Hello and thank you for coming to our website. We appreciate the opportunity to help you with your questions. I hope that this issue doesn't affect you personally, because the IRS rules that apply are going to seem very unfair under the circumstances; however, they are the rules.
To take your questions in order:
1. If the amount that the tenant kept from the attorney is over $600 and, if there is paperwork showing that money as a payment from the attorney to the tenant (if there was written notification or information that the money the insurance company issued to the tenant's attorney would go to the tenant), then the lawyer should issue a 1099-MISC to the tenant. The attorney will probably also want to do this if he/she can justify it because it allows him/her to remove that amount of money from the attorney's taxable income. If the attorney issues a 1099-MISC to the tenant, the amount the tenant received should be reported in Box 3, Other Income; rather than Box 7, Nonemployee Compensation. This is covered in the instructions on filling out Form 1099-MISC. It sounds as if there was no punitive part to the legal settlement. If there had been, that amount would have been listed in Box 3 on a 1099-MISC issued from the insurance company to the tenant.
2. Unfortunately, since ordinary living expenses aren't included in any tax deductions or issues (except when job-related), the expenses associated with this case can't be used to offset any of the taxable legal settlement. The IRS has ruled that legal settlements not involving physical injury or disease are taxable income.
3. The amounts the tenant received for the settlement should be reported to the tenant and the IRS on 1099-MISC, Box 3, "Other Income". The amounts should be reported as "Other Income" on the 1040 Form. Since this income is not in Box 7 and was not involved in any way with employment or services received, this income won't be reported on a Schedule C and it won't be subject to the self-employment tax. Any attorney's fees can be deducted on Schedule A, as expenses subject to the 2%-of-AGI limit.
4. If 1099-MISCs are reported to the IRS, the IRS will either reject the return if it doesn't reference the 1099s that the IRS received or they will definitely come after the taxpayer. The IRS receives copies of all of this paperwork and their computer program matches forms received with the taxpayer's Social Security Number with the income and forms reported on the return as one of the first checks a return goes through when it is processed.
5. The receipts won't matter because the IRS won't allow them to be used to offset the settlement income. All other papers relating to this issue should be stored for a minimum of 3 years, the normal time period the IRS goes back on audit. A maximum of seven years wouldn't be a bad idea, because if the IRS decides there may be fraud involved in the tax return, they can go back seven years. Actually, there is no real previous year at which the IRS can't demand to see documents, since the statute of limitations doesn't begin until the tax fraud is found, so there isn't really a statute of limitations on the IRS. They rarely go back more than 3 years and almost never go back more than 7 years. In general, they only go back more than 3 years if they find or think they've found an ongoing pattern of fraudulent returns.
6. If the tenant paid the former attorney $600 or more in 2012, then the tenant should issue a 1099-MISC to the attorney with the payment reported in Box 7.
Here is the information from the IRS website about legal settlements: http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Lawsuits,-Awards,-and-Settlements-Audit-Techniques-Guide#_Toc305586646
Here is where you can find the information about preparing and filing Form 1099-MISC:
Here is the actual form 1099-MISC: http://www.irs.gov/pub/irs-pdf/f1099msc_12.pdf
I hope this information answers your question satisfactorily. If you need more information about this question or clarification of any information that I've provided, I'll be happy to continue working with you on this question until you're satisfied.