In this article one of our specialist employment solicitors, Chris Hadrill, answers the question of whether a settlement agreement is tax-free.
If you’re reading this article then you’re probably an employee who has been offered a settlement agreement or, alternatively, you expect to be offered a settlement agreement. One of the principal advantages of a settlement agreement is that, in certain circumstances, the payments made under the agreement can be paid tax-free up to a maximum of £30,000 – this tax exemption makes settlement agreements attractive to departing employees and encourage settlement rather than litigation.
We’ll explore the following in this article:
- What sums under a settlement agreement are taxable?
- What sums under a settlement agreement are not tax-free?
- Examples of where sums can be paid tax-free under a settlement agreement
- What you should do if you have been offered a settlement agreement
What sums under a settlement agreement are taxable?
How much of the payments under a settlement agreement are taxable will depend on the nature and amount of the payments. The following categories of payments are generally taxable (please note that this list is not exhaustive):
- Sums that you, as an employee, are contractually entitled to (salary payments, bonus payments, commission, payments in lieu of notice etc.);
- Payments for restrictive covenants;
- Contractual redundancy payments;
- Compensation for injury to feelings where the relevant incident took place after the termination of employment;
- Payments in respect of share options and/or share awards
What sums under a settlement agreement are not tax-free?
The first £30,000 of payments that fall within section 401 of the Income Tax (Earnings and Pensions) Act 2003 can be paid tax-free under a settlement agreement, with the balance over £30,000 subject to tax but not employee National Insurance contributions (again, these are not exhaustive):
- Statutory redundancy pay;
- Sums paid as compensation for termination of employment;
- Ex-gratia payments;
- Damages for wrongful dismissal and payments on account of damages; and
- Compensation for injury to feelings where the relevant incident(s) take place before the termination of employment
Multiple payments made in respect of the same job (or different jobs with the same employer or associated employers) will be aggregated with respect to the £30,000 tax-free exemption.
Sums paid of death or because of departure due to injury/disability can be paid tax-free without limit but great care needs to be taken with these payments, as whether they can be paid tax-free depends upon the technicalities of the situation.
Examples of where sums can be paid tax-free under a settlement agreement
- Where your employer terminates your employment but agrees to pay you a sum of money to compensate you for the termination of your employment;
- Where you are discriminated against, harassed or victimised during your employment, leading to a claim for discrimination (or harassment or victimisation);
- Where a sum of money is paid to you
Please note that the £30,000 tax-free upper limit applies in respect of all of the above examples.
What you should do if you have been offered a settlement agreement
If you have been offered a settlement agreement then it is recommended that you do the following:
- Obtain details of what you are being offered in writing;
- Categorise the payments that you are receiving as best as you are able (in order to evaluate whether any sums you are receiving can be paid tax-free and, if so, how much);
- Consult an expert employment solicitor to obtain legal advice on the settlement agreement