My wife purchased long term disability policy through her employer, paying 100% of the premiums with after tax dollars. When she was forced to use the policy, the insurance company reported it on a W-2 as nontaxable sick pay (Box 12 - Code J). After 2 years, the insurance company stopped paying the policy. After retaining an attorney to fight the company, a settlement was obtained for 30k (10k of it was attorneys fees). The settlement stated that the money was for the present value of past and future payments. My understanding is that the settlement should be nontaxable. The insurance company says that it is nontaxable but because of IRC section 6041, they have to report it on a 1099-MISC, box 3 Other Income. I believe that there should be no change and they should report it on the W-2. They refuse to change it. My question is - how should I show this, so the IRS sees the 1099 but it is still nontaxable? Appreciate any help in this matter.

basically, a lawsuit settlement may involve monetary agreements between parties involved in litigation. So, the specific handling of a lawsuit can vary from case to case; the items required to be reported in box 3 include all punitive damages for nonphysical injuries and sicknesses that exceed the amounts paid out for medical care should be reported here.
Box 3 of Form 1099-MISC is used to report other income that is not reportable in one of the other boxes on the form.

However, if you receive an award of back pay that constitutes wages, it generally would be reportable on Form W-2, not Form 1099-MISC. If the settlement had actually been paid to you for physical injuries or physical illness, then that part of the settlement would not be taxable. Even though your claim may have involved a physical injury, if the settlement was not paid directly to reimburse you because of those physical injuries, then this is taxable income to you, and explains why you received the 1099 form. If the settlement had related directly to compensation for physical injuries, then a 1099 would not have been issued for that portion of the settlement.

The amounts you were paid should have been reported in box 3 of the 1099 form and you will report that amount on line 21 of 1040 as other income. If the amount reported to you on the 1099 form included the amount that was sent to your attorney, you may claim a deduction for the attorney fees on Sch A of 1040 as a miscellaneous deduction.
Note; you can, from your gross income, exclude only non-punitive awards /damages received pursuant to a settlement in a personal injury case aslongas the personal injury or sickness is physical; and received the payments on account of such injury or sickness.

My understanding is the settlement represents past and future nontaxable disability benefits! Therefore, I would think that the settlement should be nontaxable.

The setttlement states that the funds were for the past and future payment of disability benefits. These payments were originally non-taxable due to the employee paying the premisums with after tax dollars. Therefore, I believe the entire settlement to be nontaxable. Comments welcome. The big problem I have is showing the 1099-misc figure as non-taxable income. If I just ignore the 1099, I would think the IRS would charge me the income as taxable. One CPA told me to show the 1099 as other income, then on the next line deduct it back out. Comments on this?

#1;agreed.money/pmt you receive under a private disability policy are not taxable to you.however, I guess this not your case, if your ER had paid the premiums, then the disability income would be taxable.

#2;UNless you need to rpeort it on 1040 line 21, I guess ,you report he gross income on sch C or C-EZ on line 1and deduct them as other expenses on sch C or C-EZ line27

I did not want to go with sch C because she is not a business. Here original payments where charged to W2, box 12, code J - nontaxable. I found with turbotax, I can put the 1099-misc into 1040, line 21, then put a manual entry into line 21 with a brief description and a negative number, thereby zeroing out the net. At least I get a brief description so they might process it. Thank you for any help.

Ok i see, yes i guess so.g ood for you.very excellent. frankly i didn't know that way. you taught it to me. thanks alot. i am not familiar with the software. thanks alot for your comment.