deducting compensatory damages settlement

First, I'd send a certified letter to the issuer telling them of my intent to sue them under Section 7434 of the Internal Revenue Code for issuing a fraudulent information return unless they issue a correction by mm/dd/2010. That section provides for a minimum penalty of $5,000, payable to you. (That award would be taxable income, but think of the fun.) At this point whether or not you'd actually sue is irrelevant. If you do sue you also notify the IRS, which puts them on notice that you consider the 1099 fraudulent.

If they don't correct it, there are two schools of thought. Mine is to put nothing on your return and, when the IRS inquires, tell them that the 1099 was fraudulent. At that point the burden shifts to the IRS to prove that it wasn't.

Others will be along to suggest entries on your return.

Phil Marti Clarksburg, MD

Thanks for the input. In rereading my post, looks like I made an error. They didn't list it as interest on the 1099, they just reported it as miscellaneous income in box 3. I'm not sure if that makes it a fraudulent 1099 or not. Its unclear to me whether or not they should have reported it on the 1099 at all. On the one hand, this is not taxable. On the other hand, I could see how a company could legitimately not want to have to make that decision as to whether it is taxable or not and simply report it and let me do it. Would you still say its worth contacting them to tell them they should correct it? And at that point, what should I be ready to tell the IRS and what proof would they need? A copy of the original complaint from the lawsuit?

If you want to pursue that part of the question take a look at the instructions for issuing Form 1099-MISC, apply the facts of your case from the issuer's viewpoint, and you'll have your answer.

You need to be prepared to tell the IRS why it isn't taxable income when they ask why you didn't include it, which would probably be 1-2 years after you file your return. Hang on to everything from the lawsuit.

Phil Marti Clarksburg, MD