingent fee contract di-
or settlement, a claim is of uncertain value, and vests some measure of control over a claim but
that the lawyer’s services are necessary to retains the rest, and how much control is suf-
convert that claim into value to the taxpayer. ficient to trigger taxation under the
See Cotnam, 263 F.2d at 125-26 (Rives and anticipatory assignment of income doctrine is
Brown, JJ., concurring).31 Applying the not easily answerable. But we find no
familiar tree/fruit metaphor of Earl, the assistance from the fact that Alabama may
majority explained that “Mrs. Cotnam’s tree offer its contingent fee attorneys, by way of
had borne no fruit and would have been barren example, greater power to pursue relief
if she had not transferred a part interest in that directly against the opposing party. Whatever
tree to her attorneys, who then rendered the are the attorney’s rights against the defendant
services necessary to bring forth the fruit.” Id. under Texas law as opposed to Alabama law,
at 126 (Rives and Brown, JJ., concurring). the discrepancy does not meaningfully affect
the economic reality facing the taxpayer-
The Commissioner invites us to distinguish plaintiff.33
Cotnam on the ground that we are faced with
contingent fees governed by the law of Texas,
not Alabama. The distinction rests on the
32
predicate that Alabama gives its contingent fee Compare ALA. CODE § 34-3-61 with Dow
Chem. Co. v. Benton, 357 S.W.2d 565 (Tex.
1962).
33
The dissent would distinguish Cotnam by
31
The additional language offered by Judges limiting it to those contingent fee arrangements in
Rives and Brown offers the best insight into the whichSSas Alabama law providesSSan attorney
majority’s reasoning. Technically, it is Judge Wis- can pursue a claim against the opposing party on
dom’s opinion that speaks for the court. As he ex- his own, apart from the client’s decision to pursue
pressly notes in his majority opinion, however, that claim. See ALA. CODE § 34-3-61(b) (stating
Judge Wisdom speaks not for himself, but only for that “attorneys-at-law shall have the same right and
Judges Rives and Brown, in excluding contingent power over action or judgment to enforce their liens
attorney’s fees from gross income. See Cotnam, as their clients had or may have for the amount due
263 F.2d at 125 (“A majority of the Court, Judges thereon to them”). By contrast, the dissent would
Rives and Brown, hold that [attorney’s fees] should include, within gross income, contingent fees gov-
not be included in [the taxpayer’s] gross income.”). erned by Texas law, for, under Texas law, as the
See also id. at 126-27 (Wisdom, J., dissenting). dissent correctly notes, “even when the attorney has
We therefore take little guidance from Judge Wis- been assigned an ownership interest in his client’s
dom’s majority opinion, which speaks narrowly to cause of action, his rights remain wholly derivative
the attorney’s rights under Alabama law governing from those of his client,” and “the client’s action is
contingent fees and offers only cursory analysis to indivisible and may not be tried for only a per-
support the ultimate judgment. (continued...)

11
 We therefore agree with the Tax Court
(...continued) that, irrespective of whether it is proper to tax
centage of the cause of action.” See also Dow,
contingent attorney’s fees under the
357 S.W.2d at 567-68.
anticipatory assignment doctrine, the answer
That this distinction is without a difference for does not depend on the intricacies of an
purposes of the anticipatory assignment of income attorney’s bundle of rights against the
doctrine, however, is made clear simply by com- opposing party under the law of the governing
paring the laws governing contingent fee arrange- state.34 In refusing the Commissioner’s
ments in Alabama and Texas to the Supreme request to distinguish Cotnam (as the Tax
Court’s two landmark decisions establishing the Court has grudgingly done on occasion35), we
doctrine. In Horst, the taxpayer, “the owner of ne- note that what the Commissioner truly seeks is
gotiable bonds, [had] detached from them nego-
tiable interest coupons shortly before their due date
and delivered them as a gift to his son who in the (...continued)
same year collected them at maturity.” See Horst, apply similarly in the other. Rightly or wrongly,
311 U.S. at 114. That arrangement is similar to this court in Cotnam decided not to apply the an-
the severable contingent fee agreement provided ticipatory assignment of income doctrine to contin-
under Alabama law and at issue in Cotnam; like gent fee agreements. What the Commissioner and
the Alabama contingent fee lawyer, the holder of the dissent urge, in effect, is that we use whatever
the negotiable interest coupon in Horst needs no means necessary to avoid Cotnam. The Tax Court
further action from the holder of the underlying has already rejected that approach, and we do so as
negotiable bond to recover on the coupon. well.
34
By contrast, in Earl (decided ten years before See O’Brien, 38 T.C. at 712 (“In reaching
Horst), the taxpayer had merely contracted away that conclusion the majority [in Cotnam] placed
half of his future salary to his wife. See Earl, 281 considerable stress upon certain provisions of an
U.S. at 113-14. Like the Texas contingent fee law- Alabama statute relating to attorneys’ liens. . . .
yer, Earl’s wife could not enjoy the benefits of the However, we think it doubtful that the Internal
agreement absent the continued efforts of her Revenue Code was intended to turn upon such
spouse. refinements. For, even if the taxpayer had made an
irrevocable assignment of a portion of his future
The Earl CourtSSlike the instant dis- recovery to his attorney to such an extent that he
sentSSreasoned that such an arrangement was not never thereafter became entitled thereto even for a
enough to allow the taxpayer to exclude income. In split second, it would still be gross income to him
Horst, the Court noted that the court below had under the familiar principles of [Earl and
“thought that as the consideration for the coupons Horst].”); Kenseth, 2000 U.S. Tax Ct. LEXIS 32,
had passed to the obligor, the donor had, by the at *29 (rejecting distinction, quoting O’Brien, and
gift, parted with all control over them and their “declin[ing] to decide this case based on the pos-
payment, and for that reason the case was dis- sible effect of various States’ attorney’s lien stat-
tinguishable from Lucas v. Earl.” Horst, 311 U.S. utes”) (footnote omitted).
at 114-15. But the Court rejected that argument,
35
ultimately finding the two cases indistinguishable. See Kenseth, 2000 U.S. Tax Ct. LEXIS 32,
at *21 (“The Cotnam holding with respect to the
Similarly, Cotnam is indistinguishable from the Alabama attorney lien statutes has been distin-
instant case, and thus however the anticipatory as- guished by this Court from cases interpreting the
signment of income doctrine applies in one case, statutes of numerous other states. Significantly,
principles of consistency dictate that the doctrine this Court has, for nearly 40 years, not followed
(continued...) Cotnam . . . .”) (collecting cases).

12
a direct challenge to Cotnam, in the Eleventh actual damages and ignored the petitioners’
Circuit36 as well as here. We decline that claim for $2,000,000 or more in punitive
invitation and, instead, reverse the Tax Court’s damages, or their claim for interest.
decision to include contingent fees within
gross income and remand for a recalculation of To the contrary, although it did not state
the deficiency. any method of allocation, the tiered settlement
agreement demonstrated that the station’s in-
IV. surers were in fact focused on the portions of
The petitioners challenge the Tax Court’s the verdict awarding interest and punitive
decision to attribute portions of the settlement damages. The jury awarded the petitioners ac-
agreement to recovery for actual damages tual damages of $11.5 million, an amount be-
(which are not taxable) and other portions to low the level of liability triggering coverage
interest and punitive damages (which are under the Columbia Casualty Company and
taxable). They contend that the entire Hudson Insurance Company policies (that is,
settlement represents actual damages. below the $12 million to $22 million range).
That those two insurers agreed to pay $3 mil-
We determine the tax treatment of lion to settle the litigation strongly sug-
judgments and settlements by asking “in lieu of gestsSSindeed, conclusively indicatesSSthat in-
what was the judgment or litigation settlement terest and punitive damages played some role
awarded?” Knuckles v. Commissioner, 349 in settlement negotiations.
F.3d 610 (10th Cir. 1965).37 We review the
allocations made by the Tax Court only for Nor does this approach in any way
clear error. See id. at 612. Finding none, we undercut the petitioners’ assertion that
affirm that portion of the decision. punitive damages were the most vulnerable to
reduction, or even outright elimination, on
The petitioners urge that the settlement appeal. Based on the Tax Court’s
ought to represent actual damages exclusively, methodology, of the $11.5 million awarded by
because the settlement award is identical to the the jury for actual damages, combined with
amount their complaint had sought for actual additional sums for interest, Srivastava
damages. Not only is this factually untrue (in received $6 million. By contrast, though the
that petitioners prayed for actual damages “in jury awarded $17.5 million in punitive
an amount in excess of $8,500,000.00”), but it damages, the settlement agreement provided
is also not the only plausible explanation, even only $3 million.
if we were to restrict our analysis to the plead-
ings in the underlying state court litigation. The petitioners also assert that, in settling
We cannot be certain that, in settling the dis- the dispute, they were motivated solely by
pute, the parties restricted their attention to concerns regarding the solvency of the various
insurers. It is, however, the payor’s intent,
rather than the payee’s, that carries the most
weight.38 Moreover, this assertion is undercut
36
See Davis, 210 F.3d at 1347 n.4; Ken-
seth, 2000 U.S. Tax Ct. LEXIS 32, at *29 n.6.
38
See Knuckles, 349 F.2d at 613 (“The most
37
See also Raytheon Prod. Corp. v. Com- important fact in making that determination, in the
missioner, 144 F.2d 110, 113 (1st Cir. 1944) absence of an express personal injury settlement
(same). (continued...)

13
by the petitioners’ claim that they also were Internal Revenue Code provides that “there
concerned about their prospects for upholding shall be added to the tax an amount equal to
the verdictSSparticularly the punitive damages 20 percent of the portion of . . . any
portionSSon appeal.39 underpayment which is attributable to 1 or
more of the following: . . . (2) Any substantial
Even if petitioners were exclusively understatement of income tax.” 26 U.S.C. §
motivated by collection concerns, that merely 6662(a), (b). An understatement is
addresses the need for some kind of negotiated “substantial” if it is both more than “(i) 10
settlement with the station and its solvent in- percent of the tax required to be shown on the
surers. Such concerns do not implicate, in any return for the taxable year” and more than “(ii)
way, the allocation of that settlement among $5,000.” 26 U.S.C. § 6662(d)(1)(A). “No
actual damages, interest, and punitive penalty shall be imposed . . . with respect to
damages; indeed, the petitioners’ own brief at any portion of an underpayment if it is shown
times unwittingly concedes as much. Their that there was a reasonable cause for such
stated motives do not raise the level of doubt portion and that the taxpayer acted in good
about the Tax Court’s allocation methodology faith with respect to such portion.” 26 U.S.C.
necessary to trigger reversal for clear error. § 6664(c)(1).40

The Tax Court correctly concluded that Our reversal of the Tax Court’s decision to
some portion of the settlement was attributable include contingent fees in gross income
to something other than actual damages. Of naturally gives the petitioners reasonable cause
course, some arbitrariness is inevitable when for failing to pay tax on that portion of the
segregating a litigation settlement into settlement, and the Commissioner does not
different categories of recovery in specific challenge the Tax Court’s refusal to penalize
amounts. But the petitioners argue only that the petitioners fo r their failure to pay tax on
the Tax Court ought to have allocated the the punitive damages portion.41 Therefore, the
entire settlement to actual damages. They fail only portion of the deficiency vulnerable to
utterly to show that the court’s judgment to penalty is that portion of the settlement award
the contrary, and the allocation methodology representing interest (after contingent fees are
the court subsequently adopts, constitute clear excluded).
error. We therefore affirm the Tax Court’s de-
cision with regard to interest and punitive We must remand to the Tax Court to
damages. determine whether interest (excluding
contingent fees) is alone sufficient to
V. constitute a substantial understatement of
Regarding the assessment of penalties, the taxSSthat is, whether the understatement is
both more than “(i) 10 percent of the tax
required to be shown on the return for the
(...continued) taxable year” and more than “(ii) $5,000.” 26
agreement, is the intent of the payor as to the pur- U.S.C. § 6662(d)(1)(A). If the Tax Court
pose in making the payment.”). determines that the underpayment attributable
39
In their initial brief on appeal, the petitioners
claim that collectability was their exclusive con-
40
cern. But in their reply brief, they admit that they See also Treas. Reg. § 1.6664-4.
also had concerns about sustaining the jury award
41
of punitive damages in the state appellate court. See note 5, supra.

14
to interest alone is “substantial” under the aspects of Federal tax law.” Treas. Reg.
statutory definition, the penalty should be § 1.6664-4(c)(1).
assessed, because there was no reasonable
cause for failure to pay tax on that portion of The petitioners seek refuge in the
the settlement. professional advice of their attorney in the
state court defamation litigation and their
For reasons already discussed, the certified public accountant. It was not
petitioners erred in failing to pay that tax. reasonable to rely on either, however.
They argue, however, that they should not be
penalized for that failure because they Petitioners’ attorney in the state court de-
reasonably relied on the advice of famation claim testified not only that he is not
professionals. Reviewing the Tax Court’s a tax lawyer, but that he advised his client to
rejection of the petitioners’ argument only for seek out a tax lawyer for tax advice. Also,
clear error,42 we affirm. petitioners do not dispute that they never gave
their accountant a copy of the settlement
Under the governing Treasury Regulations, agreement, an obviously important factual dis-
closure that precludes a finding of reasonable
[r]eliance on an information return or on reliance, because reliance is per se
the advice of a professional tax advisor unreasonable “if the taxpayer fails to disclose
or an appraiser does not necessarily a fact that it knows, or should know, to be
demonstrate reasonable cause and good relevant to the proper tax treatment of an
faith. . . . Reliance on an information item.” Treas. Reg. § 1.6664-4(c)(1)(i).
return, professional advice, or other
facts, however, constitutes reasonable There was no one both sufficiently qualified
cause and good faith if, under all the cir- and adequately knowledgeable about the case
cumstances, such reliance was on whom petitioners reasonably could have
reasonable and the taxpayer acted in relied. Consequently, the Tax Court did not
good faith. clearly err in finding that petitioners lacked
reasonable cause to support their substantial
Treas. Reg. § 1.6664-4(b)(1). “[R]eliance underpayment. Therefore, if the Tax Court on
may not be reasonable or in good faith if the remand determines that the failure to pay tax
taxpayer knew, or should have known, that the on interest alone (excluding contingent fees)
advisor lacked knowledge in the relevant constitutes a substantial underpayment under
the statutory definition, the Commissioner may
recalculate and assess a new penalty.

42
See Treas. Reg. § 1.6664-4(b)(1) (“The de- VI.
termination of whether a taxpayer acted with rea- In summary, we REVERSE the Tax
sonable cause and in good faith is made on a case- Court’s decision to tax contingent fees and
by-case basis, taking into account all pertinent REMAND for a recalculation of the deficiency
facts and circumstances.”); Streber v. Commis- and any appropriate penalties. We AFFIRM
sioner, 138 F.3d 216, 219 (5th Cir. 1998) (“This the Tax Court’s allocation of the settlement
court reviews the tax court’s findings of negligence proceeds among actual damages, interest, and
under the clearly erroneous rule. Clear error exists punitive damages.ENDRECORD
when this court is left with the definite and firm
conviction that a mistake has been made.”) (cita-
tions omitted).

15
DENNIS, Circuit Judge, concurring in part and dissenting in part:

I respectfully dissent from the majority opinion’s reversal of the Tax Court’s decision to tax the

clients on their attorney’s fees paid out of recovery of punitive damages and interest thereon. I

concur in the balance of the majority’s decision, however, for the reasons stated in its opinion.

In my opinion, Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959), based in part on Alabama

law, is distinguishable and not controlling in the present case based in part on Texas law. In Cotnam

a majority of this court’s panel held that the amount of a contingent fee paid out of a taxpayer’s

recovery in a breach of contract action was not income to the taxpayer. The sum was held to be

income to the attorneys but not to Mrs. Cotnam, the taxpayer, for the following reasons:

The Alabama Code provides: 'The attorneys at law shall have the same right and power
over said suits, judgments and decrees, to enforce their liens, as their clients had or may have
for the amount due thereon to them'. In construing this statute the Alabama courts have given
full effect to the statute. Attorneys have the same rights as their clients. Western Railway Co.
v. Foshee, 1913, 183 Ala. 182, 62 So. 500; Denson v. Alabama Fuel & Iron Co., 1916, 198
Ala. 383, 73 So. 525. Under Alabama law, therefore, Mrs. Cotnam could never have received
the $50,365.83, even if she had settled the case directly with the Bank.
In United States Fidelity & Guarranty Co. v. Levy, 5 Cir., 1935, 77 F.2d 972, 975,
Judge Hutcheson, speaking for the Court, held that the Alabama statute creates a
charge 'in the nature of an equitable assignment . . . (or) equitable lien' in the cause of
action. An attorney 'holding such an interest has an equity in the cause of action and
the recovery under it prior to that of the defendant in the judgment to exercise a right
of set-off accruing to him after the attorney's interest had attached.'
The facts in this unusual case, taken with the Alabama statute, put the taxpayer in
a position where she did not realize income as to her attorneys' interests of 40% in her
cause of action and judgment.
Id. at 124 (footnote quoting 46 Code of Alabama § 64 (1940) omitted).

Under Texas law attorneys do not have the same right and power as their clients in the clients’

16
causes of action, suits, judgments or decrees, to enforce attorney’s liens, interests or contingency fee

claims against the defendants. In Dow Chemical Company v. Benton, 357 S.W.2d 565, 567-68

(1962), the Texas Supreme Court held that an attorney may not prosecute a cause of action on his

own behalf to secure a contingent fee after his client, the original plaintiff, has been properly

dismissed from the case for refusal to appear for deposition. The contingent fee contract involved

there was virtually identical to the one in the present case.43 The client had agreed to “sell, transfer,

assign and convey to my said attorneys the respective undivided interests in and to my said claim .

. . and to any judgment or judgments that I may obtain or that may be rendered to me or my heirs and

assigns.” Id. at 566. The Texas Supreme Court explained:

[T]he lawyer’s rights, based on the contingent fee contract, are wholly derivative from
those of his client. The attorney-client relationship is one of principal and agent.
Texas Employers Ins. Ass'n v. Wermske, Tex., 349 S.W.2d 90 (1961). Therefore, the
rights of each in a cause of action during the existence of that relationship are
necessarily dependent upon and inseparably interwoven with the other. Neither
lawyer nor client should be permitted to select the good features of his contract and
reject the bad. There is but one cause of action. Our decisions uphold an agreement
to assign a part of the recovery on the cause of action to the attorney. But we have
never held that the cause of action is divisible and may be tried for only a percentage

43
In the present case, in addition to providing for payment of expenses, the contingent fee agreement
between the taxpayers and their attorneys provided in relevant part:
I/We,the undersigned, hereinafter called CLIENTS, employ the law firm of BRANTON &
HALL, P.C., hereinafter called ATTORNEYS, understanding that the legal services rendered
and to be rendered will be by ATTORNEYS of the professional corporation at its discretion.
CLIENTS hereby sell, convey, and assign to BRANTON & HALL, P.C., as consideration
for said services a forty percent (40%) interest in and to any and all causes of action, claims,
demands, judgment, or recoveries which CLIENTS may hold or receive because of damages
and injuries received and sustained by DR. SUDHIR SRIVASTAVA and DR. ELIZABETH
PASCUAL as a result of the television broadcasts on Channel 5 in February, 1985.

17
 of the cause of action.
....
. . . [A]s long as the attorney-client relationship endures, with its corresponding
legal effect of principal and agent, the acts of one must necessarily bind the other as
a general rule.
....
We do not reject the rationale that a properly worded contingent fee contract may
effect an assignment of part of the recovery and a part of a cause of action to the
attorney. However, the attorney who has received such an assignment invariably
elects to litigate his interest simultaneously with his client's interest, in his client's
name, and elects implicitly to be bound by any judgment properly rendered in the case.
We hold that so long as the existing agency relationship is not terminated, as by the
opposite party's buying out the client's interest, the attorney must be bound by that
election.
Id. at 567-68.

Consequently, under Texas law, unlike that of Alabama, an attorney is not granted by statute the

same right and power as his client over his client’s cause of action and judgment for the independent

enforcement of his attorney’s fee claim. Under Texas law, even when the attorney has been assigned

an ownership interest in his client’s cause of action, his rights remain wholly derivative from those

of his client; the attorney-client relationship remains one of principal and agent; the rights of the

lawyer and the client are inseparable, interdependent and interwoven; the client’s action is indivisible

and may not be tried for only a percentage of the cause of action. As long as the attorney-client

relationship endures, the acts of one must necessarily bind the other as a general rule. The attorney

who has received an assignment of a part of his client’s cause of action is deemed by law to have

elected to litigate his interest simultaneously with his client’s interest, in his client’s name, and to be

bound by any judgment properly rendered in the case. So long as the attorney-client relationship is

18
not terminated by the client’s actions purporting to settle the case with the opposite party litigant, the

attorney is bound by that election.

For these reasons and others assigned by the Tax Court or acknowledged in the majority’s candid

opinion, I conclude that the taxpayers in the present case did not by virtue of their attorney-client

contract divest themselves of part of their interest s in the claim, or vest a legal, independently

enforceable ownership interest in that claim in their attorneys. Accordingly, the taxpayers received

as income the portions of the settlement consisting of punitive damages and interest that were

earmarked for the payment of their attorney’s fees, and I believe that the taxpayers must pay taxes

on those proceeds.44 “[T]he taxpayer, even o n the cash receipts basis, who has fully enjoyed the

benefit of the economic gain represented by his right to receive income, can[not] escape taxation

because he has not himself received payment of it from his obligor. . . . [Taxation] may occur when

he has made such use or disposition of his power to receive or control the income as to procure in

its place other satisfactions which are of economic worth.” Helvering v. Horst, 311 U.S. 112, 116

(1940).

44
In response to footnote 33 of the majority opinion, out of an abundance of caution, it should be noted that
this case involves only the question of whether a client may avoid payment of income taxes on his recovery of
Texas noncompensatory punitive damages which this court held not excluded from the client’s gross income
by I.R.C. § 104(a)(2). See Estate of Moore v. Commissioner, 53 F.3d 712 (5th Cir. 1995). This case does not
affect § 104(a)(2)’s exclusion from gross income of a client’s recovery of compensatory damages for personal
injuries or sickness or the exclusions from gross income of punitive damages by I.R.C. § 104(c)(1996).

19