This challenge to a notice of deficiency requires us to determine whether the portion of a judgment or settlement payable to a taxpayer'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 contrary 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.

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 Srivastava of delivering poor quality medical care and committing acts that would have been criminal under Texas law. These reports destroyed Srivastava's practice and caused substantial 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 damages, $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

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 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.

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 their claim that the settlement award represented exclusively actual damages.

Rather than examining the settlement award in its entirety, and then dividing it among actual 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.

The petitioners contend that the portion of a judgment or litigation settlement payable to their attorney pursuant to a contingent fee agreement governed by Texas law is not gross income. This is a question of substantial importance, 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 Cotnam 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 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

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 obligor. The rule [of realization], founded on administrative convenience, 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 income. The Court concluded that such an arrangement 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 income. 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).

The question, therefore, is one of characterization, and, as we have recognized, is not always easy to apply in particular 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 poles--on 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.

The most widely-applied principle for implementing the anticipatory assignment of income doctrine is that a taxpayer who makes an assignment of future income streams but retains 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 attorney'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 claim--the income source or "tree"--is neither fully divested to the attorney nor fully retained by the taxpayer-client. Rather, the claim is subject to a sort of virtual co-ownership--"[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 agreement-the "fruit" of the tree--to the attorney, thereby avoiding realization by the client of that portion of income. But attorney retainer agreements accompanied by contingent fee provisions assign more than just the fruit---and 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 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.

It might be urged, for example, that, unlike the assignees in Earl and Horst, an attorney must perform to reap the benefitsof 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 doctrine 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 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 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 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.

Nor, as some courts have suggested, does uncertainty as to the value--indeed, not even uncertainty as to the fact--of 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 anticipatorily 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

The main reason for a client to sign a contingent fee contract, presumably, is not to avoid taxation by anticipatorily assigning future 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 recognizes that, to realize and maximize the value 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 reality. 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 gain--no less than the non-monetary gains recognized as income in Earl, Horst, and their progeny--is not to be excluded from gross income solely on the basis that the money is diverted to, and realized by, the taxpayer'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 method of compensation did not meaningfully affect the gain he was able to enjoy from a favorable resolution of the litigation.

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 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 affect 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 divests some measure of control over a claim but retains the rest, and how much control is sufficient 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

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 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.

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 pleadings in the underlying state court litigation. We cannot be certain that, in settling the dispute, 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 insurers were in fact focused on the portions of the verdict awarding interest and punitive damages. The jury awarded the petitioners actual damages of $11.5 million, an amount below 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 million to settle the litigation strongly suggests--indeed, conclusively indicates--that interest 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 by the petitioners' claim that they also were concerned about their prospects for upholding the verdict--particularly the punitive damages portion--on 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 insurers. 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 decision with regard to interest and punitive damages.

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 for 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 tax--that 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 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 circumstances, 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 defamation 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 disclosure 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.

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.

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' 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.1 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 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 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 interests 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.2 "[T]he taxpayer, even on 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).