The taxation of settlements is governed by the origin of the claim. If claim by its usual nature is taxable income, then the settlement (or the portion that relates to the taxable income) is itself taxable. A settlement can allocate the proceeds to a specific claim or claims. I am sure that if you can settle on a non-taxable claim, you may settle for a lesser amount that if it was taxable. This needs to be specified in the settlement agreement. If the settlement agreement does not allocate the proceeds among the claims, then you should ask your attorney to allocate it in writing for you based on the underlying facts and claims. Notwithstanding any of the foregoing, the IRS could challenge the allocation of the settlement proceeds, and seek to tax some or all of the settlement proceeds. It all depends on the facts underlying the claims.
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