Without going into too much detail, my wife was a victim of sexual battery. She suffered physical injuries that healed and emotional scars that we still deal with daily. We filed suit against her attacker and his employer.

Years later, we have now settled. During mediation it was clear that the compensation was to "make her whole". It is my opinion (and also what the mediation judge said) that this is for personal injury and related mental distress and is not taxable income. None of this was for lost wages as my wife does not work and did not work at the time of the assault.

The defendants did not send a 1099. However, our own legal firm did issue a 1099-misc. for the amount of proceeds after deducting their fee. I asked them to correct this as I believe this is in error, but was told that they "have to report it this way". When I asked how to handle it with the IRS they responded with "we are not tax attorneys". Awesome, right?

Anyway, my question is how do I handle this on our tax return without automatically triggering an audit? Should I report the amount of the 1099 and then deduct it somewhere? If so, where should it be reported and where should it be deducted? Or, should I not report it since it isn't income and somehow explain the situation? Any solid advice is greatly appreciated. Thank you.