Wow! This is a great question. In short, the answer depends upon how your settlement amount was allocated by your settlement agreement and whether and how the Form 1099 reports the proceeds.
Legal settlement payments are generally taxable, including any punitive settlement amount and interest, except for payments made to compensate for physical injury/sickness (and emotional distress or mental anguish if directly related to a physical injury/sickness). In other words, settlements for non-physical injuries/sicknesses are normally taxable.
Using the IRS guidance, all income from whatever source is included in gross income unless a specific exception exists. The most common exceptions regarding settlements are those noted above. You may want to consider this IRS resource to guide you on the tax implications of your settlement: IRS: Tax implications of settlements and judgments and IRS: Settlements -- Taxability.
In most instances, the attorney’s fees from an otherwise taxable settlement can’t be deducted. Please see this TurboTax article: Can I Deduct Legal Fees on My Taxes?
I appreciate that this may not be the answer you were hoping for, but I hope it’s nevertheless helpful to you.
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