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The VAT flat rate scheme lets eligible businesses pay a fixed percentage of gross turnover to HMRC instead of tracking input and output VAT separately. But since the limited cost trader rate of 16.5% was introduced in 2017 the scheme has become loss-making for most service businesses who would recover more through standard VAT input claims.
VAT registration threshold 2026/27
£90,000
Raised from £85,000 in April 2024
Limited cost trader flat rate
16.5%
Applies to most service businesses
Typical annual FRS saving at LCT rate
£200
On £100,000 turnover
Why this matters in 2026
The VAT registration threshold rose to £90,000 in April 2024. With the limited cost trader rate making FRS uneconomic for most professional service businesses a systematic review is overdue. Leaving FRS is straightforward and can generate immediate savings of £500 to £2,000 per year for businesses with meaningful input VAT costs.
In this report
01
How the flat rate scheme works
Under FRS instead of tracking input and output VAT separately a business pays a fixed percentage of its gross VAT-inclusive turnover to HMRC. The business still charges customers 20% VAT. The difference between the 20% collected and the flat rate percentage paid to HMRC is retained as profit.
Flat rates vary by sector: 4% for food retailers, 14.5% for accountancy firms, 9.5% for IT consultants. To join FRS taxable turnover must not exceed £150,000 excluding VAT. New entrants receive a 1% discount in their first year.
Key insight
An IT consultant with £100,000 of standard-rated sales charges £20,000 VAT and pays £9,500 to HMRC at the 9.5% sector rate — retaining £10,500 as a VAT profit under FRS.
02
The limited cost trader rate
The limited cost trader rate of 16.5% applies where a business spends less than 2% of its VAT-inclusive turnover or less than £1,000 per year on goods. Most professional service businesses — consultants, solicitors, accountants, coaches — qualify as limited cost traders because their primary cost is labour not goods.
At 16.5% on £120,000 gross turnover the FRS payment is £19,800 versus £20,000 collected. The VAT profit is just £200 per year. Any business spending more than £1,200 on standard-rated goods and services recovers more through standard VAT input claims.
Key insight
Most service businesses under the LCT rate save just £200 per year on £100,000 of turnover — versus potentially £1,000 or more in input VAT reclaims under standard accounting.
Important
Check carefully whether you qualify as a limited cost trader before applying a lower sector rate. Using the wrong rate can result in HMRC penalties and interest.
03
Who still benefits from FRS
FRS remains genuinely beneficial for businesses with significant goods costs relative to turnover and a sector flat rate well below 16.5%. Retailers, caterers, builders and manufacturers with high goods content can still find the scheme advantageous.
For new businesses in their first year the 1% first-year discount adds meaningful benefit. An accountancy firm in year one pays 13.5% instead of 14.5% — saving an additional £1,000 on £100,000 of gross turnover.
Key insight
A catering business with a 12.5% sector flat rate and high goods spend retains £7,500 in VAT profit versus recovering £3,000 in input VAT under standard accounting — a £4,500 annual FRS advantage.
04
Calculating your position
Step one: calculate your annual FRS payment (flat rate percentage multiplied by gross turnover). Step two: calculate your standard VAT liability (20% of net turnover minus input VAT on all purchases). If step two is lower than step one leave FRS immediately.
For most service businesses spending £4,000 or more per year on standard-rated services — software subscriptions, accountancy fees, professional memberships — standard VAT accounting is more favourable.
Key insight
A consultant spending £6,000 per year on software and professional subscriptions can reclaim £1,000 in input VAT under standard accounting versus a FRS profit of £200 — an £800 annual saving from leaving.
Important
Leaving FRS is straightforward — notify HMRC in writing. There is no penalty for leaving but you cannot rejoin for 12 months after voluntary withdrawal.
05
Capital expenditure and FRS
One area where FRS is almost always disadvantageous is significant capital purchases such as computers, equipment or vehicles. Under FRS input VAT on purchases cannot generally be reclaimed — except for a single capital item with a VAT-inclusive cost above £2,000.
For a business planning to purchase £15,000 of equipment the irrecoverable VAT under FRS is £2,500. Switching to standard VAT accounting before the purchase recovers this in full.
Key insight
A business about to purchase £20,000 of equipment loses £3,333 in irrecoverable input VAT under FRS. Switching to standard VAT accounting before the purchase recovers this in full.
Action checklist
- Determine whether you qualify as a limited cost trader by reviewing annual goods expenditure
- Calculate your actual FRS saving versus potential input VAT reclaims under standard accounting
- List all standard-rated purchases including software, professional fees and equipment
- If input VAT reclaims exceed your FRS saving notify HMRC in writing to leave the scheme
- Consider the timing of any significant capital expenditure in your decision
- If in your first year assess whether the 1% first-year discount changes the calculation
- Set a calendar reminder to review the position annually as your cost base changes
Sources
- HMRC VAT Flat Rate Scheme Notice 733: gov.uk/vat-flat-rate-scheme
- VAT Act 1994 section 26 and Schedule 1
- HMRC Limited Cost Trader guidance: gov.uk/guidance/vat-flat-rate-scheme
- HMRC VAT registration threshold: gov.uk/vat-registration
- HMRC VAT rates and thresholds 2026/27: gov.uk/vat-rates
Disclaimer: For information only. Not financial, tax or legal advice. Consult a qualified adviser before making decisions. Figures correct April 2026.
Further reading
Business
Directors Loan Account UK 2026: S455 Tax, Beneficial Loans and How to Stay Compliant
Tax & HMRC
The 60% Income Tax Trap UK 2026: How to Escape the Personal Allowance Withdrawal Zone
Mortgages
Self-Employed Mortgage UK 2026: How to Get Approved With 1 or 2 Years Accounts
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