One of the hallmarks of running your own limited company is the freedom and flexibility that it offers in terms of structuring your earnings. A key area in which this flexibility can very quickly be realised is with regards to whether or not a contractor should register their limited company for VAT.
Whilst it is compulsory that a limited company earning over the VAT threshold of £79,000 per year (2013/14 threshold) be registered for VAT, this is not the case for a limited company earning under the threshold; a contractor who’s limited company earns under £79,000 is free to decide whether or not they want to VAT register their company. In order to make an educated decision as to which way to proceed, they need to have a basic understanding of the differences between operating with and without VAT registration.
A VAT registered company adds VAT to the cost of its products and/or services. This additional income doesn’t belong to the company; instead, the company is effectively collecting VAT on behalf of HMRC and the company will need to complete VAT returns and pay over the VAT to the revenue.
However, when a VAT registered company buys products or services from another VAT registered business, it can claim back the VAT that it pays.
For example, let’s assume that in a 3 month period a VAT registered limited company contractor collects £3,000 in VAT from their customer. In the same period the contractor also buys something from a supplier and is charged £100 including VAT. The amount the contractor has to give to HMRC is the VAT they’ve collected minus the VAT they’ve paid out. In other words, the contractor does not have to pay the full £3000 over to HMRC!
In this scenario then, the contractor is better off than they would have been if they weren’t VAT registered because if they weren’t VAT registered they wouldn’t have collected VAT in the first place and so wouldn’t have been able to offset their own VAT expenditure against anything.
Another key benefit of being VAT registered, aside from the direct financial advantage, is the positive impression that it can create. Rightly or wrongly, a VAT registered company often creates a better impression with clients than a company that is not VAT registered. Some clients may be apprehensive about engaging with a non VAT registered company on the basis that they think it’s too small to safely do business with. This might be unfounded, but in a highly competitive market, contractors should consider all possibilities and consider every competitive advantage.
Not to VAT…
One of the key benefits of not being VAT registered is that it results in less administrative burden. A VAT registered company must add VAT to invoices, obtain VAT invoices and expense receipts, and submit a quarterly or annual VAT return. In contrast, non-VAT registered companies do not add VAT to invoices, do not obtain VAT receipts, and do not submit VAT returns.
In addition, being non-VAT registered can put contractors at a commercial advantage if they are seeking to engage with clients who are either not VAT registered themselves (through choice), or are unable to register for VAT due to the nature of what they do. In instances where a contractor is VAT registered but is seeking to engage with a non-VAT registered client, the contractor would cost the client 20% more than a non-VAT registered contractor would do due to the fact that the client would have to pay the contractor at their pay rate plus 20% (the VAT rate) rather than just at the pay rate!
Unfortunately, however, being non-VAT registered isn’t always ideal. As we discussed previously, a non-VAT registered company cannot claim back VAT. To reiterate the above point, if an expense costs £100 including VAT, then that is the amount that would appear in the limited company’s accounts and the amount that will receive tax relief. If the company had been VAT registered, however, then the VAT element of the cost of the item could have been reclaimed from VAT charged to clients. Admittedly, this would reduce the amount against which tax relief would be applied, but it would also increase company profits! This has an overall positive effect because tax relief on the reduced amount and an additional profit to the company is better than simply getting tax relief on £100, and this is true even when the corporation tax owed on the additional profit is taken into consideration.
Available VAT Schemes…
If a decision is made to register for VAT, there are a number of different VAT schemes available to limited company contractors. The three most popular are:
Standard (or Accrual) Scheme
On the standard scheme, the amount of VAT you owe (or reclaim) is based on the date of invoices. So if you invoice someone for £1,000 + VAT, that VAT is deemed to be owed to HMRC at the end of the quarter in which you dated the invoice. This option might be less favourable to contractors on the basis that it can cause cash-flow problems due to the sometimes sporadic nature of contract work.
Cash Accounting Scheme
This solves the cash-flow problems associated with the Standard scheme since under this scheme the VAT is deemed to be owed at the end of the quarter in which you were actually paid for the invoice (and on the other side – when you paid for your purchases).
Flat Rate Scheme (FRS)
This scheme tends to be the most popular for contract workers. Contractors are given a flat VAT percentage rate which will vary depending upon the industry in which they operate (but will always be lower than 20% standard VAT
rate). Contractors charge out VAT at the standard rate (20%) but only pay over to HMRC at the flat-rate percentage on their gross turnover. Contractors can’t claim back any VAT on their purchases (with a few exceptions), but in return they are not handing over to HMRC all of the VAT that they receive in.
LB Accountancy Services is an accountancy practice specialising in the contract/freelance market-place. VAT is just one of a number of issues that contractors will need to consider when looking at the option of setting up their own limited company. For an in-depth discussion about your situation, do not hesitate to contact us.