Srivastava, et al v. CIR

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,
Circuit Judges.
JERRY E. SMITH, Circuit Judge:
This challenge to a notice of deficiency re-
quires us to determine whether the portion of
a judgment or settlement payable to a taxpay-
er’s attorney pursuant to a contingent fee
agreement governed by Texas law constitutes
gross income under § 61 of the Internal
Revenue Code, 26 U.S.C. § 61. Following
Cotnam v. Commissioner, 263 F.2d 119 (5th
Cir. 1959), which excluded from gross income
contingent fees governed by Alabama law, we
conclude that contingent fees paid according
to Texas law are also excludable.
We therefore reverse the Tax Court’s con-
trary conclusion and remand for a recalculation
of the deficiency and a new determination of
the propriety and size of any penalties. We
find no clear error in the Tax Court’s
allocation of the litigation settlement between
non-taxable items (that is, actual damages) and
taxable items (that is, interest and punitive
damages) and thus affirm on that issue.

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

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3
determinations) interest and punitive damages,
both of which are taxable,3 the Commissioner
of Internal Revenue issued a notice of
deficiency of $1,188,920 for tax year 1991 and
$33,037 for tax year 1992.4
The settlement agreement did not separate
the proceeds into the various categories of
recovery for (non-taxable) actual damages and
(taxable) interest and punitive damages, nor
did the parties discuss any method of
allocation. The Commissioner thus estimated
the amounts attributable to interest and
punitive damages by applying to the settlement
agreement the proportions of the original jury
verdict represented by interest and punitive
damages. The Commissioner also assessed
penalties of $237,784 for 1991 and $6,607 for
1992.
B.
The petitioners challenged the deficiency
notice in the Tax Court, which rejected their
argument that the portion of the settlement
payable to their attorneys under the contingent
fee agreement did not constitute gross income.
The Tax Court also rejected t heir claim that
the settlement award represented exclusively
actual damages.
Rather than examining the settlement award
in its entirety, and then dividing it among ac-
tual damages, interest, and punitive damages,
based on the proportions found in the original
jury verdict (as the Commissioner had done),
the Tax Court first broke the settlement down
by the various tiers established by the
settlement agreement, then matched each tier
to its corresponding portion of the jury award.
That is, the portion of the settlement
discharging the first $11.5 million, which the
jury had awarded for actual damages, was
attributed to actual damages. In other words,
the amounts paid by Continental Casualty and
the station were left untaxed.
The Tax Court attributed the balance of the
station’s payment to interest, a taxable item.
The payments from Columbia Casualty and
Hudson Insurance Company, representing the
remaining interest and punitive damages, was
made subject to tax.
The Tax Court reduced the deficiencies and
penalties accordingly. It disallowed the
assessment of penalties with respect to the
amount of deficiency attributable to punitive
damages, holding that the petitioners, though
wrong in doing so, had reasonable cause for
not reporting taxable income arising from the
portion of the settlement representing punitive
damages.5 The Tax Court left intact the
penalties with respect to interest.
III.
The petitioners contend that the portion of
a judgment or litigation settlement payable to
their attorney pursuant to a contingent fee
3 See 26 U.S.C. § 61(a)(4) (including interest
within gross income); O’Gilvie v. United States,
519 U.S. 79 (1996) (holding that punitive damages
are not awarded “on account of personal injuries or
sickness” pursuant to 26 U.S.C. § 104(a)(2) and
therefore constitute gross income).
4 The 1992 deficiency represents the elimination
of a net operating loss carryover attributable to the
settlement proceeds received in 1991.
5 It was not until O’Gilvie that the Court made
plain that punitive damages were not excludable
under 26 U.S.C. § 104(a)(2) and therefore were
subject to tax. See Robinson v. Commissioner,
102 T.C. 116 (1994) (holding that punitive dam-
ages are excludable from gross income under
26 U.S.C. § 104(a)(2)); Threlkeld v. Commis-
sioner, 87 T.C. 1294 (1986) (same); Roemer v.
Commissioner, 716 F.2d 693 (9th Cir. 1983)
(same).

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4
agreement governed by Texas law is not gross
income. This is a question of substantial im-
portance, for although attorney fee expenses,
if included within gross income, may be
deductible,6 various limitations may operate to
reduce the effectiveness of such deductions.7
Were we ruling on a tabula rasa, we might
be inclined to include contingent fees in gross
income. Principles of tax neutrality, if nothing
else, dictate that result, for when a taxpayer
recovers from a favorable judgment or
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
during oral argument). There is no apparent
reason to treat contingent fees differently or to
believe that Congress intended to subsidize
contingent fee agreements in such a fashion.
In Cotnam, however, this court excluded
contingent fees governed by Alabama law
from the client’s gross income. Because Cot-
nam is substantially indistinguishable from this
case, we reverse the Tax Court and decide that
contingent fees governed by Texas law are
also excludable. In doing so, we acknowledge
the circuit split on this issue, with the Sixth
Circuit recently adopting Cotnam’s reasoning,8
and the Third,9 Ninth,10 and Federal11 Circuits
6 Attorney’s fees are potentially deductible ei-
ther as an “ordinary and necessary expense[] paid
or incurred . . . in carrying on any trade or bus-
iness,” 26 U.S.C. § 162(a), or as an “ordinary and
necessary expense[] paid or incurred . . . for the
production or collection of income,” 26 U.S.C.
§ 212(1). Determining which deduction to apply
requires the use of the “origin of the claim” test.
See United States v. Gilmore, 372 U.S. 39, 49
(1963) (observing that “the origin and character of
the claim with respect to which an expense was in-
curred . . . is the controlling basic test of whether
the expense was ‘business’ or ‘personal’ and hence
whether [and how] it is deductible”). Because we
conclude that Srivastava’s contingent fees are ex-
cludable from gross income, we have no occasion
to decide which basis for a deduction would have
applied.
7 For example, “the miscellaneous itemized de-
ductions for any taxable year shall be allowed only
to the extent that the aggregate of such deductions
exceeds 2 percent of adjusted gross income.”
26 U.S.C. § 67(a). Section 68 of the Internal
Revenue Code limits the total amount of itemized
deductions allowed. See 26 U.S.C. § 68. Finally,
the alternative minimum tax also may operate to
reduce the value of a deduction. See 26 U.S.C.
§§ 55(b)(2), 56(b)(1)(A)(i). See also Barlow-
Davis v. Commissioner, 210 F.3d 1346, 1347 n.3
(11th Cir. 2000) (“The deduction for attorneys’
fees and costs which the IRS allowed was less fa-
vorable to the taxpayer than the exclu-
sion-from-income approach adopted by the Tax
Court because of the operation of technical tax
rules such as the alternative minimum tax.”);
Kenseth v. Commissioner, 2000 U.S. Tax Ct.
LEXIS 32, at *18, 114 T.C. No. 26 (2000) (“This
controversy is driven by the substantial difference
(continued...)
(...continued)
in the amount of tax burden that may result from
the parties’ approaches. The difference, of course,
is a consequence of the plain language of sections
56, 67, and 68, so the characterization of the
attorney’s fees as excludable or deductible becomes
critical.”). (Footnote omitted.)
8 See Estate of Clarks v. United States, 202
F.3d 854, 857 (6th Cir. 2000) (“We follow
Cotnam concluding that the majority in Cotnam
correctly distinguished Lucas v. Earl”).
9 See O’Brien v. Commissioner, 38 T.C. 707,
712 (1962), aff’d, 319 F.2d 532 (3rd Cir. 1963)
(holding that contingent attorney fees are “gross
income to [taxpayer] under the familiar principles
of Lucas v. Earl”).
10 See Coady v. Commissioner, 213 F.3d 1187,
____, 2000 U.S. App. LEXIS 13692, at *10 (9th
(continued...)

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5
including contingent fees in gross income.12
We also acknowledge the Tax Court’s
objection to Cotnam13 and note that, as it
properly has observed, in cases ultimately
appealable to this court,14 the Tax Court is
bound by our precedent.15
A.
Because the text of the Internal Revenue
Code is of little help,16 we turn to judicially-
developed tax law principles, one of which is
that any income or gain is not taxed until it is
“realized.”17 In addition, to combat
“anticipatory arrangements” designed to keep
income from ever being realized by one person
by the device of vesting, in advance of
realization, the rights to such income in
another, the Supreme Court has developed the
doctrine of anticipatory assignments of
income:18
In the ordinary case the taxpayer who
acquires the right to receive income is
taxed when he receives it, regardless of
the time when his right to receive
payment accrued. But the rule that
income is not taxable until realized has
never been taken to mean that the
taxpayer, . . . who has fully enjoyed the
benefit of the economic gain represented
by his right to receive income, can
escape taxation because he has not
himself received payment of it from his
(...continued)
Cir. June 14, 2000) (“We are persuaded by . . .
Judge Wisdom’s dissent in Cotnam.”); Brewer v.
Commissioner, 172 F.3d 875, 1999 U.S. App.
LEXIS 3568, at *2 (9th Cir. 1999), aff’g without
published opinion T.C. Memo. 1997-542 (“The
fact that [the taxpayer] did not actually receive the
gross payment and that the legal fees were paid
directly to counsel does not alter the fact that
Brewer received the benefit of the full settlement
amount.”).
11 See Baylin v. United States, 43 F.3d 1451,
1454-55 (Fed. Cir. 1995) (including contingent
fees in gross income).
12 The Eleventh Circuit is bound by holdings of
the former Fifth Circuit. See Davis, 210 F.3d at
1347 n.2.
13 See Kenseth, 2000 U.S. Tax Ct. LEXIS 32,
at *21 (“The Cotnam holding with respect to the
Alabama attorney lien statutes has been dis-
tinguished by this Court from cases interpreting the
statutes of numerous other states. Significantly,
this Court has, for nearly 40 years, not followed
Cotnam . . . .”) (collecting cases).
14 See 26 U.S.C. § 7482(a),(b).
15 See Golsen v. Commissioner, 54 T.C. 742,
756-57 (1970), aff’d, 445 F.2d 985 (10th Cir.)
(noting that “better judicial administration requires
us to follow a Court of Appeals decision which is
squarely in point where appeal from our decision
lies to that Court of Appeals and to that court
alone.”); Kenseth, 2000 U.S. Tax Ct. LEXIS 32,
at *29 (“With the exception of situations where . . .
we feel compelled to follow the holding of a Court
of Appeals, we have consistently held that at-
(continued...)
(...continued)
torney’s fees are not subtracted from taxpayers’
gross income to arrive at adjusted gross income.”).
16 See 26 U.S.C. § 61 (stating that “gross in-
come means all income from whatever source de-
rived”); James v. United States, 366 U.S. 213, 219
(1961) (noting “intention of Congress to tax all
gains except those specifically exempted,” and de-
fining gross income broadly to include all gains
from which, “when its recipient has such control
over it . . ., as a practical matter, he derives readily
realizable economic value”) (citations and quo-
tations omitted).
17 Helvering v. Horst, 311 U.S. 112, 116
(1940) (noting “the rule that income is not taxable
until realized “).
18 Lucas v. Earl, 281 U.S. 111, 115 (1930).

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6
obligor. The rule [of realization],
founded on administrative conven-
ience, is only one of postponement
of the tax to the final event of
enjoyment of the income, usually
the receipt of it by the taxpayer,
and not one of exemption from
taxation where the enjoyment is
consummated by some event other
than the taxpayer’s personal receipt
of money or property. This 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. . . .
[Under the anticipatory assignment of
income doctrine,] income is ‘realized’ by
the assignor because he, who owns or
controls the source of the income, also
controls the disposition of that which he
could have received himself and diverts
the payment from himself to others as
the means of procuring the satisfaction
of his wants. The taxpayer has equally
enjoyed the fruits of his labor or
investment and obtained the satisfaction
of his desires whether he collects and
uses the income to procure those
satisfactions, or whether he disposes of
his right to collect it as the means of
procuring them.
Horst, 311 U.S. at 115-17 (citations omitted).
The doctrine does not allow a taxpayer to
evade tax through an “arrangement by which
the fruits are attributed to a different tree from
that on which they grew.” Earl, 281 U.S.
at 115.
In other words, what is taxed is not
exclusively the receipt of funds, but rather any
enjoyment of gain, whether monetary or non-
monetary. For example, in the landmark Earl
case, the taxpayer had contracted with his wife
for her to receive half of any of his future in-
come. The Court concluded that such an ar-
rangement constituted an anticipatory
assignment of income and attributed all of the
income to the husband. Id. at 113-15.
Similarly, in Horst, the taxpayer, a holder of
a coupon bond, had made a gift of interest
coupons while retaining title to the bond. The
Court again held that such an arrangement
constituted an anticipatory assignment of in-
come. See Horst, 311 U.S. at 119-20. In both
cases, the taxpayer kept control of the asset or
income source and merely committed future
income streams to another. Such
arrangements cannot be used to evade tax.
On the other hand, the doctrine does not
apply to a taxpayer who transfers, sells, or
otherwise relinquishes an asset or income
source to another, because the taxpayer ceases
to receive any income from that asset
(excepting, of course, any gain realized from
the sale). After all, a taxpayer no longer
enjoys the fruits of a tree he no longer owns,
just as a taxpayer does not receive income
from “[t]he rent from a lease or a crop raised
on a farm after the leasehold or the farm had
been given away.” Id. at 119 (citing Blair v.
Commissioner, 300 U.S. 5, 12-13 (1937)).
Thus, where a stockholder had assigned to a
corporation his entire interest in a claim of
uncertain value against the government, this
court held that the anticipatory assignment of
income doctrine did not apply, because the
stockholder had fully divested himself of the
claim and thus no longer received any income
from that asset. See Jones v. Commissioner,
306 F.3d 292 (5th Cir. 1962).
B.
The question, therefore, is one of
characterization, and, as we have recognized,
is not always easy to apply in particular

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7
cases.19 There are, to be sure, “distinct and
identifiable principles which have been
developed in tax jurisprudence which serve to
guide . . . courts.” Id. at 296. As we shall see,
however, contingent fee contracts defy easy
categorization, standing as they do somewhere
in between the two polesSSon the one hand, an
obvious scheme to evade taxation through
diversion of future income streams to another,
and on the other hand, full and complete
divestment of an income source.
1.
The most widely-applied principle for im-
plementing the anticipatory assignment of in-
come doctrine is that a taxpayer who makes an
assignment of future income streams but re-
tains ownership and control over the source of
those funds has effected an anticipatory
assignment of income.20 The principle rests on
the sound inference that a taxpayer who
retains control over the tree, while handing out
its fruits, is in fact continuing to enjoy the
benefits of both. By contrast, a taxpayer who
has divested all dominion and control over a
tree cannot be said to enjoy gain from its
subsequent fruits.
Application of the taxpayer-dominion-and-
control principle to the case of contingent at-
torney’s fees yields no obvious answer,
however. We need not explore the entire
realm of attorney-client relations or articulate
all of their respective rights, duties, and
obligations to recognize that, when a client
hires an attorney to prosecute a claim on his
behalf, control over that claimSSthe income
source or “tree”SSis neither fully divested to
the attorney nor fully retained by the taxpayer-
client. Rather, the claim is subject to a sort of
virtual co-ownershipSS“[l]ike an interest in a
partnership agreement or joint venture.”
Clarks, 202 F.3d at 857.21
To put it another way, contingent fee
arrangements, to be sure, assign a percentage
of the proceeds of any judgment or settlement
agreementSSthe “fruit” of the treeSSto the at-
torney, thereby avoiding realization by the cli-
ent of that portion of income. But attorney re-
tainer agreements accompanied by contingent
fee provisions assign more than just the
fruitSSand yet divest clients of something less
than the entire tree. Contingent fees are thus
in a sense
more like a division of property than an
assignment of income. Here the client
as assignor has transferred some of the
trees in his orchard, not merely the fruit
19 See Jones, 306 F.2d at 296 (stating that
anticipatory assignment of income cases “are not
easy to decide. In seeking to reconcile the im-
plications of the infinite variety of facts presented
by the decided cases and all that has been said
about the subject of anticipatory assignment of
income, one is likely to be displeased with his own
wits; and may find his mind teetering between con-
flicting conclusions. . . . ‘Drawing the line’ is a re-
current difficulty in those fields of the law where
differences in degree produce ultimate differences
in kind.”).
20 See Horst, 311 U.S. at 119 (“We have held
without deviation that where the donor retains
control of the trust property the income is taxable
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-
come, it has been assumed that the person to whom
the income was attributed could have received it.
The underlying assumption always has been that in
order to be taxed for income, a taxpayer must have
complete dominion over it.”).
21 But see Kenseth, 2000 U.S. Tax Ct. LEXIS
32, at *31 (“Attorneys represent the interests of
clients in a fiduciary capacity. It is difficult, in
theory or fact, to convert that relationship into a
joint venture or partnership.”).

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8
from the trees. The lawyer has
become a tenant in common of the
orchard owner and must cultivate
and care for and harvest the fruit of
the entire tract.
Id. at 857-58.
The control test thus leaves us in a
quandary. In light of this ambiguity, a number
of other factors might be considered.
2.
It might be urged, for example, that, unlike
the assignees in Earl and Horst, an attorney
must perform to reap the benefits of the
contingent fee agreement.22 Certainly, a client
contemplates that an attorney will work to
earn his contingent share of any award.
Indeed, the Sixth Circuit has so noted:
Here the lawyer’s income is the result of
his own personal skill and judgment, not
the skill or largess of a family member
who wants to split his income to avoid
taxation. The income should be charged
to the one who earned it and received it,
not as under the government’s theory of
the case, to one who neither received it
nor earned it.
Id.
Similarly, some courts have noted that Earl
and Horst involved gratuitous transfers.23 A
contingent fee agreement, by contrast, is an
arm’s-length commercial transaction; we are
hard-pressed to imagine a client who would
offer his attorney a pure gratuity.
The anticipatory assignment of income doc-
trine does not recognize such distinctions,
however, for the purpose of the doctrine is
simply to capture the taxpayer who diverts a
stream of income to achieve gain in non-
monetary form and to prevent him from
evading taxation through such an arrangement.
“[I]ncome is ‘realized’ by the assignor
because he, who owns or controls the
source of the income, also controls the
disposition of that which he could have
received himself and diverts the payment
from himself to others as the means of
procuring the satisfaction of his wants.
The taxpayer has equally enjoyed the
fruits of his labor or investment and ob-
tained the satisfaction of his desires
whether he collects and uses the income
to procure those satisfactions, or wheth-
er he disposes of his right to collect it as
the means of procuring them.”
Horst, 311 U.S. at 117.
It therefore may be true that gratuitous
transfers are particularly good opportunities
for a taxpayer to enjoy his fruits in advance of
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
anticipatory assignments in that context,
however. To the contrary, a taxpayer who
anticipatorily assigns future streams of income
to obtain services in return has quite obviously
22 See Clarks, 202 F.3d at 857 (distinguishing
Earl and Horst on the ground that “[t]he assignee
[in those cases] performed no services in order to
receive the income”).
23 See Jones, 306 F.2d at 302 (“No gra-
tuity or gift is involved here as has been involved in
numerous other cases. So far as the record dis-
(continued...)
(...continued)
closes, the assignment contract was an arm’s length
transaction.”).

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9
procured a benefit.24
Thus, where a medical partnership arranged
for its patient group to fund a separate
retirement trust for the benefit of the
partnership’s physicians, without ever vesting
those funds in the partnership, the Supreme
Court applied the anticipatory assignment of
income doctrine and required the partnership
to pay tax on the funds deposited into the
retirement trust. See United States v. Basye,
410 U.S. 441, 448-53 (1973). That the
payment was made at arm’s length, rather than
as a gratuity, was of no significance.
3.
Nor, as some courts have suggested, does
uncertainty as to the valueSSindeed, not even
uncertainty as to the factSSof a contingent fee
preclude application of the anticipatory
assignment doctrine.25 There is no questioning
the fact that the value of a claim is often
uncertain and difficult to predict.26 But just
because a future income stream (or “harvest,”
if you will) is of uncertain value does not mean
a taxpayer cannot achieve gain from anticipa-
torily assigning it to another. The taxpayer in
Earl, after all, was taxed on the portion of his
future salary anticipatorily assigned to his
spouse; that there was some degree of inherent
uncertainty in his future income stream went
without comment and did not preclude
application of the doctrine. See Earl, 281 U.S.
at 113-15.27
4.
The main reason for a client to sign a
24 See Kenseth, 2000 U.S. Tax Ct. LEXIS 32,
at *26 n.4 (“[T]he transfer of trees in and of itself
could be consideration in kind and result in gains to
the taxpayer. More significantly, if the trees are
analogous to the taxpayer’s chose in action or com-
pensatory rights, then the transfer represents a
classic anticipatory assignment of income.”).
25 See First Sec. Bank, 405 U.S. at 403-04
(noting that “the assignment-of-income doctrine
assumes that the income would have been received
by the taxpayer had he not arranged for it to be
paid to another”); Jones, 306 F.2d at 301 (“We
believe it appropriate to point out that the claim . . .
was at the time of assignment . . . uncertain,
doubtful and contingent.”); Clarks, 202 F.3d
at 857 (noting that, in Earl and Horst, “the income
assigned to the assignee was already earned, vest-
ed, and relatively certain”).
26 See Jones, 306 F.2d at 301 (“Indeed, lawsuits
(continued...)
(...continued)
are rarely certain and free of doubt. Experienced
lawyers have long since learned that it is unwise
and indeed, ultra foolish to predict the results of
litigation. . . . When this assignment was made
over five months before the Court of Claims an-
nounced its decision, over nine months before the
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
confident because he believed in the justice of his
claim, certainly he could not be said to have
sufficient insight reasonably to speculate what the
United States Court of Claims would ultimately
decide.”); Cotnam, 263 F.2d at 125 (Rives and
Brown, JJ., concurring) (noting that taxpayer who
merely had a claim to pursue in court was “a long
way from having the equivalent of cash. Her claim
had no fair market value, and it was doubtful and
uncertain as to whether it had any value.”).
27 See also Baylin, 43 F.3d at 1455 (noting that
the “temporarily uncertain magnitude of the legal
fees under such an arrangement and the vehicle of
an assignment cannot dictate the income tax treat-
ment of those fees.”); Kenseth, 2000 U.S. Tax Ct.
LEXIS 32, at *30-*31 (“Despite characterizing
petitioner’s right to recovery as speculative, his
cause of action had value in the very beginning;
otherwise, it is unlikely that [his attorneys] would
have agreed to represent petitioner on a contingent
basis.”).

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10
contingent fee contract, presumably, is not to
avoid taxation by anticipatorily assigning fu-
ture streams of income to others in exchange
for non-monetary benefits. More likely, he
signs it to secure the services of an attorney
without having to put any capital at risk, and
to encourage the attorney to perform well by
offering a personal stake in the claim.
A taxpayer who enters into the contract re-
cognizes that, to realize and maximize the val-
ue of his claim, he must necessarily obtain the
resources and expertise of counsel.28 But of
course, the same is true of a client who retains
counsel on a non-contingent fee basis. The
fact that a contingent fee arrangement has the
added benefits of risk-shifting and realignment
of incentives does not alter the economic re-
ality. Such an arrangement diverts a portion of
the litigation proceeds from the client to the
attorney, thereby accruing to the client non-
monetary gain from enjoying the assistance of
counsel without otherwise having to pay for
it.29 That gainSSno less than the non-monetary
gains recognized as income in Earl, Horst, and
their progenySSis not to be excluded from
gross income solely on the basis that the mon-
ey is diverted to, and realized by, the tax-
payer’s assignee.
That is to say, if there were no contingent
fee arrangement, Srivastava presumably would
have had to compensate counsel out of his
own pocket, rather than rely wholly on the
income stream arising from his claim. He
ought not receive preferential tax treatment
from the simple fortuity that he hired counsel
on a contingent basis,30 for his attorney’s me-
thod of compensation did not meaningfully
affect the gain he was able to enjoy from a
favorable resolution of the litigation.
C.
Thus, were we to decide this case as an
original matter, we might apply the
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
Brown, JJ., concurring) (“The only economic ben-
efit she could then derive from her claim was to use
a part of it in helping her to collect the remain-
der. . . . [Her] claim . . . was worthless without the
aid of skillful attorneys. At the time that she en-
tered into the contingent fee contract, she had rea-
lized no income from the claim, and the only use
she could make of it was to transfer a part so that
she might have some hope of ultimately enjoying
the remainder. . . . [S]he could never have col-
lected anything or have enjoyed any economic ben-
efit unless she had employed attorneys . . . .”);
Clarks, 202 F.3d at 857 (“[T]he value of tax-
payer’s lawsuit was entirely speculative and de-
pendent on the services of counsel. The claim sim-
ply amounted to an intangible, contingent expec-
tancy. The only economic benefit Clarks could
derive from his claim against the defendant in state
court was to use the contingent part of it to help
him collect the remainder.”).
29 See Old Colony Trust Co. v. Commissioner,
279 U.S. 716, 729 (1929) (“The discharge by a
third person of an obligation to him is equivalent to
receipt by the person taxed.”); Baylin, 43 F.3d
at 1545 (reasoning that “although the partnership
did not take actual possession of the funds it paid
to its attorney, opting instead to pay him directly
out of its eventual recovery, it is evident that the
partnership received the benefit of those funds in
that the funds served to discharge the obligation of
the partnership owing to the attorney as a result of
the attorney’s efforts to increase the settlement
amount”).
30 See Kenseth, 2000 U.S. Tax Ct. LEXIS 32,
at *26 (observing that “taxable recoveries in law-
suits are gross income in their entirety to the party-
client and . . . associated legal feesSScontingent or
otherwiseSSare to be treated as deductions”) (foot-
note omitted).

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11
clean slate, but must follow the contrary
approach endorsed in Cotnam.
Cotnam dealt with a contingent fee
agreement governed by Alabama law. A
majority of that panel held that contingent
attorney’s fees are not subject to tax under the
anticipatory assignment of income doctrine.
The majority reasoned that, before judgment
or settlement, a claim is of uncertain value, and
that the lawyer’s services are necessary to
convert that claim into value to the taxpayer.
See Cotnam, 263 F.2d at 125-26 (Rives and
Brown, JJ., concurring).31 Applying the
familiar tree/fruit metaphor of Earl, the
majority explained that “Mrs. Cotnam’s tree
had borne no fruit and would have been barren
if she had not transferred a part interest in that
tree to her attorneys, who then rendered the
services necessary to bring forth the fruit.” Id.
at 126 (Rives and Brown, JJ., concurring).
The Commissioner invites us to distinguish
Cotnam on the ground that we are faced with
contingent fees governed by the law of Texas,
not Alabama. The distinction rests on the
predicate that Alabama gives its contingent fee
attorneys a greater degree of power to enforce
their rights than does Texas.32
These distinctions, however, should not af-
fect the analysis required by the anticipatory
assignment of income doctrine, which looks to
the taxpayer’s degree of control and dominion
over the asset. As we have said, a taxpayer
who enters into a contingent fee contract di-
vests some measure of control over a claim but
retains the rest, and how much control is suf-
ficient to trigger taxation under the
anticipatory assignment of income doctrine is
not easily answerable. But we find no
assistance from the fact that Alabama may
offer its contingent fee attorneys, by way of
example, greater power to pursue relief
directly against the opposing party. Whatever
are the attorney’s rights against the defendant
under Texas law as opposed to Alabama law,
the discrepancy does not meaningfully affect
the economic reality facing the taxpayer-
plaintiff.33
31 The additional language offered by Judges
Rives and Brown offers the best insight into the
majority’s reasoning. Technically, it is Judge Wis-
dom’s opinion that speaks for the court. As he ex-
pressly notes in his majority opinion, however,
Judge Wisdom speaks not for himself, but only for
Judges Rives and Brown, in excluding contingent
attorney’s fees from gross income. See Cotnam,
263 F.2d at 125 (“A majority of the Court, Judges
Rives and Brown, hold that [attorney’s fees] should
not be included in [the taxpayer’s] gross income.”).
See also id. at 126-27 (Wisdom, J., dissenting).
We therefore take little guidance from Judge Wis-
dom’s majority opinion, which speaks narrowly to
the attorney’s rights under Alabama law governing
contingent fees and offers only cursory analysis to
support the ultimate judgment.
32 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
limiting it to those contingent fee arrangements in
whichSSas Alabama law providesSSan attorney
can pursue a claim against the opposing party on
his own, apart from the client’s decision to pursue
that claim. See ALA. CODE § 34-3-61(b) (stating
that “attorneys-at-law shall have the same right and
power over action or judgment to enforce their liens
as their clients had or may have for the amount due
thereon to them”). By contrast, the dissent would
include, within gross income, contingent fees gov-
erned by Texas law, for, under Texas law, as the
dissent correctly notes, “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,” and “the client’s action is
indivisible and may not be tried for only a per-
(continued...)

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12
We therefore agree with the Tax Court
that, irrespective of whether it is proper to tax
contingent attorney’s fees under the
anticipatory assignment doctrine, the answer
does not depend on the intricacies of an
attorney’s bundle of rights against the
opposing party under the law of the governing
state.34 In refusing the Commissioner’s
request to distinguish Cotnam (as the Tax
Court has grudgingly done on occasion35), we
note that what the Commissioner truly seeks is
(...continued)
centage of the cause of action.” See also Dow,
357 S.W.2d at 567-68.
That this distinction is without a difference for
purposes of the anticipatory assignment of income
doctrine, however, is made clear simply by com-
paring the laws governing contingent fee arrange-
ments in Alabama and Texas to the Supreme
Court’s two landmark decisions establishing the
doctrine. In Horst, the taxpayer, “the owner of ne-
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
same year collected them at maturity.” See Horst,
311 U.S. at 114. That arrangement is similar to
the severable contingent fee agreement provided
under Alabama law and at issue in Cotnam; like
the Alabama contingent fee lawyer, the holder of
the negotiable interest coupon in Horst needs no
further action from the holder of the underlying
negotiable bond to recover on the coupon.
By contrast, in Earl (decided ten years before
Horst), the taxpayer had merely contracted away
half of his future salary to his wife. See Earl, 281
U.S. at 113-14. Like the Texas contingent fee law-
yer, Earl’s wife could not enjoy the benefits of the
agreement absent the continued efforts of her
spouse.
The Earl CourtSSlike the instant dis-
sentSSreasoned that such an arrangement was not
enough to allow the taxpayer to exclude income. In
Horst, the Court noted that the court below had
“thought that as the consideration for the coupons
had passed to the obligor, the donor had, by the
gift, parted with all control over them and their
payment, and for that reason the case was dis-
tinguishable from Lucas v. Earl.” Horst, 311 U.S.
at 114-15. But the Court rejected that argument,
ultimately finding the two cases indistinguishable.
Similarly, Cotnam is indistinguishable from the
instant case, and thus however the anticipatory as-
signment of income doctrine applies in one case,
principles of consistency dictate that the doctrine
(continued...)
(...continued)
apply similarly in the other. Rightly or wrongly,
this court in Cotnam decided not to apply the an-
ticipatory assignment of income doctrine to contin-
gent fee agreements. What the Commissioner and
the dissent urge, in effect, is that we use whatever
means necessary to avoid Cotnam. The Tax Court
has already rejected that approach, and we do so as
well.
34 See O’Brien, 38 T.C. at 712 (“In reaching
that conclusion the majority [in Cotnam] placed
considerable stress upon certain provisions of an
Alabama statute relating to attorneys’ liens. . . .
However, we think it doubtful that the Internal
Revenue Code was intended to turn upon such
refinements. For, even if the taxpayer had made an
irrevocable assignment of a portion of his future
recovery to his attorney to such an extent that he
never thereafter became entitled thereto even for a
split second, it would still be gross income to him
under the familiar principles of [Earl and
Horst].”); Kenseth, 2000 U.S. Tax Ct. LEXIS 32,
at *29 (rejecting distinction, quoting O’Brien, and
“declin[ing] to decide this case based on the pos-
sible effect of various States’ attorney’s lien stat-
utes”) (footnote omitted).
35 See Kenseth, 2000 U.S. Tax Ct. LEXIS 32,
at *21 (“The Cotnam holding with respect to the
Alabama attorney lien statutes has been distin-
guished by this Court from cases interpreting the
statutes of numerous other states. Significantly,
this Court has, for nearly 40 years, not followed
Cotnam . . . .”) (collecting cases).

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13
a direct challenge to Cotnam, in the Eleventh
Circuit36 as well as here. We decline that
invitation and, instead, reverse the Tax Court’s
decision to include contingent fees within
gross income and remand for a recalculation of
the deficiency.
IV.
The petitioners challenge the Tax Court’s
decision to attribute portions of the settlement
agreement to recovery for actual damages
(which are not taxable) and other portions to
interest and punitive damages (which are
taxable). They contend that the entire
settlement represents actual damages.
We determine the tax treatment of
judgments and settlements by asking “in lieu of
what was the judgment or litigation settlement
awarded?” Knuckles v. Commissioner, 349
F.3d 610 (10th Cir. 1965).37 We review the
allocations made by the Tax Court only for
clear error. See id. at 612. Finding none, we
affirm that portion of the decision.
The petitioners urge that the settlement
ought to represent actual damages exclusively,
because the settlement award is identical to the
amount their complaint had sought for actual
damages. Not only is this factually untrue (in
that petitioners prayed for actual damages “in
an amount in excess of $8,500,000.00”), but it
is also not the only plausible explanation, even
if we were to restrict our analysis to the plead-
ings in the underlying state court litigation.
We cannot be certain that, in settling the dis-
pute, the parties restricted their attention to
actual damages and ignored the petitioners’
claim for $2,000,000 or more in punitive
damages, or their claim for interest.
To the contrary, although it did not state
any method of allocation, the tiered settlement
agreement demonstrated that the station’s in-
surers were in fact focused on the portions of
the verdict awarding interest and punitive
damages. The jury awarded the petitioners ac-
tual damages of $11.5 million, an amount be-
low the level of liability triggering coverage
under the Columbia Casualty Company and
Hudson Insurance Company policies (that is,
below the $12 million to $22 million range).
That those two insurers agreed to pay $3 mil-
lion to settle the litigation strongly sug-
gestsSSindeed, conclusively indicatesSSthat in-
terest and punitive damages played some role
in settlement negotiations.
Nor does this approach in any way
undercut the petitioners’ assertion that
punitive damages were the most vulnerable to
reduction, or even outright elimination, on
appeal. Based on the Tax Court’s
methodology, of the $11.5 million awarded by
the jury for actual damages, combined with
additional sums for interest, Srivastava
received $6 million. By contrast, though the
jury awarded $17.5 million in punitive
damages, the settlement agreement provided
only $3 million.
The petitioners also assert that, in settling
the dispute, they were motivated solely by
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.
37 See also Raytheon Prod. Corp. v. Com-
missioner, 144 F.2d 110, 113 (1st Cir. 1944)
(same).
38 See Knuckles, 349 F.2d at 613 (“The most
important fact in making that determination, in the
absence of an express personal injury settlement
(continued...)

-- 13 of 19 --

14
by the petitioners’ claim that they also were
concerned about their prospects for upholding
the verdictSSparticularly the punitive damages
portionSSon appeal.39
Even if petitioners were exclusively
motivated by collection concerns, that merely
addresses the need for some kind of negotiated
settlement with the station and its solvent in-
surers. Such concerns do not implicate, in any
way, the allocation of that settlement among
actual damages, interest, and punitive
damages; indeed, the petitioners’ own brief at
times unwittingly concedes as much. Their
stated motives do not raise the level of doubt
about the Tax Court’s allocation methodology
necessary to trigger reversal for clear error.
The Tax Court correctly concluded that
some portion of the settlement was attributable
to something other than actual damages. Of
course, some arbitrariness is inevitable when
segregating a litigation settlement into
different categories of recovery in specific
amounts. But the petitioners argue only that
the Tax Court ought to have allocated the
entire settlement to actual damages. They fail
utterly to show that the court’s judgment to
the contrary, and the allocation methodology
the court subsequently adopts, constitute clear
error. We therefore affirm the Tax Court’s de-
cision with regard to interest and punitive
damages.
V.
Regarding the assessment of penalties, the
Internal Revenue Code provides that “there
shall be added to the tax an amount equal to
20 percent of the portion of . . . any
underpayment which is attributable to 1 or
more of the following: . . . (2) Any substantial
understatement of income tax.” 26 U.S.C. §
6662(a), (b). An understatement is
“substantial” if it is both more than “(i) 10
percent of the tax required to be shown on the
return for the taxable year” and more than “(ii)
$5,000.” 26 U.S.C. § 6662(d)(1)(A). “No
penalty shall be imposed . . . with respect to
any portion of an underpayment if it is shown
that there was a reasonable cause for such
portion and that the taxpayer acted in good
faith with respect to such portion.” 26 U.S.C.
§ 6664(c)(1).40
Our reversal of the Tax Court’s decision to
include contingent fees in gross income
naturally gives the petitioners reasonable cause
for failing to pay tax on that portion of the
settlement, and the Commissioner does not
challenge the Tax Court’s refusal to penalize
the petitioners fo r their failure to pay tax on
the punitive damages portion.41 Therefore, the
only portion of the deficiency vulnerable to
penalty is that portion of the settlement award
representing interest (after contingent fees are
excluded).
We must remand to the Tax Court to
determine whether interest (excluding
contingent fees) is alone sufficient to
constitute a substantial understatement of
taxSSthat is, whether the understatement is
both more than “(i) 10 percent of the tax
required to be shown on the return for the
taxable year” and more than “(ii) $5,000.” 26
U.S.C. § 6662(d)(1)(A). If the Tax Court
determines that the underpayment attributable
(...continued)
agreement, is the intent of the payor as to the pur-
pose in making the payment.”).
39 In their initial brief on appeal, the petitioners
claim that collectability was their exclusive con-
cern. But in their reply brief, they admit that they
also had concerns about sustaining the jury award
of punitive damages in the state appellate court.
40 See also Treas. Reg. § 1.6664-4.
41 See note 5, supra.

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15
to interest alone is “substantial” under the
statutory definition, the penalty should be
assessed, because there was no reasonable
cause for failure to pay tax on that portion of
the settlement.
For reasons already discussed, the
petitioners erred in failing to pay that tax.
They argue, however, that they should not be
penalized for that failure because they
reasonably relied on the advice of
professionals. Reviewing the Tax Court’s
rejection of the petitioners’ argument only for
clear error,42 we affirm.
Under the governing Treasury Regulations,
[r]eliance on an information return or on
the advice of a professional tax advisor
or an appraiser does not necessarily
demonstrate reasonable cause and good
faith. . . . Reliance on an information
return, professional advice, or other
facts, however, constitutes reasonable
cause and good faith if, under all the cir-
cumstances, such reliance was
reasonable and the taxpayer acted in
good faith.
Treas. Reg. § 1.6664-4(b)(1). “[R]eliance
may not be reasonable or in good faith if the
taxpayer knew, or should have known, that the
advisor lacked knowledge in the relevant
aspects of Federal tax law.” Treas. Reg.
§ 1.6664-4(c)(1).
The petitioners seek refuge in the
professional advice of their attorney in the
state court defamation litigation and their
certified public accountant. It was not
reasonable to rely on either, however.
Petitioners’ attorney in the state court de-
famation claim testified not only that he is not
a tax lawyer, but that he advised his client to
seek out a tax lawyer for tax advice. Also,
petitioners do not dispute that they never gave
their accountant a copy of the settlement
agreement, an obviously important factual dis-
closure that precludes a finding of reasonable
reliance, because reliance is per se
unreasonable “if the taxpayer fails to disclose
a fact that it knows, or should know, to be
relevant to the proper tax treatment of an
item.” Treas. Reg. § 1.6664-4(c)(1)(i).
There was no one both sufficiently qualified
and adequately knowledgeable about the case
on whom petitioners reasonably could have
relied. Consequently, the Tax Court did not
clearly err in finding that petitioners lacked
reasonable cause to support their substantial
underpayment. Therefore, if the Tax Court on
remand determines that the failure to pay tax
on interest alone (excluding contingent fees)
constitutes a substantial underpayment under
the statutory definition, the Commissioner may
recalculate and assess a new penalty.
VI.
In summary, we REVERSE the Tax
Court’s decision to tax contingent fees and
REMAND for a recalculation of the deficiency
and any appropriate penalties. We AFFIRM
the Tax Court’s allocation of the settlement
proceeds among actual damages, interest, and
punitive damages.ENDRECORD
42 See Treas. Reg. § 1.6664-4(b)(1) (“The de-
termination of whether a taxpayer acted with rea-
sonable cause and in good faith is made on a case-
by-case basis, taking into account all pertinent
facts and circumstances.”); Streber v. Commis-
sioner, 138 F.3d 216, 219 (5th Cir. 1998) (“This
court reviews the tax court’s findings of negligence
under the clearly erroneous rule. Clear error exists
when this court is left with the definite and firm
conviction that a mistake has been made.”) (cita-
tions omitted).

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16
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 of 19 --

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
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

-- 17 of 19 --

18
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 of 19 --

44In 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
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).

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