Are Payments Made For Legal Settlements Taxable?

What is a Legal Settlement?

In terms of the law, a legal settlement is an act of settling or adjusting a dispute between individuals or groups of individuals without pursuing the matter through court. Typically, it happens when the defendant agrees to some or all of the claims of the plaintiff by deciding not to fight the matter in court.

What kinds of matters can I settle?

Legal proceedings can be complicated. Given the nature of proceedings and hearings, it could take years to settle a case if you decide to take the matter to court. However, if you feel that there is no need for unnecessary legal proceedings, then the settlement is the best option. There is no list of matters that can be settled or not settled through settlements. It is at the discretion of the parties involved.

Are payments made for Legal Settlements Taxable?

As per the general rule, payments for settlements are not taxable. However, there is a limit. As long as the payment made for a settlement does not exceed the sum of £30,000, there will be no tax. Section 62 of Income Tax (Earnings and Pensions) Act 2003, specifies the following as chargeable to income tax only if the amount exceeds the exempted limit:

Are payments made for legal settlements taxable?
  • Outstanding salary payments and holiday pay,
  • Payments derived out of employment, such as non-cash payments, a bonus in cash or in kind, etc.
  • Non-cash benefits such as retention of a company car,
  • Other kinds of payments made as per the employee’s employment contract,
  • Payment made to an employee to enter into or abide by the post-employment restrictive contract, and
  • Payments made to the employee in connection to the termination of the employee’s contract that is not chargeable to income tax.

The payments made to the employee by the employer are only exempt up to the limit of £30,000, meaning anything beyond that is to be charged as per the regular income tax. (Section 401)

What kinds of payments are exempt from Taxation under Settlements?

There is no such limitation as to which type of payments will be taxable. As per section 401 of the Income Tax (Earnings and Pensions) Act 2003, payments made as statutory, contractual or ex gratia payments and payments made as non-gratia compensation for loss of employment are included. However, it must be noted that only the first £30,000 is exempt from tax.

Are there any changes to these rules?

With new rules specified by Finance (No.2) Act 2017, effective from 6th April 2018, the distinction between contractual and non-contractual payments has been removed. Earlier, payments received for non-contractual payments were exempt from the £30,000 bracket. However, with new rules, such an exemption cannot be passed. All payments made under legal settlements are liable to be taxed as per the on-going income tax rates. It must be noted that the previous rules will apply to all the terminations that were made before 6th April 2018. But for all the terminations made after or on 6th April, new rules shall be applicable.

Are Legal Costs also Taxable?

The legal costs of the solicitor for the employee are to be paid by the employer. Such payments are non-taxable as long as these payments are made for the purpose of settling the employee’s case only. Meaning as long as the services of the solicitor were made in connection to the employee’s termination of employment, the payment will not be subject to any tax.

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