Non-punitive awards and damages received pursuant to a judgment or a settlement in a personal injury case are excludible from gross income if: (a) the personal injury or sickness is physical; and (b) the payments are received on account of such injury or sickness.
Accordingly, exclusion from taxable income is available only if the personal injury or sickness alleged by the taxpayer in his suit is physical. Personal physical injuries include direct unwanted or uninvited physical contacts which result in observable bodily harms such as bruises, cuts, swelling, and bleeding. Non-physical personal injuries, such as, wrongful termination, age, race, or sex-based discrimination, constitutional torts, or loss of reputation, do not qualify. As a matter of fact, the Ninth Circuit held in Rivera v. Baker West, Inc, 430F. 3d, 1253 that amounts received under a settlement for a racial discrimination claim under Title VII represented lost wages and was includable in income and subject to withholding.
As a general rule, emotional distress also does not qualify as a physical injury. There is, however, a narrow exception under which reimbursements for medical expenses incurred to treat emotional distress qualify for an exclusion under IRC Sec. 104(a)(2).
Any legal fees are deductible as a miscellaneous itemized deduction subject to the 2% of AGI limitation, to the extent the settlement or judgment is taxable.
You should report the amount on the 1099 as miscellaneous other income on line 21 of form 1040.
Because it is impossible for me to identify and consider ALL the relevant facts, this advice is not intended or written to be used for the purpose of avoiding penalties, and cannot be used for that purpose.