My wife's father died due to medical malpractice. There was a lawsuit and the funds from the suit went into his trust. Are the funds inherited by my wife taxable?

No. Inheritance from a non retirement account is not taxed. 

I'm going to add a caveat.

Legal settlements for personal injury are not taxable to the recipient, and they would not be taxable to the heirs, either.  However, if the settlement contained pre- or post-judgement interest, the interest is taxable to someone.  Usually the recipient, so in this case any taxes on the interest would either have to be paid by the trust or by the heirs (via a K-1 statement, I think).  Since trust income tax rates are higher than personal tax rates, it may cost less overall for the trust to pass the taxable interest to the heirs.