A settlement that you receive as a result of employment termination, whether it is received through litigation or outside of litigation, is generally subject to both income taxes and employment taxes, meaning medicare and social security. The exact wording from the IRS position on this is as follows:
"Settlements of suits in cases of employee termination arise from a variety of causes of action. The settlement could be for a breach of contract, a tort, or a violation of any one of a number of federal or state statutes such as the Age Discrimination in Employment Act or the Americans with Disabilities Act. All the facts must be considered, for instance the complaint, the settlement document, a court's opinion, etc., to determine what the award is for. There is no simple answer to this question.
In general, severance payments are wages for employment and are subject to FICA taxes. If the payments arose in connection with the employment relationship and that the amounts were based on salary and years of service, these are indications that the settlement amounts are wages for employment.
Wages are generally subject to social security and Medicare (FICA) tax when they are actually or constructively paid. Severance payments are subject to FICA tax in the year in which they are paid. The FICA tax rate and wage base are those in effect in the year of payment. FUTA tax and income tax withholding also apply."
Even though the settlement you received was not for actual hours worked through employment, the settlement still arose in connection with your employment, and is therefore treated the same as normal wages.
I know this was not the answer you were looking for, but unfortunately those are the regulations.
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