The 1099-MISC probably contains taxable income from proceeds that were punitive in some form. A W-2 would represent payment for actual back wages.
When entering the 1099-MISC, indicate that the form was received from a lawsuit and the amount (if any) that represent back wages. (See attached screenshot.)
Here's some background that may be helpful:
Any portion of the settlement proceeds paid to compensate for wages must be reported through Form W-2, and will essentially be treated by the employer as a payroll check. See I.R.C. § 6051.
The employer will deduct applicable taxes and withholdings for Social Security and Medicare, and will remit the matching taxes to the IRS. See I.R.C. § 3402(a).
Any portion of the settlement proceeds paid for non-wages are typically reported through Form 1099-MISC as “other income.” See I.R.C. § 6041. The employer will not deduct any taxes or withholding and will not remit any matching taxes on these non-wage payments.
Plaintiffs often request that employers treat the entire settlement payment as “other income” under Form 1099-MISC, to avoid the deduction of taxes and withholdings. While this practice may temporarily result in a larger settlement check for the plaintiff, it subjects both the employer and the employee to substantial potential tax liability.
If portions of the settlement proceeds are misclassified as “other income” when, in fact, they are wages, the plaintiff will be responsible for all taxes, including the employer’s portion. If the employee is unable to satisfy the tax burden of settlement proceeds, the IRS will likely turn to the employer for payment.
In addition, if an employer fails to deduct and withhold income tax amounts by treating the employee or former employee as a nonemployee, the employer may be subject to additional liability, penalties, and interest. See I.R.C. § 3509.
