You cannot avoid paying taxes through an agreement with the people paying you. The taxation is based on IRS rules regardless of your agreement.
Generally, compensation for emotional distress is taxable income unless it is due to a physical injury or physical sickness claim. If it was not from a physical injury or physical sickness claim you will need to report it on your return as income. When you walk through entering the 1099-NEC, you will need to select that it was not for work and that it was a lawsuit.
"As a result of the amendment in 1996, mental and emotional distress arising from non-physical injuri..."
If this was for emotional damages due to physical injury or physical illness, then you will still need to enter it on your return, but after you do, you will then take additional steps to back the income out of your taxable income.
To enter the 1099 NEC and then remove the income take the following steps:
- Income
- 1099-NEC under Other Common Income
- Enter the information from the 1099-NEC
- Continue through and say the work does NOT involve work that is like your main job
- Say no, to did this involve an intent to earn money
Then you will take the following steps to remove the income:
- Income
- Less Common Income
- Miscellaneous Income
- Other Reportable Income
- Answer Yes to Any Other Taxable Income
- Enter the description such as 1099-NEC received for Emotional damages physical injury or illness
- Enter the amount on the 1099-NEC as a negative number.
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