Many small business owners find VAT intimidating. The terminology, thresholds, and calculations can be confusing, particularly for first-time founders. However, it’s less daunting once you understand what it is and whether you need to register for it.
It’s helpful to understand VAT early in your entrepreneurial journey. Alongside knowing your company formation options, familiarising yourself with potential tax obligations can help you prepare.
This practical guide explains the key principles of VAT, with advice from Rapid Formations.
What is VAT?
VAT stands for Value Added Tax. It’s a tax charged on many goods and services sold in the UK.
Businesses registered for VAT collect the tax directly from customers on behalf of HMRC. This means that the end consumer pays the VAT as part of the total price. VAT-registered businesses act as a link between customers and HMRC by collecting and reporting this tax.
When businesses pass VAT on to customers, their prices may appear higher than those of some competitors that aren’t VAT registered. However, these higher prices don’t necessarily mean extra profit because the VAT they collect generally belongs to HMRC rather than the business.
VAT-registered businesses must charge VAT on sales to which the tax applies. They may also be able to reclaim VAT paid on eligible business purchases. They do this by submitting VAT returns to HMRC outlining their relevant sales and expenses. When submitting a VAT return, businesses compare the VAT they’ve collected with the eligible VAT they want to reclaim. If they’ve collected more VAT than they can reclaim, they pay the difference to HMRC. If they can reclaim more than they’ve collected, they will receive a refund.
When does a small business need to register for VAT?
Not every business needs to register for VAT immediately after formation. Generally, businesses need to register for VAT if their total taxable turnover over the last 12 months exceeds the VAT threshold. As of June 2026, the VAT threshold is £90,000.
It’s important to remember the difference between the VAT threshold’s 12-month rolling period and the standard tax year. Rather than checking turnover during a fixed period each year, businesses need to continually review the previous 12 months to determine whether they’ve crossed the threshold. If you’ve exceeded the threshold during the previous 12 months, or expect to within the next 30 days, you need to register for VAT.
If your turnover is lower, you can voluntarily register for VAT. Some business owners choose to do this because reclaiming VAT on eligible purchases may outweigh the additional administrative requirements. If you’re spending a significant amount on eligible business purchases, voluntary registration may allow you to reclaim some of the VAT you’ve paid. However, businesses that pass VAT on to customers may find that their prices become less competitive, particularly when selling primarily to consumers. This could affect some customers’ purchasing decisions. While some founders feel that being VAT-registered helps them appear more established to prospective clients, others decide that the obligations associated with VAT registration outweigh the potential benefits.
Regardless of turnover, you must register for VAT if you and your business are both based outside of the UK and you supply goods or services to the UK (or expect this to be the case in the next 30 days).
Understanding the different VAT rates
VAT is not always charged at the same rate. The amount charged will depend on the goods and services being sold.
There are three main rates of VAT:
Standard rate VAT
The standard VAT rate is currently 20% and applies to most goods and services, including consultancy, adult clothing, and electronics.
Reduced rate VAT
Some goods and services are subject to a lower VAT rate of 5%. Examples of reduced-rate VAT goods include children’s car seats and domestic fuel supplied to households.
Zero-rated VAT
Some goods are taxed at 0% VAT, including books and children’s clothing.
Many food items are zero-rated, although some specific food and drink products are standard-rated. Food and drink sold for consumption on premises (i.e. in a restaurant) is also generally standard-rated.
Zero-rated items are still part of the VAT system, whereas exempt supplies operate differently. Certain activities, such as some financial and educational services, are VAT exempt.
How is VAT calculated?
VAT calculations are often simpler than they appear.
There are two key calculations to understand:
Adding VAT to a price
To add VAT to a price, you first need to know the original price of the product or service and the VAT rate that applies. Once you know this, you can calculate the VAT amount and add it to the original price.
As an example, let’s say that a business sells a product for £100 before VAT. In this example, we’ll assume the standard rate applies, and the business passes the VAT charge on to customers.
At a standard 20% VAT rate on a £100 product or service, the VAT amount is £20. This means that the new total amount charged to the customer will be £120.
To calculate the VAT amount for other prices, you can multiply the price of the item by the decimalised version of the percentage. For the standard rate of 20%, this will be 0.2. For the reduced rate, it will be 0.05. In this example, 100 x 0.2 = 20. You then add the VAT amount to the original price. In this case, it’s 100 + 20 = 120.
Working backwards from a VAT-inclusive price
Businesses often receive invoices where VAT has already been included in the total price. If they’re eligible to claim back the VAT, they likely want to know how much they can reclaim from HMRC.
If the business pays £120 for a standard-rated product, the VAT element is £20, and the pre-VAT value is £100. If the purchase qualifies under HMRC’s rules, a VAT-registered business may be able to reclaim the £20.
A VAT-inclusive price at the standard rate represents 120% of the original price. So, to work backwards from a VAT-inclusive price and determine the original price before VAT, you need to take the VAT-inclusive price and divide by 1.2. This will tell you the original price of the item. In this example, 120 ÷ 1.2 = 100, so 100 is the original price. To calculate the VAT element, you need to subtract the original price (100) from the VAT-inclusive price (120). Therefore, in this example, 120 – 100 = 20.
Accountancy software frequently automates these calculations, but it’s still worth understanding the underlying principles behind the sums.
How does VAT work in practice for small businesses?
Understanding how VAT works in practice can help small businesses know how the tax may affect day-to-day operations and overall profitability.
Let’s go through an example: a video editor charges their clients £1,200 including VAT.
As their services are standard rated at 20%, the VAT portion collected on this invoice is £200.
During the same period, they pay £300 including VAT for business expenses, which contains £60 worth of VAT.
When they fill in their VAT return, they share the following:
- VAT collected from customers = £200
- Recoverable VAT paid on eligible purchases = £60
In this example, they would need to pay a total of £140 to HMRC (as £200 – £60 = £140).
This example illustrates why VAT shouldn’t be viewed as additional business income. Setting aside the VAT collected from customers can help businesses avoid disruptive cash flow issues when payments to HMRC become due.
What should small businesses do to stay on top of VAT?
As with most elements of running a business, efficient preparation can make things more manageable. It’s important to understand your VAT obligations so that you can budget effectively and manage your cash flow more confidently.
To stay on top of VAT, it’s worth monitoring turnover regularly. By doing this, you’ll know when you need to register for VAT. Once you are registered, you can use these regular reviews to know how much VAT you’ve collected from customers. Periodically putting aside your VAT collections will help reduce the risk of cash flow complications.
It’s also worth considering seeking professional advice when circumstances become more complex. Tax advisers can help founders understand which VAT rates apply to which products and services. They can also advise on maintaining accurate records and filing returns with HMRC.
While VAT can seem daunting initially, maintaining organised records and seeking support when needed can make compliance a more streamlined process.
Understanding VAT can support better business decisions
VAT is a day-to-day part of running a business for many founders. While it doesn’t apply to every business, all entrepreneurs should understand when registration may become necessary. Some owners may also want to explore voluntary registration.
While some founders fear VAT calculations, most sums are more straightforward than they first appear. Additionally, accountancy software can assist with VAT calculations and record-keeping, while professional advisers can support you in more complex scenarios.
Understanding the basics of how VAT works can make dealing with VAT more manageable and support more informed financial decision-making.
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