Didn't taxpayer deduct their expenses in those years, even if they didn't get paid in full?

the actual expenses should have been deducted in the year(s) they were incurred, you cannot deduct them again. Yes, the income is subject SE 

@sjrcpa  and @Skylane  are both correct in their statements.  In the very unlikely event that this was a totally different revenue source and he did not deduct the expenses connected with those particular earnings, you would have the option of amending the prior year's return to include those expenses, even if that particular revenue stream Schedule C only has expenses and no income. might soften this year's damage a little,

Did they incur legal expenses?  what kind of expenses would a lawsuit settlement have?

I'm pretty sure the lawyers would have taken a percent for fees.

@sjrcpa   Why would you assume that lawyers do contract cases on a contingency basis?  Yes, some of them do, but often when it has already gone to judgment and it's just collection work.  Enforcing a contract is not like paying chiropractors for whiplash.  Businesses, unlike bad drivers, don't have insurance policies to pay contract debts.  Lawyers know that contract judgments can be discharged in bankruptcy, so that even if you win it's uncertain whether you will collect.  

I wonder what is meant by "we had to file a suit."  Maybe there were twenty people in the same situation, not really enough for a class action, but they each chipped in $1,000 and that was enough to convince the defendant to settle because otherwise the contract might have said that the winner had to pay the loser's fees.  That fee should have been deducted in the year paid. 

Even if just one plaintiff is involved, there's not enough information here to know what expenses were paid, or in what year.  To answer the question: No, this doesn't sound unique, it sounds run of the mill, and you can't "take a percentage off for expenses."

@BobKamman I stand corrected on my assumption.

 A change in the story. 

1099-NEC for past due comp was $53,963.

Settlement not included in 1099-NEC $51,289.78

How should I report the settlement? (no tax form) 

The amount represents damages and interest that our lawyer said we shouldn’t be paying taxes on but to defer to our account 

That number also includes a 7% interest that I should not be paying taxes on

Settlement not included in 1099-NEC $51,289.78

“Defer to our account(ant?)”

IRS would probably argue that the interest is subject to SE tax if the underlying claim involved SE income. It’s an “interest”ing topic.

You really need more details about what this claim involves. Just a guess, was the $51,289 for legal fees paid before the case was settled?

Why would they not pay taxes on interest earned?

The damages are the suit claim, or are they property damages covered by insurance? In other words, literal damage?

You don't report or not report income based on what is on a 1099-NEC. You do it based on facts and circumstances. Remember, if this customer was a private citizen and not a business, there is never a 1099-NEC issued, even if your client makes $3 million. They still report that income as income. 1099-NEC is informational, not a tax filing form.

The attorney doesn't know tax regulation.

If a client is on cash basis, they already incurred the costs. Labor and materials would have been on the tax form for the year incurred. If that didn't happen, that's an amendment condition. The income is considered income in the year received.

I asked for: Do you have the settlement agreement (or attorney letter) spelling out what each portion covers—lost income, emotional distress, interest, etc.

"so there is lost income as well to factor in."

How much tax do they think they should pay on the lost income?  🤔

Excluding from taxable income the settlement amount for emotional distress to a contractor for unpaid commission? I think you want to read what the IRS states:

https://www.irs.gov/government-entities/tax-implications-of-settlements-and-judgments

And you know interest is taxable.

Your client didn't have lost income. They had an unpaid receivable, which they sued for and got paid. "Lost" income is like this example:

You invoice someone for $1,000. They don't pay. You basically have a 100% discount situation. If you manage to collect later, that's 100% income.

There was a peer here that used to point out: You can't write off what you don't write on.

So, even then, you have $1,000 revenue offset by $1,000 for returns and allowances (hint: it's a wash). But a cash basis entity wouldn't put unpaid revenue on the tax return, because it hasn't happened yet.