The VAT Flat Rate Scheme lets small businesses pay HMRC a fixed percentage of their gross VAT-inclusive turnover instead of calculating output tax minus input tax on every transaction. It is famously simple, but the limited cost trader rule introduced in 2017 stripped most of its benefit from low-cost service businesses. This guide explains when the scheme still pays off, and when standard VAT accounting is the better option.
How the scheme works
You add 20% VAT to invoices as normal but pay HMRC a sector-specific flat rate on your gross VAT-inclusive turnover. The difference is yours to keep. You generally cannot reclaim input VAT on purchases, except on capital assets over £2,000 including VAT.
| Worked example (consultant, FRS rate 14.5%) | Standard VAT | Flat Rate |
|---|---|---|
| Net sales | £50,000 | £50,000 |
| VAT charged | £10,000 | £10,000 |
| Gross sales | £60,000 | £60,000 |
| Input VAT on £4,000 expenses | (£800) | n/a |
| VAT to HMRC | £9,200 | £8,700 (£60,000 x 14.5%) |
| Net VAT cost | £9,200 | £8,700 |
| Annual saving | £500 |
That saving disappears the moment you fall into the limited cost trader category.
Limited cost trader rule
A business is a limited cost trader if its goods spend in a VAT period is less than:
- 2% of VAT-inclusive turnover, OR
- 2% of VAT-inclusive turnover and less than £1,000 a year (proportional for shorter periods)
Limited cost traders pay 16.5% of gross turnover regardless of their sector code. That works out to nearly 19.8% of net turnover - effectively no benefit at all and often a small cost.
What does not count as goods:
- Services of any kind (rent, accountancy, software subscriptions)
- Capital expenditure
- Vehicles, fuel, and most vehicle costs
- Food and drink for staff
- Goods bought for resale or hire that aren’t physical (e.g. digital downloads)
What does count: stationery, raw materials, stock, postage stamps, cleaning supplies and other physical consumables.
Eligibility
To join, you must be VAT-registered with VAT-taxable turnover under £150,000 (excluding VAT) in the next 12 months. You must leave when gross turnover exceeds £230,000.
You cannot use the scheme if you:
- Were caught by the limited cost trader rule and want to game your way around it
- Use the VAT margin scheme or one of the second-hand schemes for the same supplies
- Are part of a VAT group or division
- Have left the scheme in the last 12 months
The 1% first-year discount
In your first year of VAT registration you deduct an extra 1% from the flat rate. A 14.5% sector rate becomes 13.5% for the first 12 months. Limited cost traders still get the discount: 16.5% becomes 15.5%.
Sector rates
| Sector (illustrative) | Flat rate |
|---|---|
| Accountancy, legal services | 14.5% |
| IT consultancy, computer services | 14.5% |
| Management consultancy | 14.0% |
| Hairdressing, beauty | 13.0% |
| Retailing food, newspapers | 4.0% |
| Pubs | 6.5% |
| Limited cost trader (any sector) | 16.5% |
The full list sits in the HMRC Flat Rate Scheme guidance.
When the scheme pays off
It can still be worth it for:
- Businesses with substantial physical goods purchases that aren’t capital
- Sectors with relatively low flat rates (retail, pubs)
- Very small businesses where simplicity matters more than absolute saving
- Businesses in their first year of VAT registration claiming the 1% discount
It rarely makes sense for:
- Pure-service consultants and contractors (limited cost traders)
- Businesses with high input VAT (frequent equipment purchases, high marketing spend)
- Businesses approaching the £230,000 exit limit
Wrap-up
Run the numbers both ways before joining. Pair this with our existing VAT Flat Rate Scheme page, the VAT registration threshold article, and the VAT codes in bookkeeping guide.