Should I Use the VAT Flat Rate Scheme as a New Business?

The VAT Flat Rate Scheme simplifies VAT for small businesses, but it is not right for everyone. Learn how it works and whether your new business should use it.

At Towerstone, we specialise in accountancy services for start up businesses and have written this article for business owners considering VAT registration. The purpose of this article is to explain how the scheme works, when it may suit you, and when it usually does not, helping you make informed decisions at an early stage.

The VAT Flat Rate Scheme is a simplified method of accounting for VAT. Instead of calculating VAT on every sale and reclaiming VAT on every purchase, you apply a fixed percentage to your VAT inclusive turnover and pay that amount to HMRC.

You still charge your customers VAT in the normal way, usually at 20 percent. The difference lies in how much of that VAT you pass over to HMRC.

The scheme was introduced to:

  • Reduce bookkeeping time

  • Simplify VAT returns

  • Provide certainty over VAT payments

What it does not do is guarantee a saving. This is where many people misunderstand it. Whether you save money or pay more VAT depends entirely on your business type, your expenses, and whether you are classed as a limited cost trader.

How the VAT Flat Rate Scheme works in practice

Let me explain how this works with a simple real world example.

You invoice a customer £1,000 plus VAT at 20 percent.
The customer pays you £1,200.

Under standard VAT accounting, you would owe HMRC the £200, less any VAT you can reclaim on your costs.

Under the Flat Rate Scheme, you apply your flat rate percentage to the full £1,200, not the £1,000.

If your flat rate percentage is 12 percent, you would pay HMRC £144.

The difference between the VAT you charged and the VAT you pay over, £56 in this example, is intended to cover the VAT on your business expenses.

That £56 is not tax free profit. It becomes part of your turnover and is subject to income tax or corporation tax.

The first year VAT Flat Rate discount

One feature that often attracts businesses to the scheme is the 1 percent discount available in your first year of VAT registration.

For your first 12 months after becoming VAT registered, your flat rate percentage is reduced by 1 percent.

For example:

  • A business with a normal flat rate of 12 percent would pay 11 percent in year one

  • A business with a 14.5 percent rate would pay 13.5 percent in year one

This discount can make the scheme look very attractive in the first year, especially for service based businesses with low costs. However, I always advise clients to look beyond year one and consider whether the scheme still makes sense once the discount ends.

Who can join the VAT Flat Rate Scheme

To join the VAT Flat Rate Scheme, your business must meet certain conditions.

Your VAT taxable turnover must be expected to be £150,000 or less, excluding VAT, in the next 12 months.

You can stay on the scheme until your turnover exceeds £230,000 including VAT.

You must also not have been involved in certain VAT avoidance schemes or offences.

The scheme is available to:

  • Sole traders

  • Partnerships

  • Limited companies

  • LLPs

You can apply online through your VAT account, and in many cases, approval is straightforward.

Who the VAT Flat Rate Scheme is designed for

In my experience, the scheme works best for businesses that:

  • Are service based

  • Have relatively low VAT reclaimable expenses

  • Do not regularly purchase stock or equipment

  • Want simpler VAT accounting

Examples include consultants, marketing agencies, IT contractors, and certain professional services.

That said, the introduction of the limited cost trader rules has significantly reduced the number of businesses who genuinely benefit from the scheme.

Understanding the limited cost trader rules

This is where many people get caught out.

You are classed as a limited cost trader if the VAT inclusive cost of your goods is either:

  • Less than 2 percent of your VAT inclusive turnover, or

  • Less than £1,000 per year

Goods are defined very narrowly. They must be physical items that are used exclusively for your business.

Goods do not include:

  • Services

  • Rent

  • Utilities

  • Software subscriptions

  • Phone bills

  • Accountancy fees

  • Advertising

  • Travel

  • Food and drink

If you are a limited cost trader, your flat rate percentage is fixed at 16.5 percent, regardless of your business type.

This rate is deliberately set so that, in most cases, you will pay roughly the same VAT as under standard VAT accounting.

Why the 16.5 percent rate matters

The 16.5 percent rate changes everything.

If you charge VAT at 20 percent and pay HMRC 16.5 percent of your VAT inclusive turnover, the effective VAT cost to you is very close to 19.8 percent of your net sales.

In simple terms, for many service based businesses, the Flat Rate Scheme offers little or no financial advantage once the limited cost trader rules apply.

I often find that businesses are on the scheme for years without realising they are limited cost traders, and they could be better off on standard VAT accounting.

VAT you can and cannot reclaim on the Flat Rate Scheme

Under the Flat Rate Scheme, you generally cannot reclaim VAT on your day to day expenses.

There is one key exception.

You can reclaim VAT on capital assets costing more than £2,000 including VAT, as long as:

  • The purchase is for a single item

  • It is not made up of several smaller items

  • It is not a service

Examples include machinery, vehicles used exclusively for business, and certain equipment.

This rule catches people out regularly, especially where purchases are close to the £2,000 threshold.

Exhaustive list of VAT Flat Rate percentages

Below is a full and exhaustive list of the current VAT Flat Rate percentages, based on HMRC categories. Choosing the correct category is critical, and it must reflect your main business activity.

  • Advertising, 11 percent

  • Agricultural services, 11 percent

  • Architects, civil and structural engineers, 14.5 percent

  • Boarding kennels, 12 percent

  • Bookkeepers and accountants, 14.5 percent

  • Business services not listed elsewhere, 12 percent

  • Catering services including restaurants and takeaways, 12.5 percent

  • Cleaning services, 12 percent

  • Computer and IT consultancy or data processing, 14.5 percent

  • Construction services, 9.5 percent

  • Estate agents and property management, 12 percent

  • Farming or agricultural services, 11 percent

  • Hairdressing or beauty treatment services, 13 percent

  • Hotels and accommodation, 10.5 percent

  • Labour only building or construction services, 14.5 percent

  • Management consultancy, 14 percent

  • Marketing and PR services, 11 percent

  • Photography, 11 percent

  • Printing, 8.5 percent

  • Recruitment agencies, 12 percent

  • Retailing food, confectionery, tobacco, newspapers, children’s clothing, 4 percent

  • Retailing goods not listed elsewhere, 7.5 percent

  • Secretarial and office support services, 13 percent

  • Security services, 12 percent

  • Social work services, 14 percent

  • Transport or storage including couriers, 10 percent

  • Veterinary surgeons, 12 percent

  • Wholesale businesses, 7.5 percent

  • Any other activity not listed, 12 percent

  • Limited cost trader, 16.5 percent

If your business genuinely spans multiple activities, HMRC expects you to choose the category that represents your main source of income.

Common mistakes I see with the Flat Rate Scheme

Over the years, I have seen the same errors repeated again and again.

The most common ones include:

  • Using the wrong flat rate category

  • Ignoring the limited cost trader rules

  • Assuming the scheme always saves money

  • Forgetting that the saving is taxable income

  • Staying on the scheme when turnover increases and costs change

These mistakes can be costly, especially if HMRC review your VAT returns and decide the wrong rate has been used.

Comparing the Flat Rate Scheme to standard VAT accounting

In practice, the decision often comes down to running the numbers.

I regularly compare both methods for clients by:

  • Reviewing annual turnover

  • Analysing VAT reclaimable expenses

  • Checking limited cost trader status

  • Modelling VAT payable under each method

In many cases, standard VAT accounting results in a lower VAT bill, particularly for businesses with higher costs or regular VAT reclaim opportunities.

When the Flat Rate Scheme can still make sense

Despite the changes, the scheme is not dead.

It can still work well for:

  • Newly VAT registered businesses in year one

  • Businesses with genuine goods costs above the limited cost threshold

  • Certain retail and construction businesses

  • Businesses that value simplicity over marginal savings

The key is reviewing it regularly, not setting it and forgetting it.

When I usually advise against the Flat Rate Scheme

I am often very clear when the scheme is not appropriate.

This includes:

  • Service based businesses with low costs

  • Contractors working through agencies

  • Businesses paying mainly for services rather than goods

  • Businesses close to the VAT thresholds

In these cases, standard VAT accounting usually provides better control and transparency.

Leaving the VAT Flat Rate Scheme

You can leave the scheme voluntarily at any time.

You must leave if your turnover exceeds £230,000 including VAT.

When you leave, you move back to standard VAT accounting from the next VAT period.

There is no penalty for leaving, and in many cases, switching back is financially sensible.

Final thoughts based on real client experience

In my professional opinion, the VAT Flat Rate Scheme is neither good nor bad in isolation. It is simply a tool.

For some businesses, at the right time, it can save money and reduce admin. For others, it quietly increases VAT costs year after year without anyone noticing.

The most important thing I can say is this. Do not rely on generic advice. Always run the numbers based on your actual business, your actual costs, and your future plans.

VAT decisions should be reviewed regularly, especially as your business grows or changes direction. What worked last year may not work this year.

If you take one thing away from this article, let it be this. Simpler does not always mean cheaper, and cheaper does not always mean better.

If you would like to explore related guidance, you may find What are all my first year deadlines with HMRC and Companies House and What are the risks of starting a business from home useful. For a wider overview of support for new businesses, visit our Start Up Careers Hub.