The VAT question every new contractor faces
When a contractor sets up a limited company and starts billing clients, VAT registration is one of the first practical decisions. Compulsory registration kicks in automatically at a certain turnover level. Voluntary registration is often sensible well before that. And once registered, there is a choice: standard VAT accounting or the Flat Rate Scheme. For many contractors, the Flat Rate Scheme turns out to be less attractive than it first appears, because of a rule introduced in 2017 that still catches almost every labour-only contractor who tries it.
This guide covers the registration and deregistration thresholds, how the Flat Rate Scheme works in principle, what the limited-cost trader rule is and how it operates, and our view on when the FRS is and is not worth using. There is also a worked example to make the maths concrete. All figures apply in 2026/27.
VAT registration: the £90,000 threshold, frozen since April 2024
VAT registration becomes compulsory once a business's VAT-taxable turnover exceeds £90,000 in any rolling 12-month period, or where the business reasonably expects to exceed that figure in the next 30 days. Both thresholds have been frozen since 1 April 2024 and there has been no indication of an early uplift. With income growth and no upward movement in the threshold, more contractors find themselves dragged across the registration line each year.
Most contractor services are standard-rated at 20%. A contractor billing £90,001 net to a client must register, add VAT at 20%, and account for it to HMRC. The billing to the client becomes £108,001 VAT-inclusive, and the contractor holds the £18,001 VAT element on trust until the next return.
Voluntary registration below the threshold
Registration below the £90,000 threshold is voluntary. Many contractors register early for two reasons. First, most business-to-business clients are themselves VAT-registered and can reclaim the VAT the contractor charges, so the charge is cost-neutral to the client. Second, registration allows the contractor to reclaim input VAT on their own business purchases, including software, equipment, professional fees and services they procure for the business.
A contractor whose clients are entirely private individuals (not VAT-registered) faces a different calculation: the VAT charged is a real cost to the client and cannot be recovered, which can affect competitiveness. That situation is uncommon in most contracting niches but worth noting for any contractor serving end consumers directly.
The deregistration threshold and the gap
The deregistration threshold is £88,000, also frozen since 1 April 2024. This creates a £2,000 gap between the level at which registration becomes compulsory and the level at which deregistration becomes available. A contractor who has been trading just above £90,000 and whose billings then fall cannot deregister simply because a single month is slow. The test is whether taxable turnover is expected to remain below £88,000 over the next 12 months.
This gap matters in practice for contractors winding down a contract, taking time off, or moving inside IR35 and shifting to an umbrella. If the company remains VAT-registered and trading, the £88,000 floor applies. Deregistering too early, when turnover could recover, creates a subsequent re-registration obligation and interrupts the continuity of input VAT recovery.
The Flat Rate Scheme: the basic idea
The Flat Rate Scheme (FRS) is a HMRC simplification measure. Instead of calculating output VAT on every sale and input VAT on every purchase and netting the two, a business on the FRS pays a fixed flat percentage of its VAT-inclusive turnover directly to HMRC. The business still charges clients VAT at 20% on invoices, but the amount remitted to HMRC is the flat rate percentage rather than the full 20% collected.
In the original design, the flat rate was set sector by sector at a level that approximated the typical net VAT liability for that sector, allowing businesses to keep any difference as a small benefit for choosing the simplified route. A computer and IT consultant's rate, for example, was set at 14.5% of VAT-inclusive turnover. Charging 20% on a £10,000 net invoice gives a £12,000 VAT-inclusive figure; at 14.5% the FRS payment is £1,740, compared to £2,000 collected, leaving a £260 benefit (before considering lost input VAT recovery).
Entry conditions
To join the FRS a business must expect its VAT-taxable turnover to be £150,000 or less in the next 12 months, excluding VAT. This entry threshold covers the large majority of single-contractor PSCs. There is no fee to join and no minimum commitment period, though leaving and rejoining the scheme is not straightforward if HMRC decides the usage is not genuine. The FRS is administered under the VAT Regulations 1995 (SI 1995/2518) and HMRC's VAT Notice 733.
Input VAT: mostly gone under the FRS
The significant trade-off is that a business on the FRS generally cannot reclaim input VAT on ordinary business purchases. Accountancy fees, software subscriptions, equipment and professional services all carry VAT that the FRS contractor cannot recover. There is one exception: input VAT can be reclaimed on a single purchase of capital goods where the VAT-inclusive cost is £2,000 or more. Below that threshold, capital purchases also lose their input VAT.
This is the trade that the FRS asks a contractor to make: simpler bookkeeping and a potential benefit on the output VAT side, in exchange for foregoing input VAT recovery on running costs. Whether it works in the contractor's favour depends entirely on the numbers, and in particular on the limited-cost trader test.
The limited-cost trader rule: why 16.5% changes everything
The limited-cost trader rule was introduced in April 2017 in direct response to abuse of the FRS. Service businesses with very low input VAT were using low sector flat rates to generate significant tax advantages that went beyond the simplification the scheme was designed to provide. HMRC's response was to set a 16.5% flat rate for any business that qualifies as a limited-cost trader in a given period.
The test: 2% of turnover or £1,000 a year
A contractor is a limited-cost trader in a VAT period if their spending on goods in that period is either:
- less than 2% of their VAT-inclusive turnover for the period, or
- less than £1,000 a year (scaled to the length of the period, so roughly £250 per quarter for a quarterly filer).
If either threshold is breached, the 16.5% rate applies for that period. The test is not cumulative over the year. It is applied each time a VAT return is prepared. A contractor who passes the 2% test in one quarter but fails it the next must use 16.5% in the failing quarter, regardless of their annual average goods spend.
What counts as goods and what does not
The definition of goods for the limited-cost test is deliberately narrow. Goods means physical items used exclusively for the business, and even within that category several types are excluded:
- Capital assets (even if they are physical goods, they are excluded from the test)
- Food and drink consumed on the business premises
- Vehicles, fuel and related items (unless the business's trade is in transport)
- Goods bought for the sole purpose of achieving the 2% threshold
The practical consequence for contractors is severe. The items that make up most of a typical contractor's costs, such as accountancy fees, software subscriptions, professional indemnity insurance, IT support and online platforms, are services, not goods. They do not count towards the 2% test at all. A contractor who spends £200 a month on accounting software and professional services will have qualifying goods spend of close to zero. They will be a limited-cost trader in almost every period.
Goods that do qualify
For completeness, items that can count include physical stationery and consumables, physical storage media, printed materials bought for resale or use in a project, and physical tools or raw materials where the contractor's work involves supplying them alongside their services. An IT contractor deploying client hardware they purchase and pass on may have qualifying goods spend if the items meet the definition and are not capital assets. In most pure labour and professional service engagements these situations do not arise.
Working through the numbers: does the FRS make sense?
The only reliable way to answer the FRS question for a specific contractor is to model it. The worked example below uses a typical scenario for a technology contractor billing at a rate that sits just above the compulsory registration threshold.
Assumptions
- Net monthly billings: £8,500
- Annual net turnover: £102,000
- VAT collected at 20%: £20,400 per year
- Qualifying goods spend: £0 (pure labour, no goods)
- Annual input VAT on genuine running costs (accountancy, software, PI insurance, phone): approximately £600
Standard VAT accounting
| Item | Annual (£) |
|---|---|
| Output VAT collected (20% x £102,000) | 20,400 |
| Input VAT reclaimable on running costs | (600) |
| Net payable to HMRC | 19,800 |
Flat Rate Scheme at 16.5% (limited-cost trader)
| Item | Annual (£) |
|---|---|
| VAT-inclusive turnover (£102,000 x 1.2) | 122,400 |
| FRS payment at 16.5% | 20,196 |
| Input VAT recoverable on running costs | 0 |
| Net payable to HMRC | 20,196 |
Under standard accounting this contractor retains £600 of input VAT and pays a net £19,800. Under the FRS at 16.5% they pay £20,196. The FRS costs this contractor an additional £396 per year compared to standard accounting, on top of foregoing the input VAT recovery.
The gross FRS saving before input VAT (£20,400 collected minus £20,196 paid) is £204 per year, or £17 per month. In every typical scenario, that margin is smaller than the input VAT the contractor could recover under standard accounting. The FRS is not worthwhile for this contractor.
First-year discount
A new VAT registrant joining the FRS in their first year of registration receives a 1 percentage-point discount. A limited-cost trader would pay 15.5% instead of 16.5% in that first year. On the example above, the FRS payment at 15.5% would be £18,972, a saving of £1,428 against standard accounting (before accounting for the £600 of lost input VAT, leaving a net benefit of around £828). The discount disappears automatically at the first anniversary. The first-year benefit is modest and does not change the long-run analysis for a labour-only contractor.
When the FRS can still make sense
Our position is that the FRS is rarely worthwhile for a labour-only contractor. It can still suit specific situations, and the key is to model the numbers rather than assume either answer.
Genuine, regular goods spend above the 2% line
A contractor who regularly buys physical goods that qualify for the limited-cost test, and whose spend consistently exceeds 2% of turnover, is eligible for a sector-specific flat rate lower than 16.5%. The benefit calculation then depends on the sector rate. A contractor in a trade where the sector rate is 10% to 12% and who has £3,000 to £4,000 a year of qualifying goods spend could reasonably find the FRS beneficial, though even here the input VAT trade-off needs modelling.
Administrative simplicity value
Some contractors, particularly those with very simple VAT affairs and minimal purchases, value the administrative simplification. A single percentage of gross turnover requires no invoice-by-invoice input VAT tracking. If the contractor genuinely places a high value on time saved and the financial difference between the FRS and standard accounting is small (within a few hundred pounds), the simplification argument has merit. This is a personal calculation, not a universal recommendation.
The £2,000 capital goods exception
A contractor on the FRS who purchases a qualifying capital asset with a VAT-inclusive cost of £2,000 or more in a single transaction can reclaim the input VAT on that item. This occasionally makes the FRS temporarily attractive around a significant equipment purchase. It does not change the underlying analysis for periods where no such purchase occurs.
How to apply the limited-cost test each period
Every contractor on the FRS who is near the boundary should complete the limited-cost calculation before each VAT return. The steps are:
- Calculate your VAT-inclusive turnover for the period (net sales plus VAT at 20%)
- Calculate 2% of that figure
- Total your qualifying goods spend for the period (physical goods, used exclusively for the business, excluding the categories above)
- If your goods spend is less than the 2% figure, or is less than £1,000 annualised, you are a limited-cost trader: apply 16.5% (you escape the rule only if goods spend clears both limbs)
- If your goods spend exceeds both the 2% figure and the £1,000 annual equivalent, you can use your sector flat rate
The £1,000 annual figure scales to the return period. For a quarterly filer it is approximately £250 per quarter. A monthly filer uses approximately £83 per month. These are round figures; the precise test is whether the annualised spend rate is below £1,000, so a slightly uneven spending pattern can mean different outcomes in different months.
Keeping records
A contractor on the FRS must keep records that allow the limited-cost calculation to be verified. This means retaining purchase invoices for any goods claimed, with a note of which items were included in the 2% test and which were excluded. HMRC can ask to see these records on an inspection, and a contractor who has used a sector rate below 16.5% without keeping the supporting goods spend evidence is exposed to a reassessment at 16.5% plus interest and potential penalties.
VAT, IR35 status and the interaction between them
VAT registration and the Flat Rate Scheme are entirely separate from IR35 status. A contractor can be VAT-registered regardless of whether any given engagement is inside or outside IR35. The VAT is charged by the PSC on its services; IR35 determines whether the income is then treated as employment income for income tax and NIC purposes.
There is one practical interaction worth noting. A contractor whose engagement falls inside IR35 under the Chapter 10 off-payroll working rules will have the fee-payer deduct employer NIC and operate PAYE before paying the PSC. The PSC still invoices and accounts for VAT normally. The VAT treatment of the invoice does not change because the engagement is inside IR35. However, an inside-IR35 contractor will typically find that certain allowable expenses disappear (particularly home-to-client travel under the temporary workplace rules), which affects the overall profitability analysis and therefore the importance of getting the VAT accounting right.
For a contractor who holds both inside and outside-IR35 engagements simultaneously, the VAT position is uniform: all invoices go out at 20% regardless of the IR35 status of the individual engagement. The FRS, if used, applies to all VAT-inclusive turnover in aggregate.
The FRS and Making Tax Digital for VAT
MTD for VAT applies to all VAT-registered businesses. A contractor on the Flat Rate Scheme must keep digital VAT records and file returns through MTD-compatible software, in the same way as a contractor on standard accounting. The FRS does not reduce or change the MTD obligation.
MTD for Income Tax is a separate programme. It applies to sole traders and landlords in Self Assessment, phased in by qualifying income: from 6 April 2026 for those with qualifying income of £50,000 or more, and from 6 April 2027 for those with qualifying income of £30,000 or more (with a further £20,000 tier from 6 April 2028). Qualifying income means gross self-employment and/or property income. A PSC director whose personal income is salary and dividends from the company is generally outside MTD for Income Tax, because salary and dividends are not qualifying income under the Self Assessment scope of the MTD regime. A sole-trader contractor above the relevant threshold is in scope and should already be planning for compliant digital record-keeping.
For more on what MTD for Income Tax means for different contractor structures, the contractor accountant guide covers the software and record-keeping requirements in the broader context of choosing the right compliance setup.
Registering for and leaving the FRS in practice
Registration for the FRS is done online through the HMRC VAT registration portal, either at the point of initial VAT registration or afterwards. HMRC typically processes FRS applications within a few days. The scheme can be left voluntarily at any time, though it is usually cleanest to leave at the end of a VAT return period to avoid mid-period calculations. If turnover is expected to exceed £230,000 VAT-inclusive in the next 30 days or has already exceeded it in the previous 12 months, the contractor must leave and notify HMRC.
A contractor who leaves the FRS returns to standard VAT accounting. Input VAT recovery resumes immediately on costs incurred from the leaving date. There is no adjustment mechanism for the period on the FRS when input VAT was not recoverable, so the decision to join and leave the scheme should be considered carefully, particularly where significant business purchases are expected.
Practical decision framework
Before deciding whether to join the FRS, a contractor should work through the following questions:
- What is my qualifying goods spend per quarter? If it is likely to stay below £250 per quarter consistently, the 16.5% rate applies and the analysis should start from that point.
- What input VAT do I currently recover, or would recover, under standard accounting? Accountancy, professional indemnity insurance, software, hardware under £2,000 VAT-inclusive, phone, office supplies. Total these and compare to the potential FRS benefit.
- Is the FRS benefit positive after accounting for lost input VAT? For most labour-only contractors the answer is no. For those with material goods spend it may be yes: model it quarterly using actual figures.
- Is the administrative simplification genuinely valuable? If the numbers are close and the bookkeeping saving is real, the FRS may still make sense even without a clear financial advantage. This is a personal judgement.
- Am I in my first year of VAT registration? The 1% first-year discount may tip a marginal case briefly in favour of the FRS even where the long-run maths does not.
A note on the limited company structure and VAT planning
VAT planning does not change the fundamental logic of operating through a personal service company. The choice of limited company over sole trader or umbrella is driven primarily by the mix of inside and outside-IR35 engagements, the tax-efficiency of the company's extraction strategy (salary, dividends, and employer pension contributions), and the personal risk tolerance around status decisions.
VAT accounting, whether FRS or standard, is a compliance and cash-flow decision that sits below the structural choice. Getting the VAT right matters for cash management and avoids penalties, but the FRS is not a significant tax planning tool for most PSC contractors in 2026/27. The more consequential decisions for a PSC contractor in the current tax year are the corporation tax strategy, dividend rates at 10.75% / 35.75% for 2026/27 following Finance Act 2026 s.4, and whether employer pension contributions are being used as efficiently as the £60,000 annual allowance permits. Those levers move far more money than the marginal gain or loss on FRS.
Contractors who want to verify that their current VAT approach is correct alongside their overall structure can use the IR35 status check as a starting point for understanding which compliance decisions interact with which others, or contact the team through the contact page for a review that covers VAT, extraction strategy and status together.