Why the VAT flat rate scheme is overrated

UPDATE NOV 2016 – the below was written long before the Chancellor made a further attack on the FRS for “low cost traders”!  There is still the simplicity angle that some users will enjoy, but many who did make a small profit from it too will find that from April 2017 they no longer will.

Original post from 26 Nov 2013 below:

In the world of contractors/freelancers, the flat rate scheme (FRS) is a well known VAT “trick” which many believe saves them loads of cash.  That’s not always the case.

FRS is on gross invoice

For those it does benefit, it’s rarely as good as they think.  Say you’re an IT consultant, you charge 20% VAT to your clients and pay 14.5% FRS…so you pocket 5.5% for yourself, right?  Wrong.  The 14.5% is paid on the gross invoice.
– you raise a £1,000 net invoice
– add £200 VAT charged to the client
– pay 14.5% on £1,200, being £174
– you only pocket £26 (£200 – £174), so 2.6%, or 2.167% of the gross amount.

Can’t reclaim input VAT

Perhaps obviously, you lose the ability to reclaim VAT on your purchases.  As demonstrated above, if you incur more than £26 worth of input VAT per £1,000 of VATable (more on this later) sales, you’re worse off being on the FRS.  £26 isn’t a lot.

Yes, you can reclaim when you spend >£2,000 in one go on capital assets, but that’s unlikely to be a regular occurrence…and if it is, its it because you’re buying things you don’t need just for the tax breaks?  Rarely a good idea.

Subcontract work out?

Quite a lot of contractors/freelancers at some point subcontract work out to others (or possibly buy and resell equipment to clients).  If these suppliers of yours are VAT registered themselves, you’ll quickly lose out, potentially by a lot as you’ll be getting hefty VATable invoices coming in.

When looking at your profit margin on work subcontracted out, if you’re on the FRS, consider the gross cost as your cost.  Some people mistakenly think they’ll only have to pay over FRS % on their profit margin as they feel the rest isn’t really their turnover.  Wrong.  When you subcontract (or buy and resell equipment), both your turnover and costs rocket, even though your profit only increases by your margin.

Example:
– you agree to £5,000+VAT’s work, you subcontract to someone else for £4,000+VAT.
– not on FRS, your profit would be £5,000 – £4,000 = £1,000.
– on FRS, your profit would be £6,000 – £4,800 – (14.5% x £6,000) = £330.
– £670 worse off by being on FRS for this one transaction.

Sell overseas

Many contractors/freelancers at some point also sell to outside the UK.  You need to be careful here as the VAT can get complex, but more often than not these sales will be outside the scope of UK VAT.  Whilst this means you don’t pay FRS % on that turnover as these aren’t VATable sales, bear in mind it also means you’re not making the “profit” from FRS on that turnover.

As an aside – ensure your accounting software knows these sales are outside the scope of VAT rather than exempt/zero rated.  FreeAgent tip – this generally means making sure you enter the “country” drop down properly within the “contact”…do NOT just manually change the VAT rate on the invoice to 0% or you’ll still pay FRS % on it).

You’re stuck with it for a while

If you join the FRS, you need to stay on it for at least a year before you can leave.  Reasoning for this is to stop people co-ordinating all their big VATable bills to be annual, and ensure they’re on the “normal” VAT scheme for that quarter whilst FRS for the remaining three.

Downside of this means you need to think ahead 12 months when making the choice whether or not to join.  If your current situation suits it, but then things change 3 months in, tough, you’re stuck with it.

Therefore if you’re just starting up and don’t know how things will pan out, best to play it safe and keep away from the FRS.  You can always join it later once you’ve got a better idea of how things will work.

Flat rate surplus is NOT your profit from FRS

Your bookkeeping software may well give you a flat rate surplus figure, up there next to turnover.  This is the bit of VAT you get to pocket on all your sales.  However, it doesn’t factor in the “lost” VAT that you would have been able to reclaim if you weren’t on the FRS.  When on FRS all your company expenses will be shown gross of any VAT.  Some people misunderstand that, and think that as long as the flat rate surplus shows a positive figure, they’re benefiting financially from being on the scheme.

Conclusion

So…long story short is whilst lots of people do benefit from the FRS, it’s typically far less than they think, and I’m sure many more actually lose out without knowing it.

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