Limited cost trader flat rate VAT explained, and why most consultants fail the test
One spending test decides whether the flat rate scheme saves you anything or quietly costs you. Most service businesses have never had it checked. Here is how the rule works and what we look at before recommending a scheme.
Published 27 September 2026
6 min read
Nasir Rasheed, Director, Nexus Tax and Accounting Solutions, MAAT AATQB
If someone told you the flat rate VAT scheme would save your company money, there is a single test that decides whether that is true. Limited cost trader flat rate VAT explained in plain terms: it is a rule HMRC added in April 2017 that pushes low-goods businesses onto a rate of 16.5%, whatever sector they trade in.
Our view, after looking at a lot of consultancy VAT returns, is that most consultants and contractors fail the test without realising. Their costs are software, subcontractors, rent, insurance and professional fees. None of those count as goods.
That does not make the flat rate scheme useless. It means the scheme has to be checked against what you actually spend, rather than the sector percentage on the HMRC list. Below is how the test works, what 16.5% does to your VAT bill, and when flat rate still earns its place.
What makes a business a limited cost trader
The test is about goods, and it is measured against your gross turnover including VAT.
You are a limited cost trader in a VAT period if your spending on relevant goods is either:
- less than 2% of your gross turnover for that period, or
- more than 2% but under £250 in the quarter, which works out at less than £1,000 a year.
Fail either way and your flat rate percentage becomes 16.5% for that return, in place of the sector rate you were using. A management consultancy on 14% and an IT consultancy on 14.5% both land on the same 16.5% once the goods spend falls short.
Two details catch people out. The spending figure is VAT inclusive, so you compare like with like. And it is the cost of the goods that matters, whether or not VAT was charged on them. Buying from a supplier who is not VAT registered still counts towards your goods spend.
HMRC’s own guidance on the scheme sits at gov.uk, and the definitions there are worth reading before you assume your sector rate applies.
What HMRC counts as relevant goods
Relevant goods means physical items bought for the business and used entirely in the business. Services are outside the test completely, and that is where most consultancies lose.
These do not count:
- rent, telephone, broadband and software subscriptions, because they are services
- accountancy, legal and other professional fees
- subcontractor labour, including labour-only construction work
- food and drink for you or your staff
- capital items, including computers and equipment
- vehicles, road fuel and motor parts, unless you run a transport business
These do count: stock for resale, materials used in a job, office consumables, cleaning products, printing, gas and electricity where the use is fully business.
Part private use rules an item out. A home electricity bill with some personal use cannot go in the calculation.
Run that list against a typical consultant and the answer is usually obvious within a minute. Invoice values are high, transaction volume is low, and almost every cost is a service. A trades business buying materials every week is a different story, and often passes the test comfortably.
Fourteen and a half per cent looks like a discount until someone checks the goods spend. Fail that test and you hand back almost every pound of VAT you collected.
What 16.5% does to your VAT bill
The headline rate hides how little is left once you pay it.
Here is an illustrative quarter. You invoice £10,000 plus VAT, so you collect £2,000 and your gross turnover is £12,000. At 16.5% you hand HMRC £1,980. You keep £20 on £10,000 of work, and you still cannot reclaim VAT on your purchases.
On the standard scheme, that same quarter gives you £2,000 in box 1 less whatever input VAT you have in box 4. Any reclaimable VAT at all, on software, professional fees or equipment, and the standard scheme puts you ahead.
HMRC said the limited cost trader category would affect around 123,000 flat rate users when it came in, and its own policy paper accepted that it removes the cash advantage for businesses with low costs. It did what it was designed to do.
So the sensible question is no longer whether flat rate looks tidier. It is whether your box 4 is genuinely close to empty, and whether the goods test lets you keep the sector rate at all. Those are two separate checks, and both have to pass.
The check that has to happen every quarter
Limited cost trader status is not decided once when you join the scheme. It is decided again in every VAT period.
A building firm might buy £4,000 of materials in one quarter and almost nothing in the next. The first quarter uses the sector rate, the second uses 16.5%. Get that the wrong way round and the return is wrong, with interest and penalties attached to the correction.
The £250 quarterly floor trips people up as well. Take a business with £10,000 of gross sales in a quarter and £240 of qualifying goods. That beats the 2% figure of £200, but it is under £250, so 16.5% still applies.
In practice, this is a bookkeeping job before it is a tax job. If your purchase ledger does not separate goods from services, nobody can run the test properly, and the answer becomes a guess.
We look at this on every VAT return for clients on the scheme, because a rate that was right in March can be wrong in June, and the owner has no reason to notice.
When the flat rate scheme still works
There are still businesses where flat rate is the better answer, and we move clients onto it when the numbers say so.
One of ours is a procurement consultant running a limited company. The set-up review showed box 4 was almost empty, because his costs were overseas software and reverse charge services. We compared the schemes on his actual figures, moved him from standard to flat rate, and his VAT bill fell every quarter with no change to turnover. He now gets his corporation tax and dividend position a month before the bill lands.
Worth knowing before you plan around it: you can only join if your VAT taxable turnover is £150,000 or less excluding VAT, and you have to leave once income passes £230,000 including VAT. That threshold has not moved since 2017, so a growing company can outgrow the scheme quickly. New registrations get a 1% discount for the first twelve months, which softens the first year and then stops.
If you want the wider comparison, our guide on whether the flat rate VAT scheme is worth it sets the three schemes side by side.
Common questions
Does the limited cost trader rule apply to every flat rate sector?
Yes. If you fail the goods test in a VAT period, 16.5% replaces your sector percentage whatever trade you are in. Computer and IT consultancy at 14.5%, management consultancy at 14% and hairdressing at 13% all move to the same rate for that return. The sector rate only applies when your relevant goods spending clears both limits.
Do software subscriptions and professional fees count as relevant goods?
No. Both are services, so they sit outside the test entirely. The same applies to rent, telephone, broadband, insurance and subcontractor labour. This is why consultancies with healthy overheads still fail the goods test. Your total costs can be substantial and your relevant goods figure can still be close to zero for the quarter.
Can buying a laptop keep me out of the limited cost trader category?
No. Capital items are excluded from relevant goods, so equipment purchases do not help the calculation. Under the flat rate scheme you can reclaim VAT separately on a capital asset costing £2,000 or more including VAT, but that is a different rule and it does not change your percentage for the period.
Should I leave the flat rate scheme if I am a limited cost trader?
Usually yes, if you have any reclaimable input VAT at all. At 16.5% you keep almost nothing of the VAT you charge, and you give up your reclaims. Some owners stay for the simpler admin, which is a fair choice. Compare a real quarter under both methods before deciding, rather than going on the sector rate alone.
Does the 1% first-year discount apply to the 16.5% rate?
The 1% reduction applies for the first twelve months of VAT registration, so a limited cost trader pays 15.5% during that period. It is a temporary softening rather than a reason to join. Once the year ends the rate returns to 16.5%, and most service businesses find the standard scheme gives a better result from that point.
Where we stand
That is limited cost trader flat rate VAT explained without the jargon. If your business buys services rather than goods, assume you are caught by the 16.5% rate until the figures prove otherwise, and check it again each quarter.
For most consultants and contractors we look at, the standard scheme is the better position once input VAT is counted properly. For trades and stock-carrying businesses under the turnover limits, flat rate often still wins. The only way to know is to run your own numbers through both.
If nobody has checked your VAT scheme since the day you registered, that is exactly what the set-up review covers, along with your structure, salary and dividends. Nexus takes three new clients a month, so there is time to do it properly.