Do you pay tax on the legal advice payment included in a settlement agreement?

Full answer

Settlement agreements (formerly compromise agreements) are only legally binding if the employee has received independent legal advice on the terms and effect of the agreement, and the way this advice is paid for has a specific, narrow tax exemption. **Why the exemption exists** Because independent legal advice is a legal precondition for a valid settlement agreement, HMRC exempts the employer's contribution towards that specific advice from tax and National Insurance -- otherwise, employees would effectively be taxed for complying with a legal requirement imposed for their own protection. **Conditions for the exemption to apply** The exemption only applies if: the payment is made directly by the employer to the employee's solicitor or adviser (not paid to the employee, who then pays the solicitor themselves); the settlement agreement contains a specific clause confirming the payment relates to advice on the agreement itself; and the adviser holds an appropriate qualification (a practising solicitor, barrister, legal executive, or certified trade union official/advice worker as specified in the legislation) with a current policy of indemnity insurance. **What is NOT covered** If the legal fee payment exceeds the actual cost of the specific advice on the settlement agreement, or covers unrelated legal work (such as advice on a separate personal matter, or negotiating additional termination terms beyond just explaining the agreement), the excess may not qualify for the exemption and could be treated as taxable earnings or under the termination payment rules instead. **How it interacts with the wider settlement package** The legal fee contribution is separate from, and does not count towards, the £30,000 tax-free threshold that can apply to genuine ex-gratia termination payments within a settlement agreement -- it is exempted under its own specific rule, so it does not use up any of that separate allowance. **Worked example** An employer agrees to pay £600 (plus VAT) directly to the employee's solicitor for advice on a settlement agreement that also includes a £25,000 ex-gratia termination payment. The £600 legal fee is paid tax-free directly to the solicitor under the specific exemption, and separately, the £25,000 termination payment falls entirely within the employee's £30,000 tax-free threshold for genuine redundancy/termination payments (assuming no contractual PILON element that would be taxed as earnings) -- the two amounts do not compete against each other or reduce one another. **Practical tip** Employees should check the settlement agreement wording specifically confirms the legal fee will be paid directly to their solicitor and describes it as being for advice on the agreement's terms, rather than leaving the description vague, to ensure HMRC would accept the exemption applies if ever queried.

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