Guide
VAT schemes: choosing the right one for your business
A guide to the three main VAT schemes for small businesses: Flat Rate Scheme, Cash Accounting, and Annual Accounting. Explains eligibility, advantages, disadvantages, and helps you decide which scheme suits your business.
Once you're VAT registered, you can choose how you account for VAT. The standard method requires you to calculate VAT on every invoice you issue and reclaim VAT on every purchase. This works, but it can be time-consuming and create cash flow challenges if customers pay late.
HMRC offers three alternative schemes designed for smaller businesses. Each simplifies VAT in different ways, and the right choice depends on your business type, cash flow patterns, and administrative capacity.
Quick comparison of VAT schemes
Here's how the four main approaches compare:
The standard scheme is the default. You must actively apply to use any of the alternative schemes below.
Flat Rate Scheme
The Flat Rate Scheme simplifies VAT by letting you pay a fixed percentage of your gross turnover to HMRC, rather than calculating VAT on individual transactions. You still charge customers the standard 20% VAT, but you pay HMRC a lower flat rate based on your business type.
- Turnover limit to join
- £150,000 or less (excluding VAT) in the next 12 months
- Must leave if turnover exceeds
- £230,000 (including VAT) at anniversary or expected in next 12 months
- First-year discount
- 1% reduction in flat rate percentage for first year of VAT registration
- Cannot use with
- Cash Accounting Scheme or VAT groups
How the flat rate works
You charge customers VAT at the normal rate (usually 20%), but you pay HMRC a fixed percentage of your VAT-inclusive turnover. The percentage depends on your business type - for example, accountants pay 14.5% while food retailers pay 4%.
The difference between what you charge customers and what you pay HMRC is yours to keep. This can work in your favour if your actual VAT liability would be higher than the flat rate.
Important: You cannot reclaim VAT on purchases (except for capital assets costing more than £2,000 including VAT).
Limited cost businesses
If you spend less than 2% of your turnover on goods (or less than £1,000 per year), HMRC classifies you as a 'limited cost business'. This means you must use the higher flat rate of 16.5%, which often makes the scheme uneconomical. This rule targets businesses with low material costs, such as consultants and service providers.
When the Flat Rate Scheme works well
- Low purchase costs: If you buy few goods and services with VAT, you're not losing much by not reclaiming input VAT
- High-margin services: If your flat rate is lower than your effective VAT rate, you keep the difference
- Simple administration: No need to track VAT on every purchase
- Cash flow certainty: Easy to predict VAT liability from turnover
When to avoid the Flat Rate Scheme
- High purchase VAT: If you make significant VAT-able purchases, you'll lose out by not reclaiming
- Limited cost business: The 16.5% rate rarely makes sense
- Variable margins: If your costs fluctuate significantly, the flat rate may not suit
- Growing rapidly: You'll need to leave if turnover exceeds £230,000
Cash Accounting Scheme
Under normal VAT rules, you account for VAT when you issue an invoice, regardless of when the customer pays. Cash Accounting changes this: you only pay VAT to HMRC when your customers pay you, and you only reclaim VAT on purchases when you pay your suppliers.
- Turnover limit to join
- £1.35 million or less (excluding VAT)
- Must leave if turnover exceeds
- £1.6 million
- Can combine with
- Annual Accounting Scheme
- Cannot use with
- Flat Rate Scheme
How Cash Accounting helps cash flow
The main benefit is timing. With standard accounting, you might pay VAT to HMRC before your customer has paid you - effectively lending HMRC money. Cash Accounting aligns your VAT payments with your actual cash receipts.
This is particularly valuable if you:
- Give customers extended payment terms
- Have customers who pay late
- Experience seasonal cash flow variations
Automatic bad debt relief
If a customer never pays, you never paid VAT on that sale. Under standard accounting, you'd need to claim bad debt relief separately.
When Cash Accounting works well
- B2B services with payment terms: If you invoice in advance of payment
- Trade businesses: Where customers may take 30-60 days to pay
- Seasonal businesses: Where cash flow fluctuates throughout the year
- Businesses with bad debt risk: Where some customers may not pay at all
When to avoid Cash Accounting
- Regular VAT refunds: If you usually reclaim more VAT than you pay, you'll get refunds later under Cash Accounting
- Immediate payment businesses: If customers pay at point of sale (retail, hospitality), there's no timing benefit
- Complex supplier terms: You can't use it for invoices with payment terms over 6 months or for leased/hire purchase goods
Annual Accounting Scheme
Instead of submitting four quarterly VAT returns, the Annual Accounting Scheme lets you submit just one return per year. You make advance payments throughout the year based on your estimated VAT bill, then settle any balance when you file your annual return.
- Turnover limit to join
- £1.35 million or less (excluding VAT)
- Must leave if turnover exceeds
- £1.6 million
- Can combine with
- Cash Accounting Scheme
- Cannot use with
- Flat Rate Scheme or VAT groups
Payment options
You can choose between two payment schedules:
- Monthly payments: 9 payments of 10% of your estimated annual VAT, with a balancing payment at year end
- Quarterly payments: 3 payments of 25% of your estimated annual VAT, with a balancing payment at year end
The final return and balancing payment are due 2 months after your accounting year ends.
When Annual Accounting works well
- Predictable VAT liability: If your turnover and purchases are steady, advance payments work smoothly
- Limited admin time: One return per year instead of four
- Budget certainty: Fixed monthly or quarterly payments help with cash flow planning
- Combining with Cash Accounting: Use both for maximum simplification
When to avoid Annual Accounting
- Regular VAT refunds: If you typically reclaim more VAT than you pay (e.g., zero-rated exports), you'll only get one refund per year instead of four
- Volatile turnover: Your advance payments are based on estimates; if actual turnover differs significantly, you may overpay or face a large balancing payment
- Cash flow constraints: Monthly advance payments may be harder to manage than quarterly payments after the event
Choosing the right scheme for your business
The best scheme depends on your specific circumstances. Consider these factors:
-
Calculate your effective VAT rate
Work out what percentage of your turnover you actually pay in VAT (after reclaiming input VAT). If this is higher than your business type's flat rate, the Flat Rate Scheme could save you money. If it's lower, you'd pay more under the flat rate.
-
Assess your payment terms
If customers typically pay you weeks or months after you invoice, Cash Accounting will improve your cash flow by delaying when you pay VAT to HMRC. If you're paid immediately (cash sales, card payments at point of sale), there's no timing benefit.
-
Consider your admin capacity
If bookkeeping is a burden, the Flat Rate Scheme removes the need to track VAT on purchases. Annual Accounting reduces return frequency from four times to once per year. Both save time.
-
Check your VAT reclaim pattern
If you usually get VAT refunds (you reclaim more than you pay), avoid Annual Accounting (fewer refunds) and Flat Rate Scheme (no reclaims on purchases). Cash Accounting may also delay your refunds.
-
Project your turnover
Each scheme has different turnover limits. If you're growing fast, you may outgrow Flat Rate Scheme (£150k to join, £230k to stay) quickly. Cash Accounting and Annual Accounting have the same higher limits (£1.35m to join, £1.6m to stay).
Combining schemes
You can use Cash Accounting and Annual Accounting together. This gives you the cash flow benefits of paying VAT when you receive payment, combined with the simplicity of one annual return.
However, you cannot combine:
- Flat Rate Scheme with Cash Accounting
- Flat Rate Scheme with Annual Accounting
- Any scheme with VAT group registration
Switching schemes
If you leave a scheme (by choice or because you're no longer eligible), you must wait 12 months before rejoining it. This prevents businesses from switching in and out to gain short-term advantages.
When leaving Cash Accounting, you must report and pay HMRC any outstanding VAT on unpaid invoices. You have 6 months to do this if you leave voluntarily, or must pay immediately if your turnover exceeded the limit.