Are Compromise Agreements Subject to Tax

Are Compromise Agreements Subject to Tax


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Compromise agreements, also known as settlement agreements, are legal documents that outline the terms of a settlement between an employer and employee. These agreements are typically used to resolve disputes and avoid expensive legal battles. However, one question that often arises is whether these agreements are subject to tax.

The answer to this question is not straightforward and depends on the specific circumstances of the settlement agreement. Here are the main factors to consider:

Nature of the Payment

The tax implications of a settlement agreement depend on the nature of the payment made to the employee. If the payment is made as compensation for loss of employment, it is likely to be subject to income tax and National Insurance contributions. Similarly, if the payment is made as compensation for injury to feelings or other non-financial losses, it will also be subject to income tax and National Insurance.

On the other hand, if the payment is made as an ex-gratia payment, which is not directly related to the employee`s loss of employment, it may be tax-free up to a certain amount. In order for an ex-gratia payment to be tax-free, it must not exceed £30,000, and it must be genuinely made as a gesture of goodwill, without any obligation to make the payment.

Timing of the Payment

The timing of the payment is also an important factor in determining the tax implications of a settlement agreement. If the payment is made after the employee has left the employment, it is likely to be subject to income tax and National Insurance contributions, regardless of whether it is made as compensation for loss of employment or as an ex-gratia payment.

However, if the payment is made before the employee leaves the employment, it may be possible to structure it as a tax-free termination payment, which is not subject to income tax or National Insurance contributions up to the £30,000 threshold. To qualify as a termination payment, the payment must be made under the terms of the employee`s contract of employment or in connection with the termination of the employment.

Conclusion

In summary, the tax implications of a compromise agreement depend on the nature and timing of the payment made to the employee. If the payment is made as compensation for loss of employment or non-financial losses, it is likely to be subject to income tax and National Insurance. However, if the payment is genuinely made as an ex-gratia payment and does not exceed £30,000, it may be tax-free. In order to maximise the tax efficiency of a settlement agreement, it is important to seek professional advice and ensure that the agreement is structured correctly.

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