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 2020/21, the rate of income tax paid by employees is:
- 0% on earnings below £12,500 per annum
- 20% on earnings at the basic rate (typically up to £37,500 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 (unconnected to the employer). The troncmaster pools tips and decides how to allocate them 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 2020/21, the rate of national insurance contributions paid by employees is:
- 0% on earnings below £792 per month
- 12% on earnings between £792 and £4,167 per month
- 2% on earnings above £4,167 per month
In 2020/21, the rate of national insurance contributions paid by employers is:
- 0% on earnings below £732 per month
- 13.8% on earnings above £732 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)
The practice of paying tips to staff is falling in popularity. Some businesses are choosing to pay higher salaries instead of tips.
Cash tips have been falling in popularity and the coronavirus has finished them off.
This is good for staff as they receive a predictable wage. In the past, businesses have used tips to motivate staff to provide a great level of service. But should cash tips be used as a carrot to motivate employees? I'm not convinced. There might be better ways to get the most out of your team.