As you know, life insurance benefits are normally not taxable if paid directly to you (as opposed to through an annuity).
As the IRS says: "Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren't includable in gross income and you don't have to report them."
See IRS response to the question: "Do I report proceeds paid under a life insurance contract as taxable income?"
However, because this income was reported on a 1099-MISC, the IRS now has a copy of it. If you don't report the income, an IRS computer may notice this and send you a letter.
I would add an entry in Other Income (Less Common Income, Miscellaneous Income - anyplace you can add a dollar amount and a description) the negative amount of the payout with the description "nontaxable life ins proceeds backed out".
The net effect should be to nullify the benefit on your return, so that you are not taxed on it.
Might the IRS question this, too? Sure, but you have the documentation of the policy and the check, and you can reply to any letter that according to their own instructions, you should not report this as taxable income.
My guess is that if you report it the way I suggested (as opposed to just not entering the 1099-MISC at all), that you are less likely to get that letter.
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