A flat fee or percentage fee added to a customer's bill
A payment freely given to an employee by a customer
A separate payroll consisting solely of tips and managed by an employee
Mandatory Service Charge
Mandatory service charge is always subject to income tax and NIC. The employer must deduct both income tax and NIC through payroll.
The rest of this post will discuss voluntary (discretionary) service charge and tips. For simplicity we will refer to both as tips.
When Is Income Tax Charged on Tips?
Tips paid to staff are always subject to income tax. Tips come in two forms.
Some tips are paid by a customer in cash direct to an employee. The employee is responsible for reporting these tips to HMRC. The individual can report tips on their self assessment if they already complete one. Alternatively, they can contact HMRC to adjust their tax code. This will increase the amount of tax they pay through payroll.
Some tips are paid by credit card to an employer and passed onto the employee. In this case, the burden falls on the employer to deduct income tax before paying the employee.
Finally some cash tips are pooled before being distributed to staff. The employer is also responsible for deducting income tax through payroll on pooled cash tips.
In 2022/23, the rate of income tax paid by employees is:
- 0% on earnings below £12,570 per annum
- 20% on earnings at the basic rate (typically up to £50,270 per annum)
- 40% on earnings at the higher rate (typically up to £150,000 per annum)
- 45% on earnings at the additional rate (over £150,000 per annum)
When is National Insurance Charged on Tips?
Tips allocated by the employer are subject to national insurance contributions (NIC). Tips paid in cash direct to employees are free from NIC. Income tax is still payable (see above).
How To (Legitimately) Avoid NIC on Tips
To be exempt from NIC the tip must not be allocated by the employer.
This can be achieved in one of three ways:
- The customer gives a cash tip direct to an employee.
- A troncmaster position is created (this can be any employee but not the employer - a manager is usually the best option). The troncmaster decides how to allocate tips amongst staff. A separate payroll scheme must be created. The method of payment (cash/card) is irrelevant.
- The exact tip received by card payment is allocated to the member of staff that would have kept it had it been paid in cash (which is tricky but feasible).
In 2022/23, the rate of national insurance contributions paid by employees is:
- 0% on earnings below £823 per month
- 13.25% on earnings between £823 and £4,189 per month
- 3.25% on earnings above £4,189 per month
In 2022/23, the rate of national insurance contributions paid by employers is:
- 0% on earnings below £758 per month
- 15.05% on earnings above £758 per month
Remember, employee NICs are deducted from earnings and paid to HMRC. Employer NICs are calculated on top of earnings and paid to HMRC.
Practical Tips (Pun Intended)
Some businesses opt to pay a higher wage - such as the Real Living Wage - instead of tips.
However, since July 2022 it is now unlawful for employers to withhold tips from staff. All tips and service charges must be passed onto the workers that earn them.
We find that about half of our clients operate a tronc scheme to save national insurance and the other half opt to pay tips through their regular payroll, thereby incurring national insurance.