VAT Flat Rate Scheme Explained for Directors

How the Flat Rate Scheme works

Instead of paying HMRC the difference between the VAT you charge (output tax) and the VAT you pay on purchases (input tax), you pay a fixed percentage of your VAT-inclusive turnover. The percentage varies by business sector.

Example: An IT consultant invoices £10,000 net + £2,000 VAT = £12,000 VAT-inclusive. At a flat rate of 14.5%, the company pays HMRC £12,000 × 14.5% = £1,740 — keeping £260.

When FRS is profitable

The scheme works when your actual input VAT (VAT paid on purchases) is less than the surplus between 20% output VAT and the flat rate percentage. It benefits:

• Low-expense businesses (consultants, freelancers)
• Service businesses with few VAT-able costs
• Businesses in their first year of VAT registration (1% discount applies)

The limited cost trader problem

If your goods spending is less than 2% of VAT-inclusive turnover (or under £1,000/year), HMRC classifies you as a 'limited cost trader' and applies a 16.5% flat rate — regardless of your sector. Most IT contractors, consultants, and service-only businesses fall into this category. At 16.5%, FRS is rarely profitable.

FRS and capital goods

Under FRS, you generally cannot reclaim VAT on purchases. However, you can reclaim VAT on a single purchase of capital expenditure goods costing over £2,000 (VAT-inclusive). This exception applies once per purchase, not per asset.