Many people believe that if money is paid under a settlement agreement it must be tax free. However, this not necessarily the case. The key issue is the nature of the payment. Make sure you obtain legal advice about which payments are taxable and which are not.
Which payments are taxable and which are not?
As a general rule, compensation is tax free up to a limit of £30,000. Compensation is intended to compensate you for financial losses that result from your employment ending. Typically, this would apply to compensation for future lost earnings.
A redundancy payment should not be taxable. However, this is still subject to a cap of £30,000.
Most employers make a contribution to the employee’s legal costs of obtaining advice. Others contribute towards the cost of outplacement support. Neither of these payments should be taxable.
When obtaining legal advice on the settlement agreement, make sure you discuss the nature of the payments in full so that you can avoid paying tax unnecessarily.
Which payments are taxable?
Any payments which you are entitled to because of your employment contract, such as salary and benefits, are subject to tax.
If you haven’t used all of your holiday entitlement up to the termination date, you are entitled to receive a payment for it instead. This must also be taxable.
Any payment that you receive for entering into restrictive covenants, including a confidentiality agreement, must also be taxable.
What about a Payment in Lieu of Notice?
The rules relating to a payment in lieu of notice (“PILON”) are fairly complicated.
Partly, it depends on whether the payment in lieu of notice is being made under the employment contract or not. It if is a contractual PILON, then it is taxable.
However, if there’s nothing in the employment contract to allow the employer to make a PILON, then the same amount can be paid to the employee but it should be described as compensation for not working a notice period. It can then be paid tax free, subject to the overall maximum of £30,000.
Call us for free legal advice about the tax status of payments in your settlement agreement
If you’d like to speak to a solicitor to make sure you’re not paying too much tax, give us a call.
Alternatively, you may like to download our free guide below.