What is the tax treatment of a settlement agreement payment?

Full answer

Settlement agreements (formerly called compromise agreements) end an employment relationship with an agreed payment in exchange for the employee waiving certain legal claims, and the various elements within the total payment can be taxed quite differently from each other. **Elements that are always fully taxable** Any outstanding contractual pay owed (salary up to the termination date, accrued but untaken holiday pay, contractual bonuses or commission owed) is taxed as normal earnings through PAYE, with full Income Tax and National Insurance applied -- these elements never benefit from any special tax exemption regardless of how the overall settlement is documented. **Post-Employment Notice Pay (PENP)** As with any termination, the notice pay element (whether worked or paid in lieu) must be identified and taxed as earnings under the PENP rules introduced in 2018 -- this applies even within a settlement agreement structure, and cannot be recharacterised as tax-free compensation. **The genuinely compensatory ex-gratia element** Beyond the taxable elements above, a settlement agreement often includes an additional "ex-gratia" payment specifically compensating for loss of employment (rather than for services rendered or notice) -- this portion can benefit from the £30,000 tax-free exemption, the same exemption that applies to genuine redundancy payments, PROVIDED it is genuinely compensatory in nature rather than a disguised payment for something else. **Legal fees contribution** Most settlement agreements include a contribution toward the employee's independent legal advice costs (a legal requirement for the agreement to be valid) -- this is usually paid directly to the employee's solicitor and is generally not taxable as employment income, provided it is paid directly to the solicitor for the specific purpose of advising on the agreement. **Employer NI on payments above £30,000** Since April 2020, employers pay Class 1A National Insurance on the portion of the termination payment (including any settlement agreement compensation) above £30,000, though this does not create an additional employee NI liability -- the employee's own deduction from the excess above £30,000 is Income Tax only. **Worked example** A settlement agreement totals £50,000, comprising: £5,000 unpaid holiday and bonus (fully taxable as earnings), £10,000 PENP notice pay equivalent (fully taxable as earnings), and £35,000 genuinely compensatory ex-gratia payment. Of that £35,000, £30,000 (combined with any other qualifying elements, though here there are none) is tax-free, with the remaining £5,000 taxed at the employee's marginal Income Tax rate. **Practical tip** Always ask for (and have your solicitor review) a clear tax breakdown of exactly how the total settlement figure is split between taxable earnings elements, the £30,000-eligible compensatory element, and the legal fees contribution, since the specific structure and characterisation of each part significantly affects your actual take-home amount from the settlement.

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