Every VAT-registered business in the UK must collect VAT and pass at least some of it on to HMRC. To make the process easier for small businesses, the government introduced the Flat Rate VAT Scheme (FRS) in 2002. The idea was to make accounting easier for small business owners that collected minimal VAT.
Independent contractors can benefit from the FRS if their business expenditures are comparatively low. We will explain how in this post. Suffice to say all contractors should look into FRS if they are currently operating under the standard VAT scheme.
Standard VAT is calculated through a simple equation. A small business owner keeps track of how much VAT is collected from customers who purchase goods and services. He/she also keeps track of how much VAT is paid while obtaining any products or services needed to run the business. Subtracting the latter from the former results in an amount the business owner pays to HMRC.
For the purposes of simple illustration, assume a contractor collects £5,000 in VAT from customers. The amount of VAT he pays on business-related products and services amounts to £2,000. He would then pay the government the £3,000 difference.
Under FRS, no such calculations are necessary. The contractor still charges customers the standard 20% VAT on qualifying transactions. When it's time to make a payment to HMRC, the contractor multiplies his flat rate turnover by whatever FRS percentage applies to his particular area of business.
For the record, flat rate turnover is a combination of qualifying business income and the VAT paid on that income. The contractor who works as an IT consultant would be subject to a rate of 14.5% on his flat rate turnover. For every £1,000 of turnover, the contractor would also collect £200 in VAT from clients. That £1,200 is subject to the 14.5% rate which would result in a payment of £174 to HMRC.
FRS can be a significant benefit to contractors who do not incur a lot of expenses. In other words, an IT consultant may have very few business expenses after the initial outlay needed to purchase equipment. That contractor would benefit financially from paying 14.5% as opposed to 20%. Obviously, the benefits of FRS are reduced in direct relation to the amount of expenses the contractor incurs.
To be eligible to participate in the flat rate scheme, the following conditions must be met:
In addition, contractors cannot use FRS if they have left the scheme within the last 12 months or they have been found guilty of a VAT-related offence within the previous 12 months. Contractors must immediately leave the scheme if their turnover at the end of the current 12-month period exceeds £230,000 or they expect it to exceed £230,000 in the next 12 months. Remaining in the scheme when one is ineligible can get a contractor in trouble.
Contractors should consult with their accountant or tax advisers to determine whether the FRS or standard VAT scheme is more advantageous. Additionally, they should be reviewing their businesses on an annual basis to make sure they are in the best possible tax position. There is no point in paying more in taxes than is required by law, but there is no way for contractors to know if they are not routinely reviewing their positions.