Settlement agreements explained: Top tips & how to get them right

If you’re staring down a reorganisation, a redundancy risk, or a fraying working relationship, a well-drafted settlement agreement can be the difference between clean closure and months of expensive uncertainty. In this episode, Partner Helen Goss and Solicitor Rachael McAnulty break down everything employers and employees need to know about settlement agreements.

With organisations continuing to restructure in a challenging economic climate, settlement agreements are increasingly common but they’re often misunderstood. Helen and Rachael discuss what a settlement agreement is, when it should be used, and the key clauses that must be drafted with care.

From tax treatment and PENP calculations to restrictive covenants, legal fee contributions, and the importance of getting notice arrangements right, this conversation provides clear, practical guidance for HR teams, business owners, and individuals exiting a company.

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Transcript

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Helen Goss: 0:03

Welcome all of you to our Boys Turner Employment Law Pod. My name's Helen Goss, and I'm a partner in the employment team with Boys Turner, and I'm absolutely delighted to be joined by my colleague Rachel McAnalty, who is a solicitor in the team. Hi Helen. Now then, we are going to talk today about settlement agreements. The current economic climate is difficult for a lot of employers, and we're seeing quite a lot of organisations reorganizing, resizing, rationalizing, and potentially reducing headcount. So quite a lot of people are coming through our doors having a settlement agreement, or alternatively, we're preparing them for our employer clients. So that's what we're going to look at today. So before I set Rachel on to our top 10 thrilling points, I just really wanted to talk about what is a settlement agreement and what does it do. So it's essentially a legally binding contract between an employee and an employer to end the employment relationship or as well to resolve a dispute on terms. It's generally a waiver of claims in return for an exit and some degree of compensation or exgratia payment to buy off potential claims in the employment relationship. And of course, always without admission of liability. So, Rachel, I know that you do do a lot of settlement agreements, whether that's on behalf of individuals or for companies who offer them to their employees. So when would you typically see a settlement agreement?

Rachael McAnulty: 1:51

So settlement agreements are normally used to resolve ongoing issues or short circuit some sort of process like a redundancy or a disciplinary, and they would ordinarily follow a protected conversation. There might not even be a dispute. It might be that the working relationship is breaking down or someone's career is coming to an end. And it's a way for the individuals involved to draw a line under matters and move on.

Helen Goss: 2:18

And what about the benefits? Because sometimes businesses will say, Oh, let's just do a letter. What's the benefit of a settlement agreement?

Rachael McAnulty: 2:29

So I would say there's probably five main benefits to a settlement agreement. The first being certainty, the parties know where they stand, there's written terms and obligations in the agreement. It provides closure to those involved. It avoids the time and costs of continuing to deal with the issue. It's a speedy way of resolving issues. And of course, there's confidentiality between the parties. And as you mentioned, liability is limited on the employers.

Helen Goss: 2:59

Yes, it's a good point that you raise about closure because I do find that both parties generally want to draw that line in the sand and they want to be able to go on their hopefully merry way without then dwelling on the issues. So I think it really is a good way to bring everything to a satisfactory end. Right now then, top 10 thrilling points about settlement agreements. Because when you're drafting a settlement agreement, it is so important to get it right because it is a legally binding agreement, so people can potentially sue on it because it's it's a contract. So it's absolutely essential to get it right. There are also tax implications which we'll look at. So, number one, what's the starting point for drafting a settlement agreement?

Rachael McAnulty: 3:56

So, my number one top tip is to have the contract on hand when you start to draft the settlement agreement or in fact before making the offer, so you know exactly what you're offering from the start. Employees can't consider the agreement or get advice on the terms before they know what's being offered to them. And of course, they're not going to be so receptive if we keep having to go back and make changes later. There also might be some things in the contract which we want to preserve in the agreement, such as confidentiality provisions or restrictive covenants, as you mentioned, but we'll discuss those in a little bit more detail later.

Helen Goss: 4:32

It's it's right, isn't it? Because people often have really bad memory about what's actually in their contract, whether it's their contract or the contract they have offered to employees. So you're you're absolutely right. Get the contract out and read it before you start considering what is your offer going to be, or before you start drafting a settlement agreement. Now then, number two top tip tax on termination payments. Now that's something that causes a lot of excitement, dread, or disappointment, one or the other. So when is it possible to get some sort of tax break where a settlement agreement is involved?

Rachael McAnulty: 5:19

Yeah, so this is actually one of the most attractive elements of a settlement agreement for an employee, and that is the fact that a genuine termination award can be paid tax-free, up to £30,000. Now, what is a termination award? It doesn't include any payment which is ordinarily taxable as earnings or subject to income tax, for example. So it excludes things such as contractual or statutory notice and holiday pay and things like that. So a pylon has to be taxed. Yeah, that's right. So it generally applies to the settlement or compensation figure itself. If the individual's entitled to a statutory or contractual redundancy payment, then that can also form part of the tax-free figure. So that's something to take into account when drafting. But ultimately, it's really important for employers to consider the tax implications of the offer and seek advice if they need to.

Helen Goss: 6:15

I think that it's really important as well to understand that retention bonuses and bonuses generally are always going to be taxable. And it's virtually impossible to try and convert a contractual bonus into an X Gratia payment because we're then verging on the brink of tax evasion essentially. So let's now slide into point three, Rachel, which is an area that I know employers dread. We slightly dread as lawyers, and I think most individuals have no idea what it is at all, not surprisingly. PENP, so the post-employment notice pay calculation. Can you talk to us a little bit about that? Yeah, sure.

Rachael McAnulty: 7:10

So in really simplistic terms, post-employment notice pay is tax calculation and it's used to determine income tax and national insurance contributions where an employee does not work their notice period or does not work their notice period in full, but no payment in lieu of notice or the remainder of notice has been made. And the effect is ordinarily that some part of the settlement or termination payment will be taxable. It's designed to ensure that any payment an employee receives for a notice period they do not work is treated as taxable earnings as it should be. And it prevents situations in which settlement agreements or settlement payments are used as vehicles to avoiding tax liabilities, whether or not that is intended. Usually, if an employee has worked their notice period in full or is paid in lieu of their entitlement to notice, then the calculation will come out as nil. However, the obligation is on the employer to satisfy itself that they have made the calculation and done it so correctly. There'll be an article on our website a little bit later where we demonstrate the calculation and how it works.

Helen Goss: 8:23

It's quite a complicated calculation. And we had thought we might try and describe the calculation on the pod, but I think that's that's impossible. So we have done an article. What I was just going to say about that, Rachel, is that we do sometimes see situations where employers or on request from departing employees try and amend the contract to waive notice, etc. But the whole point about the post-employment notice pay calculation is that that's not going to happen. And that and that element of the settlement payment will then be subject to tax. So it's it's unfortunately veering on tax evasion, and no business wants that because if the revenue do look into it, and very likely they would not, but if they do, then the business is going to be subject to tax audits, and absolutely no business wants that. Right now then, number four, Rachel, notice. Now there's a whole load of things that businesses can do with notice. So what are your thoughts about that?

Rachael McAnulty: 9:42

Yeah, so employers have quite a few options here. The normal options are to either require the employee to work their notice period, keep them employed for a duration of their notice period, but on garden leave, make a payment in lieu of notice or a mixture of two or more of those options. Now, generally, an employer might want to pay a payment in lieu of notice where the relationship has broken down and the parties want to draw a line under the events and go their separate ways. Garden leave, on the contrary, might be more favourable if you have a senior employee who we might not want to be working for us or contacting our staff or clients, but we would prefer to keep on the books and avoid them being out in the job market.

Helen Goss: 10:26

Yeah, and I think that's quite a good way of keeping employees out of the job market, isn't it? Is to put them on garden leave. And it's really important that if you do put them in uh on garden leave, that there is provision in your contract of employment to allow you to do that. That's right. And also that you explain to them exactly the terms on which they are on garden leave. So they don't have to come into the office. In fact, they shouldn't come into the office, they shouldn't contact employees, and they shouldn't contact clients or suppliers. So really important to put that in writing to people on garden leave. Navin, I always say number five is the most important part, really, of a settlement agreement, and that's the waiver of claims.

Rachael McAnulty: 11:21

Yeah, that's right. So, as you say, that's usually the most valuable part of the agreement for an employer. So usually the waiver of claims is made without admission of liability in almost all circumstances, as the employer is not going to want to admit any wrongdoing to make compensation payment. But equally, that admission might be quite important to the individual involved if they feel that they've been wronged. So it can sometimes be a point of contention. Claims can be seriously draining on an employer's resources. So the waiver of claims in itself is a massive advantage to entering into the agreement. However, employers need to bear in mind that there are certain claims which are not capable of being waived under the terms of settlement agreement. Broadly speaking, these are some pension rights claims, personal injury claims, and claims to enforce the terms of the agreement if we are in breach later on.

Helen Goss: 12:18

Yes, and you nearly always see those excluded, don't you? Yes.

Rachael McAnulty: 12:22

From the waiver. Ordinarily it's explicit in the agreement.

Helen Goss: 12:26

And I think it's also not possible to waive information and consultation claims in respective of 2P.

Rachael McAnulty: 12:35

Yes, that's right. And also rights in relation to the data protection legislation are not normally waivable either.

Helen Goss: 12:47

Right, now then, number six, restrictive covenants. Now I always get very excited about restrictive covenants, and I generally find that individuals want to try and ignore the restrictive covenants in the employment contract, which which of course they entered into when they were excited about their new job and couldn't anticipate that anything would ever go wrong. And they might be in a situation where they were exiting under a settlement agreement. So how are often restrictive covenants dealt with in settlement agreements?

Rachael McAnulty: 13:22

Ordinarily, I see restrictive covenants in employment contracts reaffirmed in the agreement. They're quite useful for an employer because obviously their purpose is to protect the business, particularly where we've got senior employees living under the terms of a settlement agreement, where we might not want them to compete with us or use our customer lists or use any of our important business data. So if there are restrictive covenants in the contract, then we are going to want to reaffirm these in any agreement.

Helen Goss: 14:01

Moving then, linked number seven is consideration. So what's the relevance then of consideration in respect of reaffirming restrictive covenants, probably also protecting confidential information and intellectual property?

Rachael McAnulty: 14:17

Yeah, so consideration itself is a legal principle which essentially requires an exchange of value between the parties in order for a contract to be valid. So, in simple terms, you can't make somebody promise you something for nothing. If we want to include new restrictions or reaffirm old restrictions in a settlement agreement, we will need to give a nominal value of consideration in exchange for those new restrictions. Now, this can be as little as £50, but it's really important to distinguish a consideration payment from the settlement figure as a consideration payment is taxable. And if we don't make a distinction, then this presents a tax risk to the settlement figure.

Helen Goss: 15:01

Right. Okay. Because I think a lot of people forget that that consideration figure is taxable. And I do wonder how often that slips by untaxed by the business. So an important pointer. Just going back to number six and restrictive covenants. Sometimes businesses think that the restrictive covenants in the employment contracts are not sufficient because they haven't updated them, perhaps, as an individual has been promoted or changed role and become more senior in the organization. So it is possible to agree new restrictive covenants and to include those in a settlement agreement with consideration. But of course, your negotiating position as an employer is seriously affected by trying to agree new restrictive covenants because you've got to wonder who is going to agree those unless there's a more significant payment in exchange.

Rachael McAnulty: 16:03

Yes, that's right. And I think employers, if that's what they want to do, they need to expect a fight.

Helen Goss: 16:12

Right, number eight, legal fees, always something close to my heart. How often are those dealt with in settlement agreements?

Rachael McAnulty: 16:22

So it's not required, but it's very, very common for employers to contribute towards an individual's legal cost for obtaining advice on an agreement. And I've actually never had any occasion in which an employer has failed to make a contribution. The reason being is that it's a statutory requirement for an individual to obtain advice on the terms and effects of a settlement agreement in order for that agreement to be legally enforceable.

Helen Goss: 16:50

Okay, then so the the settlement agreement needs to have a legal eye over it on behalf of the individual, but it's not an a legal requirement for the employer to contribute to the cost of that.

Rachael McAnulty: 17:03

No, that's quite right. But in the sense that the employer will want the agreement to be legally binding, and this can only be achieved if the employee has received that advice, ordinarily employers are willing to pay towards that for that security. And usually legal fees are paid directly to the legal advisor, as this is a tax-efficient method for the individual.

Helen Goss: 17:26

Yes, because if you pay it to the individual, it becomes a taxable benefit. Whereas if it's paid directly to the law firm, then it can be paid free of tax.

Rachael McAnulty: 17:37

That's right.

Helen Goss: 17:38

Now, sometimes we do see, particularly where there have been protracted negotiations between the company and the lawyer for the individual, and fees have increased over and above the initial contribution. A request that some element of the settlement amount is repurposed as legal fees so that then the full tax benefit, particularly if the settlement agreement is over 30,000. Now then, number nine, payment terms.

Rachael McAnulty: 18:13

Yeah, so this is a small point in the grand scheme of things, but employers really need to think about the payment terms that they're including in the agreement and whether these can actually be met by the payroll team.

Helen Goss: 18:25

Yeah. We've seen a lot of people getting agitated because payments haven't been made and they're outside deadlines set by the payroll system.

Rachael McAnulty: 18:35

Absolutely. And failure to pay, employers need to realise, is a breach of the time of the agreement and entitles the employee to pursue an enforcement claim, which which is a hassle and something that we want to avoid.

Helen Goss: 18:48

No, absolutely. If you've agreed to do something within a certain timescale, then please do it, particularly if you're the employer. But then equally, if you're the employee and you've agreed that you're going to return property belonging to the business, etc., make sure that you do that in time as well. So number 10, I was hoping to do a large ta-da about number 10. But our subject on number 10 is signing. Now, this does sometimes cause a lot of controversy, doesn't it?

Rachael McAnulty: 19:25

It does, yes. So if there are power of attorney provisions in the agreement, which you would ordinarily see if there are intellectual property terms, or if we are not giving consideration for any new restrictions in the agreement, then the agreement will need to be signed as a deed. And that means that the party's signatures will need to be witnessed by someone else. Otherwise, we can normally sign the agreement as a normal contract.

Helen Goss: 19:53

Yes, and businesses hate when we have to sign as a deed because only a statutory director can sign. And sometimes the statutory directors are not physically available or concerned to sign. So it can be very problematic. But it you're absolutely right. For the the relevant terms then to be binding, it does need to be signed under a deed. So where we can, we will try and ensure that we don't require signing as a deed, which requires witnesses. But on occasion, it really is necessary to give full effect to the terms that you've agreed and will want to enforce should that ever be necessary. Well, thank you, Rachel. No problem. Settlement agreements, they really are the mainstay of the work that we do, and also with a lot of companies, because they want to make sure that they do have that closure and that everything is legally enforceable, a for themselves, but also for the individuals who they are letting go. So if you do have any questions, then please do get in touch and our contact details are on the website. And as Rachel mentioned, we do have an article on the issue of post-employment notice pay and the tax calculation. I know that you're all going to hate doing it, but it really is essential that you carry out that calculation each time that you work out what the tax obligation is. We are finding that quite a lot of payroll departments don't know what the PENP is, so maybe the article can be passed over to them if they're not sure. So thank you again for listening to our Employment Law podcast. If you're interested in checking out more episodes in this series, please do go to the Boys Turner website. You can also follow wherever you listen to your podcasts. Goodbye for now.