The limited cost trader rule was introduced in 2017 specifically to reduce the profitability of the VAT Flat Rate Scheme for service-based businesses. Before the rule, IT contractors and consultants could often keep a meaningful margin between what they charged clients and what they paid HMRC. The rule changed that by creating a higher flat rate floor for businesses that spend little on goods.
- Limited cost trader: goods spending < 2% of VAT-inclusive turnover OR < £1,000/year
- Limited cost trader FRS rate: 16.5% — higher than almost every sector rate
- Most IT contractors and consultants are automatically limited cost traders
- At 16.5%, the FRS surplus is typically under £25/month — rarely worthwhile
- Best solution: leave FRS and use standard VAT accounting
What is a limited cost trader?
HMRC introduced the limited cost trader rule in April 2017 specifically to prevent low-cost service businesses from profiting from the Flat Rate Scheme. A limited cost trader is one whose VAT-inclusive expenditure on goods meets either of these conditions:
- Less than 2% of VAT-inclusive turnover in that VAT period, or
- Less than £250 per VAT quarter (£1,000 per year) — even if this is more than 2% of turnover
If either condition applies in any VAT quarter, you must use the 16.5% flat rate for that period.
The key question: what counts as 'goods'?
This is where most contractors trip up. The limited cost trader test is based on spending on physical goods only — and a significant number of common business expenses are classified as 'services', not goods:
| Expense | Goods or services for the test? | Counts toward the 2%? |
|---|---|---|
| Laptop, monitor, keyboard | Goods | Yes |
| Office stationery, paper | Goods | Yes |
| Software subscriptions (SaaS) | Services | No |
| Cloud storage (AWS, Azure) | Services | No |
| Professional indemnity insurance | Services | No |
| Training courses | Services | No |
| Accountancy fees | Services | No |
| Travel and accommodation | Services | No |
| Food and drink (staff entertaining) | Services | No |
| Vehicle fuel | Goods | Yes — but see note below |
Note: vehicle fuel counts as goods if the company pays for it directly. However, mileage reimbursements (personal vehicle) are not company purchases of goods.
Why almost all consultants are limited cost traders
An IT contractor invoicing £10,000/month typically has goods spending of:
- Office stationery: ~£10/month
- Hardware (averaged over 3 years): ~£50/month
- Total goods: ~£60/month
- 2% of £12,000 VAT-inclusive turnover: £240/month
£60 is well below £240 (the 2% threshold). This contractor is a limited cost trader in every quarter. Software, cloud tools, insurance, training, and professional fees — their main costs — all count as services, not goods.
The financial impact: 14.5% vs 16.5%
Worked example on £12,000 VAT-inclusive quarterly turnover
| Scenario | FRS rate | FRS payment | VAT collected | Quarterly surplus |
|---|---|---|---|---|
| Standard IT rate (no limited cost trader) | 14.5% | £1,740 | £2,000 | £260 |
| Limited cost trader | 16.5% | £1,980 | £2,000 | £20 |
| Standard VAT (leaves FRS) | N/A | £2,000 less input VAT reclaimed | £2,000 | Depends on purchases |
At 16.5%, the quarterly FRS surplus is just £20 (£80/year). The administrative time to check limited cost trader status every quarter costs more than this.
What to do if you are a limited cost trader
Leave the Flat Rate Scheme. On standard VAT, you pay HMRC the difference between VAT collected (output tax) and VAT paid on purchases (input tax). For most low-expense businesses, this means you pay most of the 20% you collect — but you pay exactly what you owe, no more. You also reclaim VAT on all qualifying purchases, which may produce small refunds in months with equipment purchases.
The process: notify HMRC you are leaving FRS (online via your VAT account). You can leave at any time — there is no 12-month requirement to stay.
Planning tip: Check your limited cost trader status before each VAT quarter, not just once at setup. If you make a significant equipment purchase in a quarter (new laptop, monitors, office furniture), your goods spending may briefly exceed the 2% threshold — making that quarter potentially eligible for your lower sector rate. Calculate before filing each return.
Common mistakes
- Not realising you became a limited cost trader when you joined FRS — many directors join FRS at their accountant's suggestion, not knowing the limited cost trader rule applies to them. Check immediately if you are on FRS.
- Counting software and subscriptions as goods — they are services. The goods test is narrow and most directors overestimate their goods spending.
- Staying on FRS when it costs you money — at 16.5% with minimal input VAT to reclaim, standard VAT may actually produce a slightly lower total VAT payment. Calculate both options.
Use the calculator
Frequently asked questions
Does software count as goods for the limited cost trader test?
Can I ever avoid limited cost trader status?
What if I'm already on FRS and discover I should have been using 16.5%?
Is there any benefit to staying on FRS as a limited cost trader?
How do I leave the Flat Rate Scheme?
Important: This guide is for general information only and does not constitute tax or legal advice. Tax rules change — always verify current rates and thresholds with HMRC or a qualified accountant before making decisions.