VAT schemes for small businesses: flat rate, cash accounting, and when to leave them

Standard VAT accounting charges VAT on invoices when you raise them and reclaims it on costs when you are billed. Two schemes change that for small businesses, and both are worth understanding before you choose.

Cash accounting

You account for VAT on sales when the customer pays, and reclaim VAT on purchases when you pay the supplier. If customers pay slowly, it protects your cash. You can join if your taxable turnover is £1.35 million or less, and must leave once it passes £1.6 million.

The flat rate scheme

You pay HMRC a fixed percentage of your VAT-inclusive turnover, set by your business type, and do not reclaim VAT on most purchases except capital assets over £2,000. You can join if your VAT turnover is £150,000 or less, and get a 1% discount in your first year of registration.

The trap: limited cost businesses

If your spending on goods is less than 2% of turnover, or less than £1,000 a year, you are a limited cost business and pay 16.5%. That is close to the full VAT you charge, and you give up reclaiming VAT on costs. Many consultants and service businesses fall into it without noticing.

The yearly check

• Compare what you paid under the flat rate with what standard accounting would have cost.
• Test the limited cost rules every return, as your costs change.
• If customers are slow to pay, look at cash accounting first.