How the Flat Rate VAT Scheme works (and the Limited Cost Trader rule)

If you run a small business and your business turnover is under £150,000, you may be able to simplify your VAT accounting by joining HMRC’s Flat Rate VAT Scheme.

This guide explains how the scheme works, how the Limited Cost Trader Test affects your flat rate, and whether it’s still worthwhile in 2025.

What is the Flat Rate VAT Scheme?

Instead of paying HMRC the difference between the VAT you charge and the VAT you reclaim, the Flat Rate Scheme allows you to pay a fixed percentage of your VAT-inclusive turnover. The percentage you pay depends on the type of business you run.

The aim is to reduce the burden of VAT reporting for smaller businesses.

You still charge your customers 20% VAT, but you pay HMRC a lower fixed rate. The difference between what you charge and what you pay is yours to keep, although you cannot reclaim VAT on most purchases.

How does it work?

Let’s say you invoice a customer for £1,000 + VAT, making a total of £1,200.

If your flat rate is 14.5%, you pay HMRC:

£1,200 × 14.5% = £174

You keep the difference between the VAT charged (£200) and the flat rate paid (£174), which becomes additional income.

You can’t reclaim VAT on purchases (with a few exceptions), so whether you save money depends on your level of business expenses.

Which VAT flat rate should I use?

When you join the scheme, HMRC asks you to choose the business category that best describes what you do. Each category has a different flat rate. For example:

Accountancy or bookkeeping – 14.5%
Computer or IT consultancy – 14.5%
Management consultancy – 14%
Hairdressing – 13%
Retail (general) – 7.5%

You can find the full list on the GOV.UK business sector rate guide.

If you’re unsure which category applies, it’s worth speaking to an accountant. Selecting the incorrect one can result in penalties or overpayments.

1% discount in your first year

If you’re newly VAT-registered, you are also eligible for a 1% discount on your flat rate for the first 12 months. So if your standard flat rate is 14.5%, you pay just 13.5% for your first year on the scheme.

What is the Limited Cost Trader Test?

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In 2017, HMRC introduced the Limited Cost Trader Test to reduce the financial advantage for businesses with very few goods-related expenses.

If your business passes the test, you continue to use the flat rate assigned to your business sector.

If you fail the test, you’re classed as a limited cost trader and must use a higher flat rate of 16.5%, regardless of your business type.

This rule affects many service-based businesses, especially those run by sole traders with minimal physical goods.

How is the test applied?

You must assess whether you’re a limited cost trader each time you complete a VAT return.

You are classed as a limited cost trader if your relevant goods cost:

Less than 2% of your VAT-inclusive turnover, or
Less than £1,000 a year (if 2% of turnover is less than £1,000)

What counts as “goods”?

To qualify for the test, goods must be:

Tangible items used exclusively for business
Not capital items
Not food or drink
Not for resale unless your business sells goods

Examples that count:

Printer paper and ink
Cleaning products for a salon or workshop
Stock or materials used directly in your trade

Examples that don’t count:

Accountancy or legal fees
Phone bills or broadband
Software subscriptions or downloads
Business travel or fuel
Training, rent, or advertising

See the official guidance on the GOV.UK Flat Rate VAT Scheme page.

Can sole traders use the scheme?

Yes. The Flat Rate VAT Scheme is open to any VAT-registered business with turnover under £150,000 (excluding VAT), including sole traders and partnerships.

Once you’re in the scheme, you can stay until your total business income (including VAT) goes over £230,000.

When might the scheme benefit me?

The scheme works well for:

Service-based businesses with low expenses
Freelancers and sole traders who want simpler VAT accounting
Newly VAT-registered businesses (with the 1% discount)

But it may cost you more if:

You’re classed as a limited cost trader
You buy a lot of goods or equipment
You regularly reclaim VAT on purchases under the standard scheme

If your business spends heavily on stock, tools, or VATable services, the standard VAT scheme might be more tax-efficient.

FAQs

Can I reclaim VAT on expenses if I use the Flat Rate Scheme?

No, not usually. You can only reclaim VAT on capital assets worth over £2,000 in a single purchase. Otherwise, VAT on business expenses isn’t recoverable.

How do I join the scheme?

You can apply online when you register for VAT, or later via your HMRC VAT account.

What happens if I leave the scheme or grow too big?

You must leave the scheme if your VAT-inclusive turnover exceeds £230,000. From that point, you switch to the standard VAT accounting method.

Do I have to stay on the scheme for a set period?

No, you can leave at any time, but you must notify HMRC in writing.

Can I rejoin the scheme if I’ve left it?

Yes, although HMRC may restrict re-entry if you left voluntarily. If you left due to a change in turnover or structure, you may be eligible to rejoin after 12 months.

Is the Flat Rate Scheme still a viable option in 2025?

It depends on your business. For limited cost traders, it’s usually not beneficial. For others, especially those with low overheads and straightforward billing, it can still save time and money.