The VAT Flat Rate Scheme Explained: Is It Still Worth It, and the 16.5% Limited Cost Trap

The VAT Flat Rate Scheme is still worth using if your business buys real goods, and it is usually worse than standard VAT accounting if you are a consultant who does not. The dividing line is the limited cost business rule. If your spending on goods is less than 2% of your flat rate turnover, or more than 2% but less than £1,000 a year, you pay 16.5% of your VAT-inclusive takings to HMRC instead of your trade sector percentage. At 16.5% you hand over £99 of every £100 of VAT you charge and keep £1. Almost any consultant with normal business costs does better by reclaiming input VAT the ordinary way.

The scheme was designed to save small businesses the work of tracking input VAT on every purchase. You charge your customers the normal rate of VAT, usually 20%, you issue normal VAT invoices, and then instead of paying HMRC the difference between output and input VAT you pay a fixed percentage of your gross takings. You keep the difference. That was a genuine profit for service businesses until April 2017, when HMRC introduced the 16.5% limited cost rate specifically to stop it.

Who can join, and the two thresholds that do not match

You can apply to join if your taxable turnover excluding VAT in the next year will be £150,000 or less. You have to apply to HMRC; you do not simply start using it. Read the conditions on GOV.UK before you apply.

You cannot join if any of the following apply:

• You use the second-hand margin schemes or the auctioneers' scheme, or you have to use the Tour Operators' Margin Scheme.
• In the 12 months before your application you accepted a compound penalty offer, were convicted of an offence connected with VAT, or were assessed a penalty for conduct involving dishonesty.
• You are in a VAT group, or you are eligible to join one.
• You are associated with another business.
• You left the scheme in the previous 12 months. Once you leave, you are not eligible to rejoin for 12 months.

Here is the first thing that catches people out. The joining test uses turnover excluding VAT and the figure is £150,000. The test for when you must leave uses total income including VAT and the figure is £230,000. They are different numbers measured on different bases, so you cannot watch one figure and assume it covers both. A consultant billing £185,000 net is at £222,000 gross and is still inside the scheme, even though the net figure is far above the joining threshold.

How the sector percentages actually work

You pick the trade sector that best fits your main business activity and apply that percentage to your flat rate turnover. Flat rate turnover is not your net sales. It is all the supplies your business makes including VAT: your VAT-inclusive sales for standard-rated, reduced-rated and zero-rated supplies, plus the value of any exempt income. People routinely apply the percentage to the net figure and underpay.

These are the percentages most relevant to service businesses, taken from the published table:

Two other rules matter. First, you cannot reclaim VAT on your purchases, with one exception: you can reclaim the VAT on a single purchase of capital expenditure goods where the amount of the purchase including VAT is £2,000 or more. A £1,700 laptop gets you nothing. Second, if you are in your first year of VAT registration you get a 1% reduction in your flat rate percentage, which runs until the day before the first anniversary of becoming VAT registered.

You can model any of this with the flat rate VAT calculator, and check the figures against the VAT return calculator for standard accounting.

The limited cost business rule, and both limbs of the test

You are a limited cost business, and must use 16.5%, if your spending on relevant goods is either:

• Limb one: less than 2% of your VAT flat rate turnover, or
• Limb two: more than 2% of your VAT flat rate turnover but less than £1,000 a year. If your return covers less than a year the figure is the relevant proportion of £1,000, which for a quarterly return is £250.

Most people only remember limb one. Limb two is what catches very small businesses: if your quarterly gross takings are £9,000, then 2% is £180, and buying £200 of goods clears the 2% bar but still falls under the £250 quarterly floor. You are a limited cost business anyway. To escape the rule you have to clear both hurdles in the same period.

"Relevant goods" is narrower than people assume, because services do not count at all. HMRC's own list of things that are not relevant goods includes accountancy fees, advertising costs, anything leased or hired, goods not used exclusively for business, food and drink for you or your staff, fuel for a car unless you are in the transport sector, electronic devices such as a laptop or mobile phone (excluded as capital expenditure), anything provided electronically such as a downloaded magazine, rent, downloaded software, bespoke software, and stamps and other postage costs.

Strip those out and a typical consultancy has almost no relevant goods at all. Your laptop is capital expenditure. Your software is a service. Your office rent is a service. Your accountant is a service. What is left is stationery, printer ink and coffee, and coffee for you or your staff is excluded too.

The test is not a one-off. HMRC's guidance says businesses whose goods are close to 2% may need to complete the test each time they complete a VAT return, which means the correct percentage can change from quarter to quarter.

Worked example: a consultant on 14% against standard VAT accounting

Nadia runs a management consultancy. She invoices £96,000 of fees in the year and charges 20% VAT on top, so she collects £19,200 of VAT and her flat rate turnover is £115,200. Her input VAT for the year comes to £1,300, mostly on software, her accountant and a co-working desk. She joined the scheme on the management consultancy rate of 14%.

Her relevant goods for the year total £180 of stationery and print supplies. Two per cent of £115,200 is £2,304. She is under that, so limb one bites and her real rate is 16.5%, not 14%.

On the 14% rate the scheme was worth £1,772 a year to her. On 16.5% it costs her £1,108 a year more than simply doing standard VAT accounting, and £2,880 more than the figure she has been budgeting for. That is the trap in one line: she joined on a favourable sector rate, the business never changed, and the reclassification alone flipped a £1,772 gain into a £1,108 loss.

The arithmetic behind it is worth internalising. Charging 20% VAT on a net sale of £100 gives gross takings of £120. Paying 16.5% of £120 is £19.80. You collected £20 of VAT and handed over £19.80, so you keep 20 pence. On the flat rate you keep 1% of the VAT you charge, and you give up every penny of input VAT recovery to do it. Unless your input VAT is genuinely near zero, standard accounting wins.

Worked example: the first year, and the quarter the trap springs

Marcus registers for VAT and joins the scheme as an IT consultant on 14.5%. Because it is his first year of registration he takes the 1% reduction, so he files at 13.5% until the day before his first anniversary.

His first quarter: £20,000 of net fees, £4,000 of VAT, flat rate turnover £24,000. Input VAT that quarter is £420.

• Standard accounting: £4,000 less £420 = £3,580.
• Flat rate at 13.5%: 13.5% of £24,000 = £3,240. He is £340 better off.

Now apply the test. His relevant goods that quarter were £190 of cables, adapters and consumables. His laptop does not count, because it is capital expenditure. His cloud subscriptions do not count, because they are services. Two per cent of £24,000 is £480, and £190 is below it. He is a limited cost business, so his rate is 16.5% less the 1% first-year reduction, which is 15.5%.

• Flat rate at 15.5%: 15.5% of £24,000 = £3,720. He is now £140 worse off than standard accounting, and £480 worse than the return he was about to file.

Once his first anniversary passes the 1% reduction stops, and the same quarter costs him 16.5% of £24,000, which is £3,960. That is £380 a quarter, or roughly £1,520 a year, thrown away for the convenience of not adding up his input VAT. If he is weighing up how he trades as well as how he accounts, the wider picture is in our guides on PAYE versus self-employed and salary versus dividends for directors.

When you must leave the scheme

You must leave if, on the anniversary of joining, your total income including VAT for the year then ending, excluding sales of capital assets, is more than £230,000. You must also leave if at any point you expect the total value of your income for the next 30 days alone to be more than £230,000. Both figures include VAT, and that is deliberate: HMRC's own manual explains that the leaving test is tax inclusive as a simplification, because a flat rate user is already calculating VAT on gross income, and notes that this differs from the joining test.

You can also leave voluntarily at any time by writing to HMRC, and HMRC can withdraw your use of the scheme. Whichever way you go, once you are out you cannot rejoin for 12 months, so leaving because of one unusually good year is a decision with a tail on it.

So is the Flat Rate Scheme still worth it?

Run three numbers before you decide, for a full year and then for each quarter.

• Your relevant goods against 2% of gross takings, and against £250 a quarter. If you fail either limb you are on 16.5% and the answer is almost certainly no.
• Your annual input VAT. On 16.5% your entire margin is 1% of the VAT you charge. If you reclaim more than that under standard accounting, standard accounting pays more.
• The value of your own time. Standard accounting means capturing input VAT on every purchase. With digital record keeping already the default for VAT and spreading further under Making Tax Digital for Income Tax, most of that capture is happening anyway, so the simplification the scheme was built to sell is worth less than it once was.

The scheme still works for businesses that buy stock: a retailer, a caterer, a builder buying materials, anyone whose goods comfortably clear both limbs. It also still works for a business with genuinely no input VAT and a low sector rate. For a solo consultant with a laptop, some software and an accountant, it has become a way of paying HMRC more than you owe.

If you are on the scheme and have never re-tested, do it before your next return rather than after. Filing at 14% when you should be filing at 16.5% is an underdeclaration, and it compounds every quarter you leave it. Get the numbers straight, then look at the rest of your position with our beginner's guide to self-employed tax and the self assessment deadlines guide. If you are checking supplier paperwork at the same time, the VAT invoice checker will tell you whether an invoice actually supports a claim.