Flat Rate vs Standard VAT Accounting

One fixed percentage, or output tax minus input tax? How the two VAT methods differ, what each would cost on the same numbers, and where the Flat Rate Scheme comes out ahead for a newly registered small business.

Summary

• Standard VAT accounting charges output tax minus input tax, which tends to favour businesses that pay a lot of VAT on their own purchases.
• The Flat Rate Scheme applies a fixed percentage, set by trade, to VAT inclusive turnover, with a 1% discount in your first year of VAT registration.
• You can join with expected VAT taxable turnover of £150,000 or less excluding VAT, and must leave once business income goes above £230,000 including VAT.
• Businesses that spend little on goods can be classed as limited cost and pay 16.5%, which often wipes out the scheme’s advantage.
• Flat rate traders cannot reclaim VAT on purchases, apart from certain capital assets costing £2,000 or more including VAT.

Registering for VAT, which stands for Value Added Tax and is charged on most goods and services sold in the UK, comes with an early decision that surprises many new business owners. As well as charging customers VAT, you have to choose how you account for it to HM Revenue and Customs (HMRC). For small businesses the two main routes are standard VAT accounting and the Flat Rate Scheme. They can produce very different bills from the same sales, so the arithmetic behind each is worth understanding before you pick.

Two Ways to Work Out Your VAT Bill

What you charge customers is the same under either scheme. The standard rate of VAT is 20% on most goods and services, with a reduced rate of 5% and a zero rate of 0% for some items. The difference lies in what you hand over to HMRC.

Standard accounting works out your bill as the difference between the VAT you charged customers and the VAT you paid on your own purchases. The Flat Rate Scheme instead applies a single fixed percentage to your gross turnover, and that figure is what you pay.

Because the flat rates are averages, they include an allowance for the input tax a typical business in that trade would reclaim. The Flat Rate Scheme therefore tends to favour businesses with low purchase costs, while standard accounting tends to favour those buying in a lot of taxed goods. Either way, the trigger for registering is the same: businesses must register for VAT once taxable turnover exceeds £90,000.

How Standard VAT Accounting Works: Input and Output Tax

Two terms do most of the work here. Output tax is the VAT you charge when you sell something. Input tax is the VAT you pay when you buy goods or services for the business.

On each VAT return, you total the output tax on your sales, total the input tax on your purchases and pay the difference to HMRC. If input tax exceeds output tax in a period, HMRC repays the difference instead.

A short chain shows the logic. A manufacturer sells goods to a wholesaler for £1,000 plus £200 VAT. The wholesaler sells them on for £1,500 plus £300 VAT, reclaims the £200 it paid, and sends HMRC the remaining £100. Each business in the chain pays VAT only on the value it adds, and the final consumer, who cannot reclaim anything, bears the full amount.

The practical effect is that every pound of VAT on purchases reduces your bill, so businesses that buy in a lot of taxed goods and services often do better on standard accounting than on any flat percentage.

How the Flat Rate Scheme Works and Its Sector Percentages

The Flat Rate Scheme replaces that arithmetic with one calculation. You apply a fixed percentage to your VAT inclusive turnover, meaning your sales including the VAT charged on them, and pay the result to HMRC. Anything left over from the VAT you collected is yours to keep, and it is intended to cover the VAT you paid on purchases.

The percentage depends on what your business does. HMRC publishes a rate for each type of business, and the rates sit below 20% because they build in that input tax allowance. A photographer, for instance, uses 11%. New businesses get a discount of 1% in their first year as a VAT registered business, so that photographer would pay 10% for the year.

There is a catch for businesses that spend little on goods. HMRC classes these as limited cost businesses, which applies if you spend less than 2% of your VAT inclusive turnover on goods, or less than £1,000 a year where your costs are above 2%. The rate rises to 16.5%, which removes much of the benefit.

If your business fits more than one category, use the percentage that applies to the majority of your sales. Standard rated, reduced rate, zero rated and exempt sales all count towards your turnover; only sales outside the scope of VAT are left out.

The Eligibility Rules and Turnover Limits

You can join if you are a VAT registered business and you expect your VAT taxable turnover, meaning all the sales your business makes that are not exempt from VAT, to stay at or below £150,000 excluding VAT over the coming 12 months. Once you are in, you can stay until your total business income, including VAT, goes above £230,000 a year.

Some businesses cannot join:

• You left the scheme within the previous 12 months.
• You were convicted of a VAT offence, such as VAT evasion, or penalised for evading VAT, within the previous 12 months.
• You became part of a VAT group, or were in a position to do so, at any point in the previous 24 months.
• Your VAT registration was set up as a division of a larger business at any point in the previous 24 months.
• You have joined a second-hand margin scheme or a capital goods scheme.

The scheme also cannot be run alongside the Cash Accounting Scheme or the retail schemes. That is less restrictive than it sounds, because turnover under the Flat Rate Scheme is measured on a cash basis of its own, in much the same way as under the Cash Accounting Scheme.

Worked Examples on the Same Numbers

Take one quarter under each scheme. A business makes £30,000 of standard rated sales, adding £6,000 VAT, so its VAT inclusive turnover is £36,000. Over the same period it buys £10,000 of goods plus £2,000 VAT.

• Standard accounting: pay the £6,000 output tax minus the £2,000 input tax, giving £4,000.
• Flat Rate Scheme at 11%: pay 11% of £36,000, giving £3,960. In the first year of VAT registration, the 1% discount brings that down to £3,600.
• Flat Rate Scheme at the limited cost rate of 16.5%: pay £5,940, nearly £2,000 more than standard accounting.

Now reverse the cost structure. A consultancy with almost no taxable purchases beyond a laptop would owe the full £6,000 under standard accounting, while the flat rate at 11% still costs £3,960. The lower your input tax, the wider the gap in the Flat Rate Scheme’s favour.

Even in the first example the gap is narrow. HMRC is candid that, because the flat rates are averages, some businesses end up owing HMRC more under a flat percentage than they would under ordinary accounting. Which side of that average you fall on depends on your costs.

When the Flat Rate Usually Saves Money and When It Does Not

The pattern behind the table is fairly consistent. Service businesses selling to the public often come out ahead, because they have little input tax to reclaim and the flat rate leaves them keeping part of the VAT they collect.

Several situations work against the flat rate:

• Most of your customers are VAT registered. You still have to work out the VAT on each sale and produce VAT invoices just as before, so much of the admin simplification disappears.
• You usually claim a lot of input tax, for example because you buy in taxed goods to resell.
• Your trade involves goods crossing UK borders, whether bought in from abroad or sold overseas, which makes the scheme more complex.
• Your business regularly receives repayments from HMRC, which the scheme is considered unsuitable for.

Record-Keeping Under Each Scheme

Standard accounting means tracking the VAT on each sale and each purchase, keeping the invoices that support your reclaims and completing a return showing both figures. The Flat Rate Scheme was built to cut down the bookkeeping: one percentage applied to turnover instead of two columns of VAT reconciled against each other.

The simplification applies to your return, not your invoices. Even on the flat rate you still charge customers VAT at the normal rate and, where required, issue VAT invoices showing that amount. The scheme also measures turnover on a cash basis, so you count payments you have actually received.

One further detail: if your trade changes and a different flat rate applies part way through an accounting period, you run two calculations, one from the start of the period to the changeover date and one from the new rate to the end.

How to Join, Leave or Switch Schemes

Joining means applying to HMRC. Check the conditions first, since some of them look back over the previous 12 or 24 months. If your circumstances are unusual or the sums are close, HMRC itself suggests talking to an accountant or tax adviser about whether the scheme is right for you.

You can leave voluntarily, and you must leave once your business income goes above £230,000 a year including VAT. Leaving carries a consequence: you cannot rejoin for 12 months. Businesses that regularly receive repayments under standard accounting are a poor fit anyway, since the flat rates assume some input tax.

Switching the other way, from flat rate to standard accounting, means notifying HMRC and then reverting to tracking output and input tax from your next return. If you later want to return to the flat rate, the joining conditions, including the 12 month wait after leaving, apply again.

Next steps

• Sole Trader or Limited Company? What Changes for Your Tax: how your business structure shapes the tax you pay, which sits alongside your VAT choices.
• Before You Register as Self-Employed With HMRC: what to sort out before you register, so VAT decisions fit a wider plan.
• How to File Your First Self Assessment Tax Return: the practical steps if you are new to dealing with HMRC directly.

Questions readers ask