A Piece of the Pie: Making Sense of Taxes in Employment Law Settlements

A Piece of the Pie: Making Sense of Taxes in Employment Law Settlements

Congratulations! After a disheartening termination, you and your employment lawyer have managed to work out a settlement with your former employer that compensates some of your financial losses and helps put your mind at ease. Yes, you’ll probably need to find a new job in time, but it is hard to deny the immediate sense of relief that comes from ending the negotiation process. 

The one thing you probably haven’t thought of though is tax, and thankfully your employment lawyer has. Yes, there are taxes even when it comes to settlement, and your lawyer has worked hard to structure the deal in a way that makes the most sense for you financially. 

That means that your employment law settlement will probably look a bit complicated. Instead of one large lump sum of money, it will likely be structured in a complex fashion featuring various types of payments that your lawyer will carefully explain to you in something much closer to plain English. 

Without making things too complicated (I am not an accountant or a financial professional), here’s a primer on some of the tax considerations, such as damages, retiring allowances, and employment income, that may come up when settling your employment law matter. 

General Damages

Let’s start with the good news. General damages, which are awards given to compensate you when you’ve been wronged, are not taxable! 

So what does that mean for you? General damages will often cover human rights damages, which are common in many employment law terminations. If you were discriminated against at all in your termination, you may have included a human rights element to your complaint, either in your lawyer’s initial letters to your former employer or in any further documents such as a Statement of Claim, etc. 

This not only tells the former employer of how you feel your rights were violated, but will likely lead the lawyers later on to structure a portion of the settlement as general damages. It will not likely be the whole settlement, but perhaps a portion that the employer can attribute to any perceived wrongdoing, and a portion on which the employee will not pay tax.

The amount of these general damages can be the subject of some negotiation between the lawyers. While a larger number is obviously more tax advantageous for an employee, an employer will likely be unwilling to have too large a lump sum payment go out for in case it raises any concerns from the Canada Revenue Agency. Therefore, while an employee’s lawyer may argue for much of the settlement to go towards these general damages, the end result may be something of a compromise.

Retiring Allowance

A retiring allowance is an amount received after an employee retires or is no longer at their position, voluntarily or involuntarily. It is preferable for employees because it is taxed at a more favourable rate than if the money was paid out entirely as employment income.  

Employees also have the option, if they were with their employer for many years, to move a portion of their retiring allowance directly into an RRSP without affecting the employee’s deduction limit. Employees can roll over $2,000 per year for every year worked prior to 1996, and $1,500 per year for every year worked prior to 1989. This is, of course, an advantage for longer service employees who have been in their role for several decades. 

Employment Income

While it may not be the most ideal for tax purposes, your employer will likely be looking to pay any money owed for reasonable notice as employment income. This includes any salary, benefits, vacation pay owing or any other pay in lieu of notice. 

Even though it comes after the fact, this still counts as employment income according to the Canada Revenue Agency, and so it will still be taxed as such. 

That said, there may be something of a silver lining. While employment income is taxable, there are possible tax deductions for income purposes for legal fees spent to reclaim income in a given year. There are, of course, various conditions on these deductions, so it's best to consult with a tax professional who can explain things further. 

Call The Pros

If this sounds complicated, that’s because it is! Most lawyers, unless they practice specifically in the field, are not tax experts. An employment lawyer will likely consult with your financial professional (after receiving your permission) to be sure that your settlement is structured in the best possible manner for your personal situation. 

For both employers and employees, it can be beneficial to at least have a working knowledge of how settlements are taxed in order to take full advantages of any arrangements that may be available to optimize your personal tax scenario. Your lawyer will work with you carefully to make sure any payments are structured in a way that makes sense from a tax perspective, although keep in mind there will likely still be some tax payments involved. Yet even if you have a working knowledge of the subject, it still would be beneficial for both parties to consult with an expert just to avoid any nasty surprises from CRA.

The bottom line is that tax planning is complicated, but that doesn’t make taxes go away, and there are skilled professionals who are happy to help. 

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