How do I enter the amount for a lawsuit settlement, for out of pocket legal fees, reported on a 1099-NEC to avoid being taxed?

[ejorda12]

I received a settlement from a discrimination lawsuit in 2020 from a former employer.  The monetary portion of the settlement was for reimbursement for my out of pocket attorney's fees.  I received a 1099-NEC from the former employer for the full amount of the reimbursement.  Since the monetary settlement was a reimbursement of my out of pocket expenses, this should not be taxed.  How do I enter the settlement amount in Turbo Tax so it is not taxable?  When I enter it in Federal, Wages & Income, 1099-MISC and Other Common Income, and Income from Form 1099-NEC, Turbo Tax is requiring me to create a Schedule C,   even though I chose "This was money from a lawsuit settlement".  I'm looking for a way to enter the amount reported on the 1099-NEC and offset it without being taxed.

[rjs · Accepted solution]

Is the entire amount on the Form 1099-NEC reimbursement for attorney's fees? If so, I think they should have reported it on a 1099-MISC, not a 1099-NEC. But here's how you can enter it in TurboTax. You didn't say whether you are using TurboTax Online or the CD/Download TurboTax software. This can only be entered in the CD/Download software because it requires entries in forms mode. TurboTax Online does not have forms mode.

• Click the Federal Taxes tab.
• Click Wages & Income.
• On the screen "Your 2020 Income Summary" scroll down to the section "1099-MISC and Other Common Income." Click the Start button for "Income from Form 1099-NEC."
• Did you get a 1099-NEC? - Click Yes.
• Do You Want to Enter Your 1099-NECs Now? - Click "Add a 1099-NEC."
• Enter the payer's name and federal ID number, and the amount of the payment in box 1. Click Continue.
• Describe the reason for this 1099-NEC - Enter a short description, such as "Attorney fees" or "Lawsuit settlement." The description that you enter will not appear on your tax return. Click Continue.
• Does one of these uncommon situations apply? - Select "This was money from a lawsuit settlement."
• Was any part of the lawsuit settlement for back wages? - Select No. Click Continue.
• On the next screen, "1099-NEC Summary," click Done.
• The next screen says "Looks like we're missing some info." Click Continue.
• The next screen says that the 1099-NEC will be deleted. Click No. This returns you to "Your 2020 Income Summary." The 1099-NEC has not been deleted.
• Click the Forms icon at the top to switch to forms mode.
• In the list of forms on the left, there will be a red exclamation point next to the 1099-NEC Worksheet, and it will say "Not Done." Open the 1099-NEC Worksheet if it has not appeared automatically.
• In box 1 of the Form 1099-NEC Worksheet, the Schedule C line will be shaded pink. A few lines below that, still in box 1, click the Other Income checkbox. The pink shading, the red exclamation point, and the "Not Done" will all disappear.

Now open the "Form 1040 or Form 1040-SR Worksheet" (1040/1040SR Wks). Scroll down to the Schedule 1 section (Additional Income and Adjustments to Income), then to Part II Adjustments to Income, and then to the Other Adjustments to Income Smart Worksheet between lines 21 and 22. The attorney fees are entered on line H of the Smart Worksheet. In the text entry box on the left side, right after the H, enter UDC. Enter the amount in the space on the right. The letters UDC and the amount will then appear on the dotted line to the left of the amount on line 22, and the fees will be added to any other amount that was already on line 22. The same notation, UDC and the amount, will appear on line 22 on Schedule 1.

The amount from the 1099-NEC will be reported as other income on Schedule 1 line 8, and it will be entered as an adjustment (i.e. a deduction) on Schedule 1 line 22. The net result is that it is not included in your Adjusted Gross Income (AGI) on Form 1040 line 11, so you do not pay tax on it.

[ejorda12]

Thank you for your reply.  Yes, the entire amount on the Form 1099-NEC was a reimbursement for attorney's fees.  I am using the CD/Download TurboTax software and I was able to enter into forms mode.  I followed your very detailed instructions and the adjustment was correctly reflected in my tax return.  You're a life saver, as I could not figure this out.   

[rjs]

I'm glad I could help you.

Unfortunately you will probably get a letter from the IRS saying that you should have filed Schedule C and Schedule SE, and that you owe self-employment tax on the payment. I don't think there's any way to avoid this. The letter is computer-generated when there's a 1099-NEC (over $400) and no Schedule C. No human being looks at the tax return until they get your reply to the letter. You will have to reply to the letter explaining that the payment was incorrectly reported on Form 1099-NEC instead of 1099-MISC, and that it's a lawsuit settlement for attorney's fees, not back wages.

You could try to get the company to issue a corrected 1099-NEC with a zero amount, and a 1099-MISC with the payment in box 3, but that might be more of a hassle than answering the letter from the IRS.

[bribeck18]

Hi, I have the same situation, receiving an 1099 NEC from my employer for a settlement from a lawsuit we knew nothing about.  The exception is that i had no expenses and am doing this online for 2021 tax year.  When i got to the review stage and clicked review due to the issue it opened a page with what i believe was a schedule C window but wasn't sure if i could nor what i could do anything there.  Is it that i cannot do this with the online version?

Thanks

[rjs]

@bribeck18  As I said in my long post above, the steps that I outlined can only be done in the CD/Download TurboTax software because they require forms mode, which is not available in TurboTax Online.

[mjensen427]

Anyone figure this out for 2022 online??

[DaveF1006]

With a few exceptions, individual taxpayers may not deduct legal expenses on their tax returns because of the Tax Cuts & Job Act of 2018.  The IRS has a few exceptions to this rule in Publication 529

1. You can deduct legal expenses that are related to doing or keeping your job, such as those you paid to defend yourself against criminal charges arising out of your trade or business. 
2. You can deduct expenses of resolving tax issues relating to profit or loss from business reported on Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship), from rentals or royalties reported on Schedule E (Form 1040), Supplemental Income and Loss, or from farm income and expenses reported on Schedule F (Form 1040), Profit or Loss From Farming, on that schedule. 
3. Expenses for resolving nonbusiness tax issues are miscellaneous itemized deductions and are no longer deductible.

If your legal expenses fall within the realm described above, you can deduct these in your online program by going to.

1. Federal>wages and income>less common income>miscellaneous income>
2. other reportable income
3. When it asks if you have other taxable income, say yes.
4. The next screen asks for a description.  Here you will mention reimbursement for attorney fees.  if the text box will allow it, mention why these fees should be deductible.  Then in the box below the description, put the amount of the attorney fees with a minus sign in front of the amount. This will exclude this from your taxable income.

@mjensen427 

[David]

How do I enter 1099-NEC for a law suit settlement - no out of pocket legal fees?  Turbo tax wants to start a schedule C.

[JohnW152]

To enter a taxable lawsuit settlement in TurboTax Online without triggering self-employment tax:

1. If you don’t see 2022 TAXES in the left pane, select the dropdown to the right of Income & Expenses on the Hi, let’s keep working on your taxes! page and then select Let’s get started, Pick up where you left off, or Review/Edit. 
   • Otherwise, in the left pane, select Federal, then Wages & Income (This is labelled Income & Expenses in TurboTax Self-Employed)
2. Scroll down and select the Show more dropdown to the right of Less Common Income
3. Select  Start or Revisit to the right of Miscellaneous Income, 1099-A, 1099-C
4. Select  Start to the right of Other reportable income
5. Select  Yes on the Any Other Taxable Income? screen
6. On the  Other Taxable Income page, enter a description of the settlement and the amount, then select Continue
7. On the  Other Miscellaneous Income Summary screen, select Done

@David