A recent federal decision out of Arizona offers a useful reminder about the tax treatment of settlement payments, as well as risks that arise when settlement agreements fail to address tax characterization clearly.
In Adusei v. Auer, a former nursing student sued a college, its attorneys, and others after Forms 1099 were issued following settlement of earlier litigation. The plaintiff alleged the settlement funds should have been treated as non-taxable educational reimbursements rather than taxable income. She asserted a wide range of claims, including fraudulent tax reporting, malpractice, emotional distress, discrimination, abuse of process, and violations of criminal statutes.
The court dismissed nearly all claims, holding that the complaint failed to plausibly allege that the Forms 1099 were improper.
The decision is not a landmark tax opinion. Though it does illustrate important reminders for for lawyers and taxpayers dealing with informational reporting obligations after litigation resolves.
Link to The dispute centered on a lump-sum settlement payment The dispute centered on a lump-sum settlement payment
According to the complaint, the plaintiff previously sued Arizona College after being dismissed from its nursing program. The matter later settled for approximately $57,644.
The plaintiff later alleged the payment actually represented refunds of Pell Grants, student loans, transcript fees, and related educational amounts that should not have been treated as taxable income. She further alleged that both the college and the law firm involved in the settlement issued Forms 1099 reporting the payment to the IRS, resulting in duplicate reporting and significant asserted tax liability.
But the court focused heavily on the plaintiff’s own exhibits, including the settlement agreement and attached Forms 1099. The court noted that the settlement agreement apparently did not allocate the payment among educational reimbursements, loan refunds, damages, or any other categories. Instead, the agreement reflected a general lump-sum settlement payment.
Link to Settlement payments are generally presumed taxable unless a specific exclusion applies Settlement payments are generally presumed taxable unless a specific exclusion applies
The court relied on a familiar principle of federal tax law: gross income is interpreted broadly, and settlement proceeds are generally presumed taxable unless a specific exclusion applies.
Citing prior authority addressing settlement-related Forms 1099, the court explained that payments resolving litigation will ordinarily constitute taxable income absent a clear statutory exclusion.
The plaintiff pointed to several Internal Revenue Code provisions involving scholarships, educational assistance, and student loan treatment, including Sections 117 and 108(f). But the court concluded those authorities did not plausibly apply because the settlement documents did not establish that the payment itself actually constituted scholarships or discharged student debt.
This case provides a practical roadmap regarding settlement practice and how to characterize proceeds. Oftentimes, determining what was intended after the fact, is much harder when there was not thought put into the underlying settlement documentation. Courts, however, generally look to the origin of the claim being settled, the economic substance of the payment, and the actual language of the settlement agreement.
If parties intend for some or all of a settlement payment to represent non-taxable amounts, the agreement should usually address that issue directly.
Link to The court also rejected the “duplicate 1099” theory The court also rejected the “duplicate 1099” theory
The plaintiff additionally alleged that both the college and the law firm improperly issued Forms 1099 reporting the same payment.
According to the opinion, the settlement funds were first paid into the law firm’s IOLTA account before being disbursed to the plaintiff. The plaintiff argued the second Form 1099 was improper because it effectively doubled the amount reported to the IRS.
The court rejected the argument, noting that the plaintiff cited no authority establishing that the law firm acted improperly by issuing a Form 1099 after transmitting settlement funds from its trust account.
That portion of the opinion reflects a broader issue practitioners regularly encounter. Informational reporting obligations involving settlement payments can become complicated when attorneys, insurers, structured settlement entities, or multiple payors participate in the payment process.
Link to Section 7434 claims remain difficult to sustain Section 7434 claims remain difficult to sustain
The plaintiff also asserted a claim under 26 U.S.C. §7434, which creates a civil cause of action for willfully filing a fraudulent information return.
While these causes of action are sometimes brought forward, courts tend to distinguish between: 1) a knowingly false Form 1099; and 2) a disagreement about the proper tax treatment of a payment.
The Arizona court concluded the plaintiff failed to plausibly allege the Forms 1099 were fraudulent because the reported amounts and payment characterization aligned with the settlement documentation itself. Section 7434 is not a general remedy for every disputed Form 1099.
Link to The opinion also reflects growing judicial frustration with unsupported claims and fabricated authority The opinion also reflects growing judicial frustration with unsupported claims and fabricated authority
The court dismissed the plaintiff’s remaining claims for malpractice, emotional distress, discrimination, abuse of process, and constitutional violations.
The opinion is also notable for its warning regarding nonexistent or fabricated legal citations. The court specifically cautioned that citing fake or misleading authority, even by pro se litigants, can result in sanctions or dismissal.
That language reflects an issue courts across the country are increasingly confronting in the AI era.
Link to Practical takeaway for settlement drafting Practical takeaway for settlement drafting
For lawyers handling litigation settlements, Adusei reinforces a practical point that often gets overlooked during negotiations: tax characterization matters.
Settlement agreements should carefully address the intended treatment of payments where possible, particularly when parties believe some portion of the payment may fall within a statutory exclusion from gross income. Ambiguous lump-sum settlements create substantial room for later disputes.
Likewise, parties should understand potential informational reporting obligations before settlement funds are issued. Once Forms 1099 are filed with the IRS, resolving disputes becomes substantially more difficult and expensive. The case also demonstrates the limits of attempting to convert ordinary tax reporting disputes into broader tort or civil rights litigation.
For taxpayers and practitioners alike, the better approach is usually preventative: careful settlement drafting, clear allocation language where appropriate, and early consideration of reporting obligations before the agreement is signed.
The case is Adusei v. Auer et al, No. 2:2025cv01722 – Document 102 (D. Ariz. 2026)