Originally posted on: 5 August 2024
Updated on: 15 December 2025
Introduction
When clients register their business for VAT they must decide whether to use the standard VAT scheme or the flat rate scheme for calculating how much VAT is due to the HMRC. This is a common source of confusion for new clients, where they can get conflicting information between us, their colleagues, and their mates at the local pub.
If you are new to contracting, or have been working for a while and need a VAT refresher, this blog article will tell you everything you need to know about the differences between the standard rate scheme and the VAT flat rate scheme, and which one is best for you. It may be advantageous for you to bookmark this blog post, so you can quickly find it next time you speak to your mate down at the pub.
VAT is a consumption tax that is applied to most goods and services sold in the UK. VAT stands for Value Added Tax, and you pay VAT as you consume goods and services in the UK. The more goods and services you buy, the more VAT you pay.
It’s actually a very effective way for the UK government to raise tax revenue because it is applied to so many goods and services sold in the UK. The standard rate of VAT is currently 20%, and that is the rate you will pay on most goods and services. There are, however, some different rates of VAT. For example, 5% VAT is commonly applied to things such as your power and gas bills, and there are also 0% rates of VAT, which are applied to items such as postage, books, and public transport.
When businesses become registered for VAT, they effectively become tax collectors for the HMRC. For our typical limited company contractor clients, once they become a VAT registered business they add VAT onto their invoices, and every 3 months they need to report the amount of the VAT collected on their invoices, and pay it across to the HMRC. They also get a deduction for any VAT on goods or services that their business has spent money on over the same period, which we will cover in more detail below.
Its Not Your Money
The VAT that you add onto your invoices is NOT your money. It belongs to the HMRC. Do not spend this money on yourself. You need to keep it to one side and periodically pay it across to the HMRC.
VAT Registration
Businesses with an annual taxable turnover that exceeds the VAT registration threshold, which is currently £85,000, must register for VAT. If your taxable turnover is below this threshold, you can choose to voluntarily register. VAT returns for our clients are usually submitted every quarter to the HMRC. The bookkeeping software that all of our clients use, called Joy Pilot, has a direct link to the HMRC system, so VAT returns are filed directly from the Joy Pilot software to the HMRC.
There are a few different VAT schemes available to businesses, but an important decision that you need to make is whether you want to be registered for the Standard VAT Scheme, or the Flat Rate VAT Scheme. Each of these schemes has its own rules and potential benefits for our clients.
Standard Rate VAT Scheme
The standard rate scheme is the “normal” option. Many small businesses, most medium sized businesses, and I’m sure every single large business, will be registered for the standard rate scheme. Before April 2002 (when the VAT flat rate scheme was introduced) the standard VAT rate scheme was the one that every single VAT registered business used.
How Does the Standard Rate VAT Scheme Work
The standard VAT scheme is super easy to understand. Over the VAT period (usually every 3 months), you add together all the VAT that you have billed out to your clients, you deduct from this all the VAT that you spent on buying goods and services for your own business, and the difference is what you pay across to the HMRC.
Let me give you an example of a normal standard rate VAT calculation. Peter runs his own consulting firm, CBA Limited, which is a VAT registered business that supplies engineering consulting services to large oil & gas companies. He bills his clients £450 + VAT per day, and needs to prepare his next VAT return which covers the period from 01 April 2024 to 30 June 2024. Over this period he worked for 58 days, and incurred the following expenses;
(a) mobile phone costs of £90 (£75 + £15 VAT)
(b) our accounting fee of £414 (£345 + £69 VAT)
(c) train travel costs of £195 (no VAT)
(d) new Dell laptop purchase for £1,254 (£1045 + £209 VAT).
Over the course of the three-month period here is a summary of his income and expenses.
Total income = £450 per day * 58 days = £26,100 + 20% VAT = 26,100 + £5,220 (VAT) = £31,320
Total Expenses = £1,869 + £293 (VAT) = £2,162
So over this period Peter has billed his client £31,320 which included £5,220 in VAT, and he has also spent £2,162 on the various expenses listed above which included £293 in VAT.
When preparing his VAT return he takes the total VAT that he billed his client, and deducts from this the total VAT that he has spent on goods and services over the same period.
VAT due to be paid to HMRC = 5,220 – 293 = £4,927.
For Peters VAT return covering the period 01 April 2024 to 30 June 2024, the return must be filed by 07 August 2024, and his VAT bill of £4,927 must also be paid by this date.
Advantages of Standard Rate Scheme
The advantages of using the standard rate scheme for our typical limited company contractor clients are;
- You can reclaim all the VAT that you spend on goods and services for your business. If you have several expenses every month that include 20% VAT, you will often be financially better off than using the VAT flat rate scheme.
- There are no eligibility restrictions or rules related to using the standard VAT scheme (unlike for the flat rate scheme)
“…the service has been fabulous.”
Ah Mike, we think you’re pretty fabulous too!
Disadvantages of Standard Rate Scheme
The disadvantages that are relevant for our types of clients include;
- Record keeping is more onerous. It is important to keep VAT receipts for all of your expenses which prove you are claiming the correct amount of the VAT. This can be a little time consuming, unless of course you have an AI powered receipt scanning tool like the one offered by our Joy Pilot accounting software.
- Potential for human error is higher, because there may be multiple rates of VAT charged on a single receipt. For example, while travelling for business, a meal out might include 20% VAT, but the voluntary service charge added to your bill will not have any VAT at all;
- A common disadvantage often quoted is also the potential requirement to need accounting software to more accurately track that VAT on your income and expenses. However, all of our clients use our Joy Pilot accounting software which handles all VAT rates nicely.
The Flat Rate VAT Scheme
The flat rate scheme was introduced in April 2002 and its purpose was to reduce the administrative burden for VAT registered businesses by being a little more simplified in how to calculate the amount of the VAT due.
Back when it was first introduced, it was a very compelling scheme for our clients to use. In most cases the administrative burden was reduced, and it was financially advantageous. Then in April 20217 the Limited Cost Trader rules were introduced to address concerns that some businesses were benefiting disproportionately from the Flat Rate Scheme.
How Does the Flat Rate VAT Scheme Work
The most misunderstood part of the VAT flat rate scheme is how the calculation works. At first glance you would think it comes with financial substantial benefits but this is not the case for most clients.
The first step in joining the VAT flat rate scheme is to decide what category your services fall under. The HMRC have produced a large list are various categories for businesses, and have applied a flat rate percentage to each one.
Here are some examples;
- Accountancy or book-keeping, 14.5%
- Architect, civil and structural engineer or surveyor, 14.5%
- Entertainment or journalism, 12.5%
- Management consultancy, 14%
- Limited cost trader, 16.5%
There is a full list of services here. As an added incentive to join the flat rate scheme, VAT registered businesses in their first year of registration get their flat rate percentage discounted down by 1%.
Limited Cost Trader Rules
Let’s quickly talk about the limited cost trader rules because they impact the vast majority of our clients. When these rules were initially introduced there were numerous strategies trialled by businesses to circumvent their effectiveness, but they were all too manufactured, and in our view were never fit for purpose. Your friend down at the pub will probably have a strategy for you that they will claim allows you to avoid the Limited Cost Trader rules, but in all likelihood, they will be wrong because I would be willing to bet their strategy will never pass a VAT audit with the HMRC.
Under the Limited Cost Trader rules, businesses that have low spending on goods (note its “goods”, not “goods and services”) are required to use a higher flat rate of 16.5%. This classification applies to businesses whose spending on goods is either less than 2% of their VAT inclusive turnover or less than £1,000 per year (if their total cost of goods is more than 2%). Excluded from the “goods” calculation is
(a) food and drink for the business or its staff
(b) all capital expenditure
(c) vehicles, vehicle parts and fuel.
The sorts of “goods” that your business would need to be purchasing are things such as stationery, small tools, spare parts, materials used for producing goods or services, cleaning products, packaging materials, and protective clothing. For a client with VAT inclusive annual income of £96,000, they would need to be spending more than £1,960 per year on these sorts of things, and for the vast majority of our contractor clients, annual expenditure on these small items like this tend to only be £100 – £300 per year, so it’s likely that freelancers/consultants WILL meet the limited cost trader criteria.
Like I say, I’ve seen all sorts of artificial implementations of “goods” spending to attempt to circumvent the limited cost trader rules, but none of them ever work. Two clients I have seen recently who do successfully avoid the limited cost trader rules have been artists (who regularly purchase raw materials), and freelancers who design, build, and install signage for large firms.
Buying Assets
Under the VAT flat rate scheme you do not get to reclaim VAT on any goods or services purchased through your business. There is a concession however if you buy capital equipment where you do get to reclaim the VAT, alongside your normal flat rate VAT calculation. Here is how it works.
You can reclaim the VAT you have been charged on a single capital purchase (not services) where the amount of the purchase is £2,000 incl VAT or more. For example if you buy a computer for £1,600, a printer for £300, and a scanner for £200, (total cost of £2,100 incl VAT), and they were all purchased from the same store and listed on the same receipt, then they qualify as a “single purchase”, and you can reclaim all of the VAT back from the entire purchase even though you’re on the VAT flat rate scheme. If instead they were purchased from 3 different suppliers or at 3 different times, then none of the purchases would qualify.
Flat Rate VAT Scheme Calculation
Lets now look at the flat rate VAT calculation for Peter who runs his own consulting firm, CBA Limited. We will use the exact same figures as the standard VAT scheme calculation example above. Peter does not spend more than 2% of their VAT inclusive turnover on goods, so his is a limited cost trader. Let’s also assume that he has been VAT registered for more than one year, so he no longer gets the 1% discount.
To recap from above, Peter bills his clients £450 + VAT per day, and needs to prepare his next VAT return which covers the period from 01 April 2024 to 30 June 2024. Over this period he worked for 58 days, and incurred the following expenses;
(a) mobile phone costs of £90 (£75 + £15 VAT)
(b) our accounting fee of £414 (£345 + £69 VAT)
(c) train travel costs of £195 (no VAT)
(d) new Dell laptop purchase for £1,254 (£1045 + £209 VAT).
His VAT inclusive turnover is £450 per day * 58 days = £26,100 + 20% VAT = 26,100 + £5,220 (VAT) = £31,320. This one area often overlooked. We have to use the VAT inclusive turnover in this calculation.
Being a limited cost trader, his flat rate percentage is 16.5%, so the amount of VAT he has to pay to the HMRC for the current 3-month period is 31,320 * 16.5% = £5,167.80.
It’s a nice simple calculation. He does not need to worry about receipts for his expenses, because the amount of VAT that is due as based purely off the value of his invoices. There is a downside though. From the standard rate calculation previously, he was required to pay £4,927, whereas with the flat rate scheme now he must pay £5,167.80. Being on the VAT flat rate scheme in this case has cost him £240.80. He would be better off financially using the standard rate scheme.
Lets look at another example.
We will use the same example for Peter above, except now he is an artist supplying artwork to studios and film sets. He earns the same as the first scenario, with identical costs, except now he also spends £1,200 + VAT on raw materials every three months, and uses the “Entertainment or journalism” flat rate scheme percentage of 12.5%. He is not a limited cost trader because his “goods” purchases exceeds 2% of this VAT inclusive turnover.
His flat rate percentage is 12.5%, so the amount of VAT he has to pay to the HMRC for the current 3-month period is 31,320 * 12.5% = £3,915.
If he were using the standard rate VAT scheme his VAT liability (including the raw materials he purchases) would be £4,687.
Being on the flat scheme leaves him significantly better off financially. He has a £772 “profit” by being on the flat rate scheme, and so you can see why it is attractive for a lot of small businesses. The main hurdle is overcoming the limited cost trader barrier.
Advantages of Flat Rate Scheme
Main advantages of being on a flat rate scheme for our typical clients are;
- The accounting is simplified and there is no requirement to track and accurately record the VAT on every single purchase.
- So long as you are not caught by the limited cost trader rules and have a low level of purchases with 20% VAT, you can be financially better off using the flat rate scheme.
- There is also the 1% reduction in the flat rate percentage in the first year of the VAT registration.
- Compliance can also be improved with the reduced risk of errors due to the simplified VAT calculation.
Disadvantages of Flat Rate Scheme
Along with advantages also comes some disadvantages. Here are the main ones to consider.
- You may potentially face a higher VAT liability than you would if you were using the standard rate scheme. This is especially the case if you are a limited cost trader, and you have a handful of expenses every month that contain 20% VAT.
- If you purchase capital items (such as a new computer) with a total value of less than £2,000 including VAT, you don’t get to reclaim VAT on that at all.
- If your business regularly purchases goods and services that are charged with 20% VAT, you may also potentially face a higher VAT liability than if you are using the standard rate scheme.
- There are eligibility criteria that you must abide by. For example you cannot join the scheme if you expect your VAT taxable turnover (excluding VAT) to exceed £150,000 in the next 12 months. Also, you must leave the scheme on the anniversary of joining, if your turnover in the last 12 months was more than £230,000 (incl VAT).
The Best Scheme for your Business
Over the years we have found that the best VAT scheme for your business depends on two main factors.
The first is your attitude towards administration and compliance. If you would rather not have the administration responsibility for keeping accurate records of the VAT on all goods and services your business has purchased, even if you are a limited cost trader, then often the flat rate VAT scheme will be the most attractive. Financially you may not be as well off as using the standard rate scheme, but the ease of administration and compliance overrides this.
The second that is the financial impact of using the VAT flat rate scheme versus the standard rate scheme. If you are not a limited cost trader, your business can be considerably better off using the flat rate scheme. If you are a limited cost trader, and spend more than around £200 to £300 + VAT per month on goods and services billed at 20% VAT (or plan on buying some capital equipment such as a computer) then you will probably be better off using the standard rate scheme.
It’s a trade-off between these two factors which typically determines what scheme our clients want to use.
Summary
In this blog article we have a taken a bit of a deep dive into the standard rate VAT scheme, and the flat rate VAT scheme. When new clients join our service, the decision of what scheme to use is often a big unknown, and we can sometimes get a bit frustrated with the misinformation that is out there, particularly around the use of the flat rate scheme calculation.
Our blog not only describes how each scheme works, but it also offers example scenarios with detailed VAT calculations, so you can see for yourself exactly how each scheme works.
Frequently Asked Questions
What is the difference between the Standard Rate and Flat Rate VAT schemes in the UK?
The main difference is how the VAT due calculation is performed. With the standard rate scheme, the amount of VAT due that is the sum of the VAT on your invoices that you have billed out to your clients, less the sum of VAT that you have spent on purchasing goods and services for your business over the same period. With the flat rate scheme, the amount of VAT due is the VAT-inclusive total of your invoices multiplied by your flat rate scheme percentage.
How does the Standard Rate VAT scheme work for UK contractors?
For contractors using the standard rate scheme, they must add VAT to all of their invoices from the VAT registration start date onwards. They must also accurately record the correct rates of VAT on the purchase of all goods and services and keep appropriate records as evidence of this.
What are the advantages of using the Standard Rate VAT scheme?
The two main advantages of using the standard Rate VAT scheme are (a) you get to reclaim all the VAT on goods and services your business has purchased which may leave you better off than using the flat rate scheme (b) there are no eligibility criteria that you need to abide by.
What is the Flat Rate VAT scheme and how does it benefit UK businesses?
The flat rate scheme is a simplified VAT scheme that requires less administration and compliance. So long as you are not caught by the limited cost trader rules, your business may also benefit financially from using the scheme.
Who qualifies as a Limited Cost Trader under the Flat Rate VAT scheme?
A limited cost trader as a business that either (a) spends less than 2% of their VAT inclusive turnover on eligible goods, or (b) spends more than 2% of their VAT inclusive turnover on eligible goods but less than £1,000 per year.
Can I switch between Standard Rate and Flat Rate VAT schemes?
To switch to the flat rate scheme, you can fill in Form VAT600FRS online. It takes just a few minutes to complete. To switch back to the standard rate scheme you must write to HMRC and they will confirm your leaving date.