The UK VAT threshold is one of those policies that looks sensible on a Treasury spreadsheet and does real damage in the wild. If you run a small software business, you will hit it sooner than you think, and the way it works creates a cliff edge that punishes the exact companies the government says it wants to grow.
I have bootstrapped several businesses, and every one of them had a moment where the VAT line was in view and I had to make a decision. Here is how the threshold actually bites, and what you can do about it.
How the VAT registration threshold works
Once your taxable turnover passes the registration threshold, currently £90,000, you must register for VAT and start charging 20% on your sales. It is measured over a rolling twelve months, not your financial year. You also have to register if you expect to go over it in the next thirty days alone.
That sounds reasonable until you think about what it means on the day you cross it. Your price to a customer who cannot reclaim VAT jumps by a fifth overnight, or you swallow the cost out of your own margin. There is no gentle slope. You are either under the line or over it.
The cliff edge that punishes growth
Take a small SaaS product turning over £89,000 a year, selling mostly to consumers and tiny businesses. A single good month tips you over, and suddenly you owe HMRC a fifth of everything you sell from then on. If you want to keep your take home the same, you have to put your prices up by 25%.
Most founders I speak to have seen this and quietly capped their growth. They hold off on a launch, push invoices into the next period or stay a sole trader doing more work for the same money. I think that is a terrible outcome for the economy, and I wrote about the wider pattern in my post on UK tax policy and the cost to entrepreneurs.
Why a frozen threshold makes it worse
The threshold has been frozen for years while costs, wages and prices have risen. That means a business that is not actually growing in real terms still creeps towards the line through inflation alone. It is a stealth tax rise, and it lands hardest on the smallest companies.
Meanwhile, other countries have much higher thresholds, and some have sensible tapering. Ours is among the highest in Europe in headline terms, which the government likes to point out. But a high number with a hard cliff is still a cliff.
Voluntary VAT registration for software companies
Here is the bit people miss. If your customers are VAT registered businesses, registering early costs them nothing, because they reclaim it. For a B2B software company, voluntary registration can actually be a smart move.
You can reclaim VAT on your own costs too, such as hosting, tools, software licences, equipment and contractors who charge it. For a business that spends real money on Azure and developer tools, that adds up quickly. I would take the reclaim over the admin saving almost every time.
The trade off is simple. If you sell to consumers or to other tiny businesses that cannot reclaim, registering early makes you look 20% dearer. Know who your buyers are before you decide.
What to do before you hit the threshold
Do not wait until you are at £88,000 and panicking. Plan for it a year ahead, because the decisions you make about pricing and contracts take time to land.
Watch your rolling total every month
Keep a simple rolling twelve month turnover figure in your reporting. It takes five minutes in a spreadsheet or your accounting software. Set an alert at around £75,000 so you have runway to act.
Build VAT into your pricing early
If you can, quote prices that already work at 20% more. It is far easier to launch with sensible pricing than to push through a big rise on existing customers. I covered similar thinking in my guide to annual vs monthly billing for bootstrapped SaaS, because billing cycle choices change when VAT lands and how much cash you hold.
Check the flat rate scheme properly
The flat rate scheme can simplify things, but it is a bad fit for many software firms. If you spend very little on goods, the rules around limited cost businesses can push your rate up to 16.5%, which kills most of the benefit. Run the numbers with your accountant rather than assuming it will save you money.
Get the cash flow right
VAT is not your money. It sits in your account for a few weeks and then goes to HMRC, so put it in a separate pot the day it arrives. I have seen perfectly healthy small companies get into trouble because they treated a quarterly VAT balance as working capital.
What the government should actually do
I would like to see a taper rather than a cliff. Phase VAT in gradually so that growing past the line does not mean an instant 20% hit. Other countries have tried versions of this, and it removes the incentive to stay small on purpose.
At the very least, index the threshold to inflation so that standing still does not drag you over it. If we are serious about the founders who build the next generation of UK software companies, this is the kind of unglamorous change that helps most. I make the same argument more broadly in my piece on why UK small business policy keeps failing entrepreneurs.
Until that happens, the practical answer is to plan early, price sensibly and treat the threshold as a deliberate decision, not a surprise. Do that and it becomes just another line in the plan, rather than a wall you run into.
