Settlement Agreements: When Employees Must Pay Their Solicitor Directly

Settlement agreements are commonly used in employment law to resolve disputes and bring employment relationships to an agreed conclusion. These agreements allow employers and employees to settle potential legal claims and avoid the time, cost and uncertainty of employment tribunal proceedings.

For a settlement agreement to be legally binding, the employee must obtain independent legal advice before signing. In many cases, employers contribute towards the employee’s legal costs. However, some settlement agreements are structured so that the employee must pay their solicitor directly, while the employer makes a separate payment to the employee towards those legal fees.

Although this arrangement may appear straightforward, it can result in employees receiving less than expected once tax, National Insurance and VAT are taken into account.

Understanding how these payments work is therefore important before signing a settlement agreement.

Why Independent Legal Advice Is Required

Settlement agreements must satisfy specific legal conditions to be valid. One of the most important requirements is that the employee receives advice from an independent legal adviser.

This requirement arises under the Employment Rights Act 1996.

The adviser must confirm that the employee has been advised on:

• the terms of the settlement agreement
• the legal effect of signing it
• the employment rights that are being waived

Without independent legal advice, the settlement agreement will generally not prevent the employee from bringing employment claims against the employer.

When the Employer Pays the Employee Instead of the Solicitor

In many settlement agreements, the employer pays the employee’s solicitor directly for providing the required legal advice. When structured in this way, the solicitor submits an invoice to the employer and the contribution is usually paid directly to the law firm.

However, some agreements take a different approach.

Instead of paying the solicitor directly, the agreement may state that:

• the employee must pay their solicitor directly, and
• the employer will pay a contribution towards legal fees to the employee.

This means the employee receives the contribution as part of the settlement payment and must then use those funds to pay their solicitor.

While this may seem administratively simple, the structure of the payment can create financial issues.

Tax and National Insurance on Legal Fee Contributions

Where a contribution towards legal fees is paid directly to the employee rather than the solicitor, the payment may form part of the employee’s termination payment.

Depending on how the settlement agreement is structured, the payment may be subject to income tax and, in some circumstances, National Insurance contributions.

For example, if a settlement agreement states that the employer will contribute £500 towards legal fees, the employee may not necessarily receive the full £500 if deductions apply.

The amount available to pay the solicitor could therefore be reduced.

Employees should obtain advice on the tax treatment of termination payments, as the position can vary depending on how the settlement agreement is drafted.

VAT on Solicitors’ Fees

Another important consideration is VAT on legal services.

Solicitors’ professional fees are generally subject to VAT at the prevailing rate. This means that a solicitor charging £500 for advising on a settlement agreement will normally issue an invoice for:

• £500 legal fees
• £100 VAT

Total: £600

If the employer’s contribution is £500 and that amount is paid to the employee rather than the solicitor, the employee may still need to pay the VAT element of the solicitor’s invoice.

Example of How This Can Affect Employees

Consider a settlement agreement that states:

The employer will contribute £500 towards the employee’s legal costs.

The agreement also provides that the employee must pay their solicitor directly and that the contribution will be paid to the employee.

In practice, the position may be as follows:

• Employer pays the employee £500 towards legal fees
• Depending on the structure of the payment, deductions may apply
• The solicitor’s invoice may be £500 plus VAT (£600)

In this situation, the employee may receive less than £500 after deductions but still have to pay £600 to their solicitor.

As a result, the employee may need to contribute towards their own legal costs despite the employer offering a legal fee contribution.

Why the Structure of Legal Fee Payments Matters

The way legal fee contributions are structured in a settlement agreement can significantly affect the amount the employee ultimately receives.

There is an important difference between:

Employer Paying the Solicitor Directly

• the solicitor invoices the employer
• the contribution is paid directly to the law firm
• the payment may be structured so that tax deductions do not apply.

Employer Paying the Employee

• the payment may form part of the settlement payment
• tax or National Insurance may apply depending on the circumstances
• the employee must still pay the solicitor’s invoice, including VAT

For this reason, employees should carefully review how legal fee contributions are structured before signing the agreement.

What Employees Should Check Before Signing a Settlement Agreement

Before signing a settlement agreement, employees should confirm:

• whether the employer will pay the solicitor directly
• whether the legal fee contribution is stated plus VAT
• whether the payment may be subject to tax or National Insurance deductions
• whether the contribution is sufficient to cover the anticipated legal fees.

Clarifying these issues early can help avoid unexpected costs.

Taking Advice on Settlement Agreements

Settlement agreements are designed to provide certainty for both employers and employees, but the legal and financial implications should be clearly understood before signing.

Independent legal advice ensures that employees understand:

• the rights they are giving up
• the structure of the settlement payment
• the potential tax implications
• how legal fee contributions will operate

A solicitor advising on the agreement can also consider whether it may be appropriate to ask the employer to pay legal fees directly to the solicitor, rather than paying a contribution to the employee.

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Disclaimer: The information contained in this article is provided for general guidance only and does not constitute legal or tax advice. The law and tax treatment relating to settlement agreements can vary depending on individual circumstances.