If you’re new to contracting or freelancing there are a few things you need to consider, one of which is how you will account for VAT and whether you’ll use the Flat Rate Scheme. But what is the Flat Rate Scheme and is adopting it the right decision for you and your circumstances?
Let’s explore the world of the Flat Rate Scheme to help make the right decision for you.
What is the Flat Rate Scheme (FRS)?
The VAT Flat Rate Scheme (or FRS abbreviated) is an option to pay VAT for small businesses and contractors.
Initially, the Flat Rate Scheme (FRS) was created to simplify VAT for businesses with an expected annual turnover no greater than £150,000 excluding VAT or £180,000, including VAT. These businesses always apply to HMRC.
Many freelancers and contractors use the FRS due to its simplicity, but also because of its financial benefits which can be greater than using the standard method.
How does FRS work exactly?
Generally, the amount of VAT that businesses pay or claim back from HMRC is the difference between the VAT the business pays on their own and the VAT charged by that business to clients.
FRS works by calculating the amount of VAT payable to HMRC as a flat percentage of the value of your services plus the VAT charged, rather than working out the difference between the VAT received and paid.
The percentage that you’d pay is based on industry type. So a few examples of flat rate by type of business:
|Industry / Business type
|VAT flat rate
|Computer and IT consultancy or data processing
|Film, radio, television or video production
|Architect, civil and structural engineer or surveyor
You can see what percentage you’d pay based on your industry type by taking a look at the gov.uk website.
The FRS percentage selected ultimately depends on the category that best suits your industry and profession. You may pay a different rate if you only spend a small amount on goods.
The FRS was originally created to be a simplification of the administrative process rather than to provide a financial benefit, but for many freelancers and contractors, the amount of VAT retained is higher than what’s actually incurred.
Example of FRS with a financial benefit
As an IT consultant your percentage would be 14.5% and lets say your turnover is £80,000 (VAT excluded):
VAT output tax: £80,000 x 20% = £16,000
VAT inclusive turnover: £96,000
Therefore under the FRS, the VAT paid to HMRC will be £96,000 x 14.5% = £13,920
Many contractors wouldn’t be incurring VAT input tax equivalent to the difference between the received and paid VAT (£16,000 – £13,920 = £2,080 above) and therefore financially benefit from the difference, by adopting the FRS rather than the standard VAT scheme.
Limited Cost Trader (LCT) – The 16,5% FRS rate
April 2017 saw a new Flat Rate percentage of 16.5% introduced. From this date onwards the new FRS rate of 16.5% was applied to freelancers and contractors whose business falls within a wholly new Limited Cost Trader (LCT) definition.
To explain, should your normal adopted category be 14.5%, for a VAT quarter where you meet the definition of LCT, the 14.5% is replaced by 16.5%.
Is your business classified as a Limited Cost Trader?
HMRC defines contractors or freelancers as Limited Cost Traders when their spending on ‘Relevant Goods’ within the VAT period is:
- Less than 2% of the VAT inclusive sales within the VAT period
- Greater than 2% if the amount of Relevant Goods is less than £250 per quarter on quarterly VAT or £1000 per year
The difference between the FRS versus the Limited Cost Trader category can be rather dramatic financially. It’s always worth discussing your personal circumstances with a specialist accountant who will be able to advise on the best possible financial outcome for you.
What are Relevant Goods?
When you purchase something for your business, it’ll either fall into the category for goods or services. Goods are usually tangible items where a title of ownership is present, whereas services are everything else.
Under Limited Cost Trader, Relevant Goods are those used only for the purposes of your main business activity, not only excluding costs which incur both personal or partial costs, specifically excluding food and / or drink, goods you wish to re-sell or hire (unless this is your main business activity), and all vehicle costs including fuel and mileage.
For examples of Relevant and Non-Relevant Goods, visit HMRC’s website.
Should you use the VAT Flat Rate Scheme for your business?
To decide whether the VAT Flat Rate Scheme is right for your business or not you will need to analyze what your company does (and so the flat rate that applies for you), what kind of VAT charges and pays, etc.
Many contractors and freelancers benefit from using the FRS, and assessing quarterly whether they fall into the Limited Cost Trader category (and therefore whether to use the 16.5% rate). It’s still worth doing for some as they will continue to benefit from the FRS’s simplification of VAT for your business.
It may be worth you considering the Annual VAT Return cycle rather than quarterly returns, as there may be an opportunity to manage for qualifying for full FRS as costs as usually incurred annually.
Whilst these decisions are there for you to make, we strongly advise speaking to someone who specializes in tax and VAT, as your personal circumstances may make you unsuitable for certain options.