Robert W. Wood (Robert W. Wood, P.C., San Francisco) has published Discharging Debt, Settling Litigation, and Singing the Blues, also available on the Tax Analysts web site as Doc 2005-23296, 2005 TNT 221-40.  Here is the Conclusion:

Settling a lawsuit often — if not always — involves tax considerations. It is important for litigants and their counsel to be aware that discharge of indebtedness will generally be treated as income to the relieved debtor. A litigant may achieve some economic relief by being released from all or a portion of the debt he otherwise owes, yet tax law generally translates debt relief into income and subjects the person afforded relief to income tax on the amount forgiven.

Although there are exceptions and nuances to that complex rule (such as the contested liability theory), a taxpayer generally will be unable to escape tax liability related to cancellation of debt. That means it’s worth considering the contested liability theory before settlement time and using its get-out-of-jail-free card when appropriate. And although there are fewer concerns for creditors in these cases than for debtors, it is worth paying attention to the discharge of debt and satisfaction of debt rules even if you are a defendant paying settlement money, so you don’t end up paying a settlement that you can’t deduct. All of those principles should be kept in mind, because they may affect the terms of any settlement ultimately entered into by a litigant.