                        T.C. Memo. 1998-362


                      UNITED STATES TAX COURT



  SUDHIR P. SRIVASTAVA AND ELIZABETH S. PASCUAL, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 26605-95.             Filed October 6, 1998.



     Michael D. Cropper, for petitioners.

     W. Mark Scott, for respondent.


            MEMORANDUM FINDINGS OF FACT AND OPINION

     PARR, Judge:   Respondent determined deficiencies in, and

penalties on, the Federal income tax for 1991 and 19921 of Sudhir

P. Srivastava (petitioner) and Elizabeth S. Pascual (Pascual) as

follows:

                               Accuracy-Related Penalty
     Year      Deficiency            Sec. 6662(a)
     1991      $1,188,920              $237,784
     1992          33,037                 6,607


     1
        The deficiency for 1992 is for petitioners' short taxable
year that began on Jan. 1, 1992, and ended July 7, 1992.
                                - 2 -

    All section references are to the Internal Revenue Code in

effect for the taxable years in issue, and all Rule references

are to the Tax Court Rules of Practice and Procedure, unless

otherwise indicated.    All dollar amounts are rounded to the

nearest dollar, unless otherwise indicated.

     The issues for decision are:    (1) Whether petitioners may

exclude from their gross income contingent fees of $3,455,500

paid to their attorneys from the settlement proceeds of

petitioner's personal injury suit.      We hold they may not.   (2)

Whether under section 104(a)(2) petitioners may exclude from

their gross income the entire amount of the settlement petitioner

received in 1991.   We hold a portion of the amount petitioner

received in settlement is attributable to punitive damages and

interest and is taxable income to petitioners in the year it was

received.   (3) Whether petitioners may deduct the attorney's fees

under section 162(a).    We hold they may not deduct the attorney's

fees under section 162(a), but they may deduct the fees under

section 212(1), to the extent set out below.      (4) Whether

petitioners are liable for an accuracy-related penalty pursuant

to section 6662 for 1991 and 1992.      We hold they are to the

extent set out below.

                          FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulated facts and the accompanying exhibits are
                               - 3 -

incorporated into our findings by this reference.    Petitioners

were husband and wife during the taxable years at issue and filed

1991 and 1992 Forms 1040, U.S. Individual Income Tax Return,

using the status of "Married filing joint return".    At the time

the petition in this case was filed, petitioners resided in

Midland, Texas.

     Petitioner and Pascual are medical doctors.    In 1970,

petitioner graduated from a medical school in India.    He came to

St. Louis in 1972 for a residency in general surgery and later

went to Canada to complete a residency in general and

cardiothoracic surgery.   In 1981, petitioner returned to the

United States to practice medicine in Texas.   Petitioner is

certified as having an adequate level of training and practice

for the cardiac surgery specialty by the American Board of

Specialties Surgery and by the American Board of Thoracic

Surgery.

The Lawsuit

     In 1984 and 1985, petitioner was practicing as a

cardiovascular thoracic surgeon in San Antonio, Texas.    On

February 8, 1985, a San Antonio television station, KENS-TV,

began broadcasting a series of investigative reports about

petitioner and his practice entitled "A Second Opinion".    KENS-TV

is a wholly owned subsidiary of Harte-Hanks Television, Inc.,

which in turn is owned by Harte-Hanks Communications, Inc.

(Harte-Hanks Television, Inc., and Harte-Hanks Communications,
                              - 4 -

Inc., are referred to hereinafter as Harte-Hanks).    The reports

claimed that petitioner performed unnecessary surgery and

delivered poor quality medical care; the reports alleged acts

that would be criminal under the laws of Texas.    As a result of

the broadcast reports, petitioner's reputation and medical

practice were destroyed, his hospital privileges were revoked,

his medical malpractice insurance was canceled, and he was

subjected to multiple malpractice suits.

     After the series aired, petitioner brought suit in the 224th

Judicial District Court of Bexar County, Texas, based upon

defamation due to libelous and false statements, invasion of

privacy, infliction of emotional distress, tortious interference

with contracts, libel per se, and loss of medical practice,

patients, and potential patients.2    Petitioner pled for actual

damages in an amount in excess of $8,500,000 and punitive damages

in an amount in excess of $2 million, with prejudgment interest

on damages, and interest on the judgment at the legal rate from

date of judgment.

     The case was tried before a jury in San Antonio during March

and April 1990 resulting in a verdict on April 10, 1990.    The

jury found that the broadcast series was defamatory and false,

impeached the honesty, integrity, virtue, or professional



     2
        The suit was styled Sudhir Srivastava, M.D. vs. Harte-
Hanks Television, Inc. d/b/a KENS-TV and Harte-Hanks
Communication, Inc..
                                 - 5 -

reputation of petitioner, and exposed him to public hatred,

ridicule, or financial injury; and that the television station

acted with knowledge of the falsity or with reckless disregard

for the truth or falsity of the subject matter of the broadcasts.

The jury also found that the series constituted an intentional

infliction of emotional distress and trauma on petitioner.

     The jury awarded petitioner $11,500,000 in actual damages,

composed of the following amounts:       $1,750,000 for loss of past

earnings from his medical practice, $5 million for loss of future

earning capacity, $1 million for past mental anguish, including

embarrassment and humiliation, $500,000 for future mental

anguish, $1,500,000 for loss of past reputation, and $1,750,000

for future loss of reputation.    In addition, the jury awarded

punitive damages of $17,500,000, bringing the total award to $29

million, plus interest.

     Petitioner moved for a posttrial amendment of his pleadings

to allow for damages in excess of $10,500,000, the total amount

he initially sought in his suit, and the court allowed petitioner

to amend his pleadings to conform to the adduced proof and the

jury's verdict.   The district court then entered judgment (the

judgment).

     Of the $11,500,000 in actual damages, the court found that

$4,250,000 represented actual damages that had occurred between

the date of the broadcast and the date of the judgment.

Prejudgment interest of $2,597,201 had accrued on this portion of
                               - 6 -

the award, which brought the total actual damages and prejudgment

interest to $14,097,201 and the total actual and punitive damages

and prejudgment interest to $31,597,201.     Postjudgment interest

of 10 percent per annum as provided by Texas law was ordered to

be paid on this total sum.

     After the judgment was entered, Harte-Hanks moved for a new

trial, but its motion was denied on June 15, 1990.     On August 3,

1990, Harte-Hanks appealed the case to the Court of Appeals for

the Fourth Court of Appeals District, San Antonio.3     However,

while the appeal was pending, the parties agreed to settle.

The Insurance Coverage

     Harte-Hanks' insurance coverage, which insured it against

loss attributable to petitioner's claims against it, was

"tiered".   That is, no insurance company provided coverage for

the full range of Harte-Hanks' potential liability; rather,

insurance was provided by several companies, and each insurance

company provided coverage for a defined level of liability.        The

television station's insurance coverage was provided as follows:

     Insurance Company                 Layer of Insurance Coverage

                          Lower Tier

Continental Casualty Co. (Continental)      First $2 million
American Casualty Company1                  Same as Continental

Mission Insurance Company (Mission)         $2 million to $7 million

Western Employer's Casualty (Western)       $7 million to $12 million

     3
        This case was styled Harte-Hanks Television, Inc. and
Harte-Hanks Communications, Inc. (Appellants) vs. Sudhir
Srivastava, M.D. (Appellee).
                                - 7 -

Columbia Casualty Company (Columbia)       $12 million to $22
                                             million
Hudson Insurance Company (Hudson)          Co-insurer with Columbia



                           Upper Tier

Federal Insurance Company (Federal)        Above $22 million
     1
       Continental and American Casualty hereinafter are
collectively referred to as Continental.

     After the judgment had been communicated to the insurance

companies, and while the appeal of the judgment was pending,

petitioner learned that Mission had been declared insolvent, and

Western was functionally insolvent.     The insolvency of these two

companies created an uninsured gap in Harte-Hanks' coverage

between the $2 million and $12 million levels, which Harte-Hanks

had to cover to activate coverage at the upper levels.

The Settlement Agreement

     On January 17, 1991, after prevailing at the trial level but

before he was aware that the two insurance companies were

insolvent, petitioner attempted to settle the entire case with

Harte-Hanks for $21 million; $9,500,000 to settle the actual

damages and $11,500,000 to settle the punitive damages.    Although

this offer was rejected, the parties continued to negotiate.

     On February 25, 1991, after he became aware of the insurance

companies' insolvency, petitioner authorized his attorneys to

settle with the   lower tier insurance companies (the first $22

million of coverage) for $8,500,000, and to make a demand for

settlement upon the   upper tier insurance company (Federal) for
                               - 8 -

$2 million.   On March 14, 1991, upon authorization of petitioner,

a partial settlement agreement (the agreement) was entered into

by petitioner, petitioner's attorneys, and Harte-Hanks.

     The agreement provided for a payment to petitioner of

$8,500,000 from Harte-Hanks and its insurers.   Of that amount,

Continental agreed to pay $2,100,000, and Harte-Hanks agreed to

pay $1 million to settle the first $7 million in principal

liability of the judgment.   Harte-Hanks agreed to pay $2,400,000

to settle the principal amount of the judgment between $7 million

and $12 million, and to the extent necessary, to settle all

postjudgment interest liability on the first $22 million of the

judgment.   Columbia and Hudson agreed to pay $3 million to settle

the principal amount of the judgment between $12 million and $22

million.

     In reaching agreement, none of the payors considered whether

the amounts they were paying were for actual or punitive damages.

Nor did the payors or petitioner discuss any allocation of the

settlement amount between actual or punitive damages.   Instead,

the parties regarded the judgment as a claim that totaled in

excess of $31 million, considered the tiered structure of the

insurance coverage, and tried to work out a settlement that

preserved petitioner's claim against the upper tier insurer and

resolved his claim against the lower tier insurers.4

     4
        Federal did not participate in the settlement
negotiations, nor did it join in the appeal of the trial court's
judgment. After the agreement was entered into, Federal filed a
                                                   (continued...)
                               - 9 -

The Contingency Fee

     Although petitioner was represented at trial by the law firm

of Branton & Hall, petitioner was initially represented in his

suit by "Racehorse" Haynes and his law firm (the Haynes Firm).

Petitioner's payment agreement with the Haynes firm was a

straight fee arrangement.   However, due to difficulties

associated with the dissolution of the Haynes firm, petitioner's

case languished.   By the time petitioner hired Branton & Hall on

May 30, 1989, he could not afford to pay the attorneys by the

hour; therefore, he agreed to a contingency fee arrangement.

     The payment arrangement was characterized by Jim Branton

(Branton) as a "standard contingent fee arrangement".   In

addition to providing that all expenses necessary to prepare the

case for settlement or trial, as well as expenses for trying the

case, were to be paid by the client, the fee contract provided in

relevant part that

     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

     4
      (...continued)
motion seeking a declaratory judgment that it had no liability
for insurance coverage for any loss or damages arising out of the
judgment obtained against Harte-Hanks by petitioner.
     Federal's motion was granted, and a judgment was entered on
Apr. 24, 1992, and subsequently affirmed by the Court of Appeals
for the Fifth Circuit. Federal Ins. Co. v. Srivastava, 2 F.3d 98
(5th Cir. 1993).
                              - 10 -

     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.

          *       *      *      *         *    *      *

          It is further agreed that this Contract does not
     include the appeal of any Judgment, and in the event of
     an appeal from any Judgment, CLIENTS shall advance the
     anticipated costs of appeal and the percentage
     contingent fee interest shall be increased from forty
     percent (40%) to fifty percent (50%).


     Later, while the settlement negotiations were in progress,

Branton & Hall hired Franklin S. Spears (Spears) in an of-

counsel capacity to aid the firm with the appeal of petitioner's

suit.   Spears was also paid on a contingency fee basis.   Spears'

contract with Branton & Hall provided that he would be paid a

contingency fee of $1,200,000 for the preparation of petitioner's

briefs upon recovery of the total amount of the judgment, and a

proportionally lesser amount if less than the total amount of the

judgment was obtained.   In the event of a partial settlement

before the preparation and submission of petitioner's briefs,

Spears would collect an amount determined on a sliding scale for

each $1 million received in settlement.

     When the case settled, Spears was paid $92,500 "off the

top"; that is, the fee due Spears was deducted from the

settlement proceeds before calculating the amount due Branton &

Hall.   Branton & Hall was paid $3,363,000; 40 percent of the

settlement proceeds reduced by the $92,500 paid to Spears.

Petitioner received the balance of the proceeds, $5,044,500, from
                                - 11 -

which petitioner paid Branton & Hall $44,730 for legal expenses.

     Petitioners did not include any portion of the settlement

proceeds in their income.    In the notice of deficiency,

respondent determined that the amounts paid to the attorneys did

not reduce the amount of the settlement proceeds includable in

petitioners' gross income; however, respondent allowed the

attorney's fees as a Schedule A miscellaneous itemized deduction.

                               OPINION

Issue 1.    Whether Petitioners May Exclude From Their Gross Income
            Contingent Fees Paid to Their Attorneys

     Respondent determined that petitioners received $8,500,000

in settlement of their claim, and that they may not exclude from

their gross income the portion of the settlement proceeds paid to

Branton & Hall.    Petitioners assert that they never realized the

amount paid to Branton & Hall, because they assigned Branton &

Hall a 40-percent-ownership interest in the cause of action.

Furthermore, petitioners assert that this issue was settled by

the Court of Appeals for the Fifth Circuit in Cotnam v.

Commissioner, 263 F.2d 119 (5th Cir. 1959), affg. in part and

revg. in part 28 T.C. 947 (1957).    We disagree with petitioners

that Cotnam controls the Court's decision herein.

     This case is appealable to the Court of Appeals for the

Fifth Circuit, and under the Golsen rule, we follow the law of

the circuit in which a case is appealable.     Golsen v.

Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir.

1971).     The Court of Appeals' decision in Cotnam v. Commissioner,
                              - 12 -

supra, is based upon an interpretation of Alabama State law.

This case involves an interpretation of Texas State law.     The

Golsen rule is therefore not applicable.    See Golsen v.

Commissioner, supra at 757.

     In the Cotnam case, the taxpayer had entered into a

contingent fee arrangement with her attorneys, under which the

taxpayer agreed to pay the attorneys 40 percent of any amount

recovered on a claim that they litigated on her behalf.     The

taxpayer received a judgment on the claim, and a check in the

amount of the judgment was made payable to both her and the

attorneys.   The attorneys retained their share of the proceeds,

and remitted the balance to the taxpayer.   The Commissioner

treated the amount of the judgment as taxable income and allowed

a deduction for the attorney's fees.   In holding that the amount

retained by the attorneys was not includable in the taxpayer's

gross income, the Court of Appeals for the Fifth Circuit

concluded that under applicable State (Alabama) law, the

contingent fee operated to assign to the attorneys

anequitablelien and interest as to 40 percent of the judgment.5


     5
        As stated in the provision of the Alabama Code relied
upon by the Court of Appeals for the Fifth Circuit:

          2. Upon suits, judgments, and decrees for money,
     * * * [attorneys] shall have a lien superior to all
     liens but tax liens, and no person shall be at liberty
     to satisfy said suit, judgment or decree, until the
     lien or claim of the attorney for his fees is fully
     satisfied; and attorneys at law shall have the same
                                                   (continued...)
                                - 13 -

Cotnam v. Commissioner, supra at 125.

         The State of Texas, unlike the State of Alabama, does not

regulate attorney's liens by statute.      Instead, Texas relies upon

common law for authority on this issue.      Thomson v. Findlater

Hardware Co., 156 S.W. 301, 303 (Tex. Civ. App. 1913).

     In Texas, an attorney's lien is paramount to the rights of

the parties in the suit and is superior to other liens on the

money or property involved.     In re Willis, 143 Bankr. 428, 432

(Bankr. E.D. Tex. 1992).     However, a lien is neither property nor

a debt, but a right to have satisfaction out of property to

secure the payment of the debt.     Crutcher v. Continental Natl.

Bank, 884 S.W.2d 884, 888 (Tex. App. 1994); Texas Bank & Trust

Co. v. Custom Leasing, Inc., 402 S.W.2d 926, 930 (Tex. Civ. App.

1966); Windham v. Citizens Natl. Bank, 105 S.W.2d 348, 350 (Tex.

Civ. App. 1937).     In Texas, an attorney at law has not been given

a general lien on a cause of action or a judgment or money until

it was collected and in his hands.       Finkelstein v. Roberts, 220

S.W. 401, 405 (Tex. Civ. App. 1920).      Furthermore, while an

attorney has a lien on money collected by him for his client, he

has no such lien for the debt in the hands of the debtor before


     5
      (...continued)
     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. [Cotnam v.
     Commissioner, 263 F.2d 119, 125 n.5 (5th Cir. 1959)
     (quoting 46 Ala. Code sec. 64 (1940) (quotation marks
     omitted)), affg. in part and revg. in part 28 T.C. 947
     (1957).]
                                - 14 -

the money has been collected.     Thomson v. Findlater Hardware Co.,

supra at 303.   Nor does a lien create an ownership interest in

the attorney.     P&T Manufacturing Co. v. Exchange Sav. & Loan

Association, 633 S.W.2d 332 (Tex. App. 1982) (holders of valid

mechanic's lien who had not foreclosed could not sue for

conversion as they were not owners and did not have legal right

to possession).

     We do not find under the common law of Texas that because

petitioner's attorneys were entitled to secure their earned

contingent fee with a lien on the proceeds, the lien was a

conveyance of an ownership interest in the settlement proceeds.

     We turn next to petitioners' assertion that they never

realized the amount paid petitioner's attorneys as they

transferred to Branton & Hall a 40-percent ownership interest in

petitioner's cause of action.    Petitioners submit the contingency

fee agreement as evidence of the transfer.

     The question before us is to what extent, if any, petitioner

could transfer to his attorneys an interest in his cause of

action.   We must look to the law of Texas for the answer to the

question thus posed.    Our determination in this regard should,

according to the mandate of the Supreme Court of the United

States in Commissioner v. Estate of Bosch, 387 U.S. 456 (1967),

be predicated on State law, and the State's highest court is the

best authority on its own law.

     In Dow Chem. Co. v. Benton, 357 S.W.2d 565 (Tex. 1962), the
                              - 15 -

Supreme Court of Texas decided the issue of whether an attorney

may prosecute a cause of action on his own behalf to secure a

contingent fee after his client has been properly dismissed from

the case.   The attorneys argued that the contingent fee contract

created in them "an immediate, vested, unrestricted, separate and

distinct interest in the plaintiff's cause of action."6    In

holding the attorneys may not litigate a case after their client

has been dismissed, the Supreme Court of Texas found that

attorneys operating under a contingent fee contract do not have

rights in a cause of action equal to those of their clients.     Id.

at 567.

     The court first noted the fact that as the case involved the

attorney-client relationship, it could not regard the case as one

involving an ordinary assignment, devoid of public policy

considerations.   The court stated that the basic fallacy of the

attorney's position was that it ignored the fact that the

lawyer's rights, based on the contingent fee contract, are wholly

derivative from those of his client.   In Texas, the attorney-

client relationship is one of principal and agent.   Id.


     6
        The contingent fee contract, which the Texas Supreme
Court characterized as "the usual one", provided that the
plaintiff 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".
Dow Chem. Co. v. Benton, 357 S.W.2d 565, 566 (Tex. 1962). The
contract further provided that if the case settled before filing
of suit, the attorneys were to receive one-third of whatever was
recovered for the plaintiff, and they would receive greater
percentages if the suit was filed or appealed after trial. Id.
                             - 16 -

     Furthermore, the court stated that

     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.
     [Id.; emphasis added.]

     An attorney with a contingent fee contract is not so

directly interested in the subject matter of a lawsuit as to make

him a party; thus, Texas attorneys operating under a contingent

fee contract do not have the same rights as their clients in the

cause of action.7

     We conclude, therefore, that under the facts and

circumstances of this case, Branton & Hall and Spears had no

ownership interest in petitioner's claim before settlement.

Consequently, in analyzing this issue, we consider petitioner's

contingent fee agreement an agreement to assign a part of the

recovery on the cause of action to his attorneys.8

     State law determines what property rights and interests a

taxpayer has, but Federal law determines the consequences of such

rights and interests for tax purposes.    Lyeth v. Hoey, 305 U.S.



     7
        The court clarified that its holding does not necessarily
apply to the case where a plaintiff has assigned a portion of his
cause of action to an independent third party.
     8
        See Brenan v. LaMotte, 441 S.W.2d 626, 629 (Tex. Civ.
App. 1969) (contract of employment which stated "we do hereby
sell, transfer, * * * assign and convey unto * * *, our attorney,
an undivided interest" in whatever plaintiffs may realize out of
decedent's estate, held executory contract for contingent fee;
contract did not convey interest in estate).
                              - 17 -

188 (1938).   An attorney's right to compensation pursuant to a

contingency fee agreement is a property right determined under

applicable State law.   Barnhill v. Johnson, 503 U.S. 393 (1992);

Marre v. United States, 117 F.3d 297, 307 (5th Cir. 1997);

Augustson v. Linea Aerea Nacional-Chile S.A., 76 F.3d 658, 662

(5th Cir. 1996).   Under Texas State law, a contingency fee

agreement is generally considered to be an executory contract.

In re Willis, supra at 431; Brenan v. LaMotte, 441 S.W.2d 626,

630 (Tex. Civ. App. 1969); White v. Brookline Trust Co., 371

S.W.2d 597, 600 (Tex. Civ. App. 1963).   Therefore, as a general

rule, an attorney does not receive a legal or equitable interest

pursuant to a contingency fee contract until the contingency

actually occurs.   In re Willis, 143 Bankr. at 431.

     Although it is unclear what constitutes the defining moment

at which the contingency occurs, at minimum, the contingency

cannot occur before judgment is affirmed on appeal or when the

time for filing an appeal has lapsed.    Marre v. United States,

supra at 308 (comparing Lee v. Cherry, 812 S.W.2d 361, 363 (Tex.

App. 1991) (explaining that an executory contract is one that is

still unperformed by both parties or one with respect to which

something still remains to be done on both sides); White v.

Brookline Trust Co., supra (contingency occurs after prosecuting

or defending to final judgment all suits); Carroll v. Hunt, 168

S.W.2d 238, 240, 242 (Tex. Commn. App. 1943) (contingency occurs

after successful termination of the litigation)).     Once the
                              - 18 -

contingency occurs, the attorney has a lien on the judgment or

settlement securing his services.       In re Willis, supra at 432.

     Accordingly, until the contingent fee agreement between

petitioner and Branton & Hall ripened through finalization of the

lawsuit, it was executory.   Once the contingency occurred, the

attorneys were entitled to a lien on the funds, which ultimately

was satisfied when they received payment according to the terms

of the agreement.

               The Supreme Court has held that

     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. * * * [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.

     *        *        *            *          *       *         *

     [T]he import of the statute is that the fruit is not to
     be attributed to a different tree from that on which it
     grew. [Helvering v. Horst, 311 U.S. 112, 116-120
     (1940); citation omitted.]

     It is for this reason that "[taxation cannot] be escaped by

anticipatory arrangements and contracts however skillfully

devised to prevent * * * [the settlement amount] when paid from

vesting even for a second in the man who earned it."       Lucas v.

Earl, 281 U.S. 111, 115 (1930).   It is clear that petitioner

enjoyed the full benefit of the settlement amount by using it to

pay his attorneys for their services.      It is equally clear that
                              - 19 -

as petitioner's attorneys could not be parties in the cause of

action and did not otherwise have rights in the cause of action

equal to those of petitioner, in the terms of Lucas v. Earl,

supra, the attorneys did not own any portion of the tree from

which the settlement proceeds were derived.

     Accordingly, we find that petitioners realized benefit from

the entire amount of the settlement proceeds, and they may not

exclude from their gross income the portion of the settlement

proceeds paid to Branton & Hall and Spears.

Issue 2.   Whether Under Section 104(a)(2) Petitioners May Exclude
           the Entire Settlement Amount From Their Gross Income

     Respondent and petitioners agree that the amount received by

petitioner for actual damages is excludable from petitioners'

income under section 104(a)(2).

     Respondent determined that the $8,500,000 settlement amount

should be allocated proportionally to the judgment of $11,500,000

in actual damages, $17,500,000 in punitive damages, and

prejudgment interest of $2,597,201.9

     Petitioners assert that as $8,500,000 is exactly the amount

that petitioner initially pled as actual damages, and as it is



     9
        We note that this method of allocation was approved in
Robinson v. Commissioner, 70 F.3d 34, 38 (5th Cir. 1995), affg.
in part, revg. in part and remanding 102 T.C. 116 (1994); see
also Rozpad v. Commissioner, T.C. Memo. 1997-528 (the judgment,
albeit not final, nonetheless furnishes an adequate guideline for
allocation by the Commissioner to the extent that it is composed
of both compensatory damages and prejudgment interest), affd. __
F.3d __ (1st Cir. Aug. 25, 1998).
                               - 20 -

less than the amount awarded by the jury for only actual damages,

the entire settlement amount is excluded from their gross income

under section 104(a)(2).    Respondent's determination is presumed

correct, and petitioners bear the burden of proving that

respondent's determinations are erroneous.    Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).

     We have often been asked to decide the proper allocation of

proceeds of a settlement agreement in the context of section

104(a)(2).    It is well settled that express allocations in a

settlement agreement will be respected to the extent that the

settlement agreement is entered into by the parties at arm's

length and in good faith.    Robinson v. Commissioner, 70 F.3d 34

(5th Cir. 1995), affg. in part, revg. in part and remanding 102

T.C. 116 (1994).    If a lawsuit is settled, but no express

allocations are made in the settlement agreement, we must

consider the pleadings, the jury awards, or any court orders or

judgments.    Robinson v. Commissioner, 102 T.C. at 127.   In order

to characterize income as taxable under section 61 or excluded

from taxation under section 104(a)(2), we must ascertain "in lieu

of what were damages awarded" or paid.    Bent v. Commissioner, 87

T.C. 236, 244 (1986), affd. 835 F.2d 67 (3d Cir. 1987).

     In the instant case, the partial settlement agreement does

not specify how the $8,500,000 settlement amount is allocated

between actual and punitive damages, or between principal and

interest.    Accordingly, we consider all the facts and
                                - 21 -

circumstances to ascertain in lieu of what the settlement amount

of $8,500,000 was paid.   Id.

     We do not find that the evidence supports petitioners'

assertion that none of the amount paid in settlement was paid in

lieu of either punitive damages or interest.    To the contrary,

the partial settlement agreement shows that Harte-Hanks agreed to

pay, and petitioner agreed to accept, $2,400,000 in satisfaction

of the principal amount of the judgment between $7 million and

$12 million, and to extinguish any and all postjudgment interest

liability on the first $22 million of the judgment.    Furthermore,

Columbia and Hudson agreed to pay, and petitioner agreed to

accept, $3 million in satisfaction of the principal amount of the

judgment between $12 million and $22 million.    Columbia's and

Hudson's liability threshold was $12 million, and the judgment

provided total actual damages of $11,500,000; Columbia and Hudson

would not have paid $3 million unless they thought prejudgment

interest and punitive damages would total at least $3,500,000.

     Harte-Hanks' agreement to pay postjudgment interest and

Columbia's and Hudson's actual payment of several millions of

dollars speak with a voice heard more clearly than petitioners'

assertions.   We find that petitioners have not carried their

burden of proving that respondent's determinations are erroneous.

     On brief, respondent proposes an alternative method of

allocation which he concedes may be "the most proper methodology

to use to allocate the settlement payment."    Under this
                              - 22 -

alternative method, it is presumed that actual damages would be

paid before prejudgment interest, postjudgment interest, or

punitive damages, and that prejudgment interest would be paid

before punitive damages.

     Under this methodology, the combined $3,100,000 payment made

by Continental and Harte-Hanks, which was the amount agreed upon

to settle Harte-Hanks' liability for the first $7 million of

damages, is allocated to settle $7 million of the $11,500,000 of

actual damages provided by the judgment.     Accordingly,

petitioners would exclude $3,100,000 under section 104(a)(2) as

the settlement amount they received for $7 million worth of the

actual damages.

     Harte-Hanks paid $2,400,000, to settle the principal amount

of the judgment between $7 million and $12 million, and to the

extent necessary, to settle all postjudgment interest on the

first $22 million of the judgment.     This amount is allocated to

actual damages of $4,500,000,10 prejudgment interest of $500,000,

and postjudgment interest of $1,826,301.11    Accordingly,

$1,582,116 of the $2,400,000 payment is allocated to actual



     10
        This figure equals the $11,500,000 total actual damages
minus the $7 million actual damages which were settled for
$3,100,000.
     11
        Respondent calculated postjudgment interest on the first
$22 million of the judgment assuming a period of 303 days, from
May 15, 1990 (the judgment date), to Mar. 14, 1991 (the date of
the partial settlement agreement), a 365-day calendar year, and a
rate of 10 percent per annum.
                                 - 23 -

damages,12 and the remaining $817,884 is allocated to prejudgment

and postjudgment interest.

     Finally, the $3 million paid by Columbia and Hudson to

settle their liability for coverage between $12 million and $22

million is allocated entirely to prejudgment interest and

punitive damages.   At this level, all of the $11,500,000 in

actual damages has been exhausted, in addition to $500,000 of

prejudgment interest and all of the postjudgment interest.

Furthermore, the settlement amount of $3 million for $10 million

of liability ($22 million minus $12 million) reflects the

diminished likelihood of petitioner's recovering damages and

interest in an amount above $12 million if the case was appealed.

     Extending respondent's alternative method of allocation, we

find that of the $3 million paid by Columbia and Hudson, $629,160

was paid in lieu of prejudgment interest, and $2,370,840 was paid

in lieu of punitive damages.13


     12
        This amount is calculated by multiplying the $2,400,000
paid by Harte-Hanks by $4,500,000 of remaining actual damages
divided by the sum of the $4,500,000 (actual damages), $500,000
(prejudgment interest), and $1,826,301 (postjudgment interest).
     13
        In the alternative allocation scheme, respondent assumed
that the prejudgment interest would be paid before the punitive
damages. The prejudgment interest totaled $2,597,201, of which
$500,000 was already settled out of the $2,400,000 payment by
Harte-Hanks. Columbia and Hudson would therefore pay the balance
of the prejudgment interest, $2,097,201, before they paid any
punitive damages.
     The portion of Columbia's and Hudson's payment allocated to
interest is calculated by dividing the balance of the prejudgment
interest by Columbia's and Hudson's total liability, $10 million,
                                                   (continued...)
                              - 24 -

     Accordingly, on the basis of all the facts and circumstances

of this case, we find that $4,682,116 of the settlement proceeds

was paid to petitioner in lieu of actual damages, which is

excluded from gross income under section 104(a)(2), and

$3,817,884 was paid in lieu of punitive damages and interest,

which is included in gross income under section 61.

Issue 3.   Deductibility of Attorney's Fees Under Section 162

     In the notice of deficiency, respondent allowed petitioners

a deduction under sections 212(1) and 265 for legal fees

allocable to the taxable portion of the settlement proceeds.

Petitioners assert in their reply brief that if this Court finds

that petitioners realized the amount paid to petitioner's

attorneys, they are entitled to deduct that amount under section

162(a) as an ordinary and necessary expense incurred during the

taxable year in carrying on a trade or business.

     In analyzing the issue of whether the attorney's fees were

an expense incurred for the production or collection of income

under section 212(1) or as an ordinary and necessary expense

under section 162(a), we consider the origin and character of the

claim with respect to which the litigation expense was incurred.

United States v. Gilmore, 372 U.S. 39 (1963).


     13
      (...continued)
and multiplying that amount by their $3 million payment.
     Similarly, the amount allocated to punitive damages is
calculated by dividing the balance of their liability, $10
million minus $2,097,201, by their total liability, $10 million,
and multiplying that amount by their $3 million payment.
                               - 25 -

     As there is no general Federal common law of torts, nor

controlling definitions in the tax code, we must look to State

law to analyze the nature of the claim litigated.    Burnet v.

Harmel, 287 U.S. 103, 110 (1932) (State law creates legal

interests; Federal law determines when and how to tax).

     Petitioner's personal injury suit was for libel, a

defamation action.   All defamatory statements (whether libel or

slander) attack a person's good name.14   See MacFadden

Publications, Inc. v. Wilson, 121 S.W.2d 430 (Tex. Civ. App.

1938).    Whether the defamatory attack is on the personal

reputation or the professional reputation of the individual, the

defamation is personal in nature.    Gulf At. Life Ins. Co. v.

Hurlbut, 696 S.W.2d 83, 96-97 (Tex. App. 1985) (the action of

defamation is to protect the personal reputation of the injured

party, whereas the action for injurious falsehood or business

disparagement is to protect the economic interests of the injured

party against pecuniary loss), revd. and remanded on other



     14
          Texas law provides the following:

                A libel is a defamation expressed in written
           or other graphic form that tends to blacken the
           memory of the dead or that tends to injure a
           living person's reputation and thereby expose the
           person to public hatred, contempt or ridicule, or
           financial injury or to impeach any person's
           honesty, integrity, virtue, or reputation or to
           publish the natural defects of anyone and thereby
           expose the person to public hatred, ridicule, or
           financial injury. [Tex. Civ. Prac. & Rem. Code
           Ann. sec. 73.001 (West 1997).]
                               - 26 -

grounds 749 S.W.2d 762, 766 (Tex. 1987).   In Newspapers, Inc. v.

Matthews, 339 S.W.2d 890, 893 (Tex. 1960), the Texas Supreme

Court reaffirmed that a business is not the subject of libel and

that the defamation, if any, is of the owner of the business and

not the business itself, whether the owner be an individual,

partnership, or corporation.

     If as a result of defamatory statements attacking the

individual's character, the individual suffers some impairment of

his professional relationships--in this case, petitioner's

relationship with his patients and hospitals--the injury is to

the person, although it may have derivative consequences for the

business.   Roemer v. Commissioner, 716 F.2d 693 (9th Cir. 1983)

(a defamatory attack on one's character should not be confused

with the damage that flows from that injury), revg. 79 T.C. 398

(1982); see also Threlkeld v. Commissioner, 87 T.C. 1294 (1986)

(holding Roemer v. Commissioner, 79 T.C. 398 (1982), revd. 716

F.2d 693 (9th Cir. 1983), will no longer be followed by this

Court and expressing agreement with the reasoning for its

reversal by the Court of Appeals for the Ninth Circuit), affd.

848 F.2d 81 (6th Cir. 1988).

     As the defamation of an individual is a personal injury

under the law of Texas, the expenses of litigating petitioner's

claim for personal injury are not deductible as ordinary and

necessary expenses incurred in carrying on a trade or business.

     Petitioner cites McKay v. Commissioner, 102 T.C. 465 (1994),
                              - 27 -

vacated and remanded without published opinion 84 F.3d 433 (5th

Cir. 1996), as authority for deducting the costs of litigating a

personal injury suit as a business expense.   We disagree.

     In McKay, the taxpayer was an employee who brought suit for

wrongful termination, breach of employment contract, RICO, and

punitive damages.   The taxpayer was awarded damages for lost

compensation, "future" damages, and punitive damages for

wrongful, malicious, and oppressive acts by his employer.    After

trial, the parties settled, and the settlement agreement provided

that sums were paid in extinguishment of the taxpayer's tort

claim for wrongful discharge and extinguishment of his breach of

contract claim.   In the settlement agreement, the parties agreed

that the amount attributable to the wrongful discharge claim

represented compensatory damages excludable under section

104(a)(2), and the amount allocable to the breach of contract

claim was includable in income under section 61.15   Finding that

the allocations were the result of an arm's-length negotiation

between hostile adversaries, this Court accepted the express

allocations in the settlement agreement.   Id. at 487.



     15
        The Court of Appeals for the Fifth Circuit vacated our
decision in this case. Citing Commissioner v. Schleier, 515 U.S.
323 (1995), the Court of Appeals held that the damages
attributable to the taxpayer's wrongful discharge claim were not
excludable under sec. 104(a)(2), because they were not received
on account of a personal injury. McKay v. Commissioner, 84 F.3d
433 (5th Cir. 1996), vacating and remanding without published
opinion 102 T.C. 465 (1994).
                               - 28 -

     We held that under section 265, the portion of the

attorney's fees allocable to the settlement amount for wrongful

discharge was not deductible, but the portion of the attorney's

fees allocable to the taxable portion of the suit, the breach of

contract action, was deductible under section 162.

     The facts of McKay v. Commissioner, supra, are clearly

distinguishable from the facts of this case.     In McKay, the

taxpayer had two causes of action--one arising from the law of

torts, the other from the law of contracts.     The taxpayer in

McKay received separate settlement amounts for each claim.       In

this case, petitioner has brought suit for a claim in tort,

personal injury.    Furthermore, the damages petitioner received

all flow from the personal injury suit.     McKay v. Commissioner,

supra, is therefore, inapposite.

     We agree with respondent's determination that the portion of

petitioner's legal expenses allocable to the punitive damages and

the interest received on the award are deductible under section

212(1) as expenses paid for the production of income.     This

treatment is consistent with other cases in which the taxpayer

received damages in a defamation action.     See, e.g., Roemer v.

Commissioner, supra at 700; Church v. Commissioner, 80 T.C. 1104,

1110-1111 (1983).

     Section 265, however, disallows deductions for amounts that

are allocable to tax-exempt income.     Consequently, only the

attorney's fees attributable to punitive damages and interest are
                                - 29 -

deductible.

     In Church v. Commissioner, supra, we used the following

formula to calculate the correct deduction:

   Total attorney's fees        Nonexempt income      Deductible
     and legal expenses     X   ----------------- =   expenses
                                   Total award

     We have held that a portion of the settlement proceeds is

attributable to punitive damages and interest and is includable

in petitioners' income.    Accordingly, we find that $1,572,173 of

attorney's fees and legal expenses is deductible under section

212(1) as a miscellaneous itemized expense.

Issue 4.   Accuracy-Related Penalty Under Section 6662

     Respondent determined that petitioners are liable for

accuracy-related penalties for the substantial understatement of

tax under section 6662(a) of $237,784 and $6,607 for 1991 and

1992, respectively.   See sec. 6662(b)(2).   Petitioners assert

that they are not liable for the penalty, because there was

substantial authority for their reporting position, and they

relied upon the advice of their professional tax adviser.

     Section 6662(a) imposes a penalty in an amount equal to 20

percent of the portion of the underpayment of tax attributable to

one or more of the items set forth in subsection (b).     Section

6662(b)(2) provides that section 6662 shall apply to any portion

of the underpayment attributable to any substantial

understatement of income tax.

     There is a substantial understatement of income tax if the
                              - 30 -

amount of the understatement for the taxable year exceeds the

greater of (1) 10 percent of the tax required to be shown on the

return or (2) $5,000.   Sec. 6662(d)(1)(A).   For purposes of

section 6662(d)(1), "understatement" is defined as the excess of

tax required to be shown on the return over the amount of tax

that is shown on the return reduced by any rebate.    Sec.

6662(d)(2)(A).

     After adjustments,16 respondent determined that the amounts

of tax required to be shown on the returns are $1,194,296 and

$45,969, and the amounts of the understatements of tax are

$1,188,920 and $33,037 for 1991 and 1992, respectively.      As each

of these understatement amounts exceeds the greater of 10 percent

of the tax required to be shown on the return or $5,000 for the

year at issue, respondent applied the penalty.

     Section 6662(d)(2)(B)(i) provides that the amount of the

understatement shall be reduced by the portion of the

understatement that is attributable to the tax treatment of any

item if there is or was substantial authority for such treatment.

The substantial authority standard is an objective standard


     16
        Respondent determined that computational adjustments
should be made for 1991 which would preclude petitioners from
claiming deductions for personal exemptions, eliminated their
deductions for medical expenses, adjusted the amounts of self-
employment tax and the deduction for self-employment tax, and
increased the allowance for charitable contributions.
     Respondent determined that computational adjustments should
be made for 1992 which would adjust petitioners' deduction for
charitable contributions to conform with the percentage
limitations.
                               - 31 -

involving an analysis of the law and application of the law to

relevant facts.    Sec. 1.6662-4(d)(2), Income Tax Regs.   There is

substantial authority for the tax treatment of an item if at the

time the return containing the item is filed or on the last day

of the taxable year to which the return relates, the weight of

the authorities supporting the treatment is substantial in

relation to the weight of authorities supporting contrary

treatment.17   Sec. 1.6662-4(d)(3)(i), (iv)(C), Income Tax Regs.

      It is the taxpayer's responsibility to establish he is not

liable for the accuracy-related penalty imposed by section

6662(a).   Rule 142(a); Tweeddale v. Commissioner, 92 T.C. 501,

505 (1989).    Petitioners did not report any of the settlement

proceeds they received in 1991.    We have found that a portion of

the proceeds is attributable to punitive damages and interest,

which are taxable under section 61.     Therefore, the burden is on

petitioners to prove that there is substantial authority for

their reporting position.

     Respondent pled in his answer that petitioners negligently

failed to report any portion of the settlement payment as gross

income for 1991 and, therefore, are liable for the section 6662

penalty for negligence or disregard of rules or regulations.      See

sec. 6662(b)(1).    This is a new matter; the burden of proof is



     17
        Petitioners timely filed their return for calendar year
1991 on Oct. 15, 1992, and the return for their short taxable
year 1992 on Mar. 15, 1993.
                                - 32 -

therefore on respondent to prove that petitioners were negligent

or disregarded rules or regulations.     Rule 142(a).

Punitive Damages

     The issue of whether punitive damages received in a tort or

tortlike suit are excludable from income was resolved by the

Supreme Court in O'Gilvie v. United States, 519 U.S. 79, 117 S.

Ct. 452 (1996).    Before the Supreme Court's decision, the Courts

of Appeals for the Fourth, Ninth, and Tenth Circuits had held

that punitive damages are not excluded from income under section

104(a)(2), and the Court of Appeals for the Sixth Circuit had

held they are excluded.18    Id. at ___, 117 S. Ct. at 454.   The

Supreme Court granted certiorari to resolve the conflict among

the circuits.     The Supreme Court held that punitive damages

received in a tort suit for personal injuries were not received

"on account of" personal injuries and, therefore, were not

excluded from taxable gross income as defined during the years at

issue.19   Id.


     18
        See O'Gilvie v. United States, 66 F.3d 1550 (10th Cir.
1995), affd. 519 U.S. 79, 117 S. Ct. 452 (1996); Hawkins v.
United States, 30 F.3d 1077 (9th Cir. 1994); Horton v.
Commissioner, 33 F.3d 625 (6th Cir. 1994), affg. 100 T.C. 93
(1993); Commissioner v. Miller, 914 F.2d 586 (4th Cir. 1990),
revg. and remanding 93 T.C. 330 (1989).
     19
          The Omnibus Budget Reconciliation Act of 1989 (OBRA),
Pub. L. 101-239, sec. 7641(a), 103 Stat. 2379, amended sec.
104(a) by adding the sentence "Paragraph (2) shall not apply to
any punitive damages in connection with a case not involving
physical injury or physical sickness." OBRA sec. 7641(b)(2), 103
Stat. 2379, provided the amendment shall not apply to any amount
                                                   (continued...)
                              - 33 -

     It is clear from the Supreme Court's decision that the issue

of whether punitive damages received in a tort suit are excluded

under section 104(a)(2) was unresolved at the time petitioners

filed their returns for 1991 and 1992.

     Furthermore, before the decision in O'Gilvie v. United

States, supra, this Court decided Estate of Moore v.

Commissioner, T.C. Memo. 1994-4, revd. and remanded 53 F.3d 712

(5th Cir. 1995).   In Estate of Moore, we held, citing Threlkeld

v. Commissioner, 87 T.C. 1294 (1986), and Roemer v. Commissioner,

716 F.2d 693 (9th Cir. 1983), that punitive damages received in a

settlement of a lawsuit for malicious prosecution and invasion of

privacy may be excluded from gross income pursuant to section

104(a)(2).

     The Court of Appeals for the Fifth Circuit reversed Estate

of Moore v. Commissioner, supra, holding that punitive damages

awarded under Texas law are not intended to compensate plaintiffs

for injury and are therefore not excludable under section

104(a)(2).   Estate of Moore v. Commissioner, 53 F.3d at 715-716.

     After we decided Estate of Moore, but before it was

reversed, this Court decided Robinson v. Commissioner, 102 T.C.


     19
      (...continued)
received pursuant to any suit filed on or before July 10, 1989.
Petitioners filed suit in 1985 and are therefore within the
exception to the amendment.
     The Supreme Court decided the issue in O'Gilvie v. United
States, 519 U.S. 79, 117 S. Ct. 452 (1996), upon the preamendment
version of sec. 104(a)(2); the holding is therefore applicable to
petitioners in this case.
                             - 34 -

116, 125-126 (1994), in which we stated:

     Under section 104(a)(2), gross income does not include
     the amount of any damages received (whether by suit or
     agreement) on account of personal injuries or sickness.
     From that section, and the regulations thereunder, we
     understand that damages received through a settlement
     of a lawsuit are excludable from gross income only if
     the damages were received on account of a "tortlike
     personal injury". For this purpose, no distinction is
     drawn between tortlike personal injuries that are
     physical versus tortlike personal injuries that are
     nonphysical (i.e., psychological). Thus, for example,
     damages are excludable from gross income under section
     104(a)(2) if the damages were received pursuant to a
     settlement of a tortlike personal injury that resulted
     in: * * * punitive damages, Horton v. Commissioner, 100
     T.C. 93, 96 (1993); see also Miller v. Commissioner, 93
     T.C. 330, 337-342 (1989), revd. 914 F.2d 586 (4th Cir.
     1990). [Some citations omitted; emphasis added.]


     As the lawsuit in the Robinson case included an award for

mental anguish, as well as punitive damages, we allocated a

percentage of the settlement amount to punitive damages and held

that the taxpayers could exclude that percentage from their gross

income under section 104(a)(2).   Id. at 136.   The Court of

Appeals for the Fifth Circuit, citing Estate of Moore v.

Commissioner, 53 F.3d 712 (5th Cir. 1995), revg. and remanding

T.C. Memo. 1994-4, reversed that part of our decision.     Robinson

v. Commissioner, 70 F.3d at 37 & n.4.

     It is clear from these decisions that, until Estate of Moore

v. Commissioner, supra, was reversed, this Court was of the

opinion that taxpayers residing in Texas could exclude punitive

damages from income under section 104(a)(2).    We therefore find

that there was substantial authority for petitioners' reporting
                               - 35 -

position with respect to the punitive damages portion of the

settlement amount.

     Because of our finding that there was substantial authority

for petitioners' reporting position, we need not address the

issue of whether they were negligent in not reporting the

punitive damages as income.

     Accordingly, we find that petitioners are not liable for the

section 6662(a) penalty for the portion of the underpayment of

tax attributable to the punitive damages portion of the

settlement amount.

Interest

     Petitioners did not report any of the amount of the

settlement proceeds that they received in 1991 as interest

income.    Respondent determined that a portion of the settlement

amount is attributable to interest.     Petitioners have presented

no argument to support their reporting position on this issue,

other than their assertion that section 104(a)(2) excludes the

entire settlement amount.

     In Kovacs v. Commissioner, 100 T.C. 124 (1993), affd. per

curiam without published opinion 25 F.3d 1048 (6th Cir. 1994), we

stated that we had last analyzed this issue in Aames v.

Commissioner, 94 T.C. 189 (1990), in which we held that interest

was not excludable under section 104(a)(2).    In Aames, we drew a

distinction between the damages and the interest on the damages,

noting that the nature of interest is that it is paid because of
                              - 36 -

the delay in the receipt of a principal amount (the damage

award).   Kovacs v. Commissioner, supra at 129.

     Furthermore, in Kovacs, we stated that the issue of the

excludability of damages and the interest awarded thereon first

arose in Riddle v. Commissioner, 27 B.T.A. 1339 (1933), which

held, applying the predecessors of sections 61(a) and 104(a)(2),

that interest was not part of damages and is includable in

income.   We also stated that since Riddle was decided in 1933, we

have found no cases which suggest that interest paid on an award

of damages received on account of personal injury is excludable

under section 104(a)(2).

     Finally, we observed that since Riddle was decided, the

exclusion for personal injury damages has been reenacted and

amended numerous times; nevertheless, the statute continues to

exclude only "damages" and omits any reference to "interest",

which implies a continuing acceptance by Congress of the existing

interpretation of the exclusion.

     Accordingly, we find that there was no substantial authority

for petitioners' reporting position for the interest portion of

the settlement amount they received in 1991.

     Reasonable Cause and Good Faith Exception

     Section 6664(c)(1) provides that the penalty under section

6662(a) shall not apply to any portion of an underpayment if it

is shown that there was reasonable cause for the taxpayer's

position with respect to that portion and that the taxpayer acted
                                - 37 -

in good faith with respect to that portion.    Sec. 6664(c)(1).

      The determination of whether a taxpayer acted with

reasonable cause and good faith within the meaning of section

6664(c)(1) is made on a case-by-case basis, taking into account

all the pertinent facts and circumstances.    Sec. 1.6664-4(b)(1),

Income Tax Regs.   The most important factor is the extent of the

taxpayer's efforts to assess the taxpayer's proper tax liability.

Id.   Reliance on the advice of a professional (such as an

attorney or an accountant) does not necessarily demonstrate

reasonable cause and good faith.    Reliance on professional

advice, however, constitutes reasonable cause and good faith if,

under all the circumstances, such reliance was reasonable and the

taxpayer acted in good faith.    Id.

      Petitioners assert that they are not liable for any section

6662(a) penalty, because they relied upon the advice of their

attorneys and their certified public accountant in reporting

their income.

      Petitioner testified that at different times he asked

Branton, who was hired to represent petitioner in his personal

injury lawsuit, Thomas Weir (Weir), a tax attorney from San

Antonio, and Bill Elms (Elms), petitioners' certified public

accountant, if the settlement amount was taxable.    Petitioner

testified that all told him that none of the settlement amount

was taxable.

      Branton testified that he did not consider himself to be a
                                - 38 -

Federal tax lawyer.    In response to a question by the Court,

Branton stated that whenever a client asked him whether an item

was taxable, his response has always been that he is not a tax

lawyer, and that the client should get a tax lawyer.    Thus,

petitioners could not reasonably and in good faith rely upon

Branton regarding the taxability of the settlement amount.       See

sec. 1.6664-4(b)(2), Example (1), Income Tax Regs.

     Petitioner testified that he consulted with a tax attorney,

Weir.     Petitioner was not certain whether he spoke with Weir on

the phone or consulted with him in person.    Nor was petitioner

certain of what documents he provided Weir.    We cannot assume the

testimony of absent witnesses would have been favorable to

petitioner.     Rather, the normal inference is that it would have

been unfavorable.     Pollack v. Commissioner, 47 T.C. 92, 108

(1966), affd. 392 F.2d 409 (5th Cir. 1968); Wichita Terminal

Elevator Co. v. Commissioner, 6 T.C. 1158, 1165 (1946), affd. 162

F.2d 513 (10th Cir. 1947).

        Petitioner testified that he consulted with his accountant,

Elms.     Elms testified that in his initial interview with

petitioner they talked extensively about the lawsuit.     When Elms

prepared petitioners' Federal income tax return for 1991,

petitioners were involved in a bankruptcy proceeding and had

given their only copy of the settlement agreement to that court.

Elms therefore never saw a copy of the settlement agreement.

Petitioner did provide Elms with a copy of the Texas district
                              - 39 -

court's charge to the jury and the jury's answers to the

interrogatories submitted to them.     This document lists the

amounts the jury awarded on each of the charges on which

petitioner brought suit; it does not, however, indicate that

prejudgment or postjudgment interest is to be provided on the

amounts.

     Elms testified that at the time he prepared petitioners'

return, it was his understanding that punitive damages awarded on

a personal injury case were not taxable.     Elms was concerned

whether the award included some interest income; however, he

concluded that no part of the amount received would be considered

interest income.

     Petitioner signed the partial settlement agreement;

therefore, he knew that Harte-Hanks agreed to make a settlement

payment in part for all of the postjudgment interest on the first

$22 million of liability.   Petitioner knew the actual damages

totaled $11,500,000, he knew that Columbia and Hudson were not

liable to pay anything unless the total award exceeded $12

million, and he knew that Columbia and Hudson paid $3 million to

settle their potential liability.    Therefore, petitioner knew

that the settlement agreement contained pertinent information

that was not included in the document he provided Elms.

     Petitioner, in possession of pertinent information, may not

claim good faith and reasonable cause when he stands mute while

his tax adviser in ignorance of such information comes to an
                              - 40 -

incorrect opinion.

     We therefore find that petitioners are liable for the

section 6662(a) penalty for the portion of any underpayment of

the tax required to be shown on the return that is due to not

reporting the interest portion of the settlement amount as

income.

     Due to our finding that petitioners are liable for the

accuracy-related penalty for the substantial understatement of

tax, we need not address the issue of whether they are liable for

the accuracy-related penalty for negligence or disregard of rules

or regulations.   See sec. 1.6662-2(c), Income Tax Regs.

     To reflect the foregoing,

                                          Decision will be entered

                                       under Rule 155.
