We have been offered a "cash and keep" settlement by the manufacturer in a lemon law claim in the State of Ohio. If we accept, the vehicle will not be declared a lemon and we would use the cash settlement to supplement the trade-in value at the same dealer where we bought it to purchase a different vehicle. I have read that the taxable portion of a lemon law settlement is the amount that exceeds our loss, which is defined as the difference between the amount we paid and the fair market value of the vehicle at the time we bought it. This seems counterintuitive to me as I would assume that a good negotiator should be paying fair market value for a new car at the time of purchase, plus taxes, doc fees, etc. That doesn't take into account the true loss.  This vehicle with an MSRP of $41,070 that we paid $33,276 for before tax, fees and extras ($34,023 total) is now worth only $22,000 in trade-in value 7 months later, while we have dealt with all of the warranty issues and three months of waiting on the manufacturer to respond to the lemon law claim. In addition, we have also paid about $1,800 in interest on the auto loan. The manufacturer is offering $10,000, not including attorney's fees, which wouldn't fully recover our loss but it would be even worse if we learned after the fact that we owe tax on the settlement and and the $10,000 becomes $6,000 or less.

Our attorney has advised us that the manufacturer will supply them with a 1099 for only the legal fees and that they are not required to issue a 1099 to us for the actual cash award.

So, will I have to pay tax on what is essentially a return of capital or will I get to retain the full amount? Do I need to claim it as income at all given the absence of a 1099?