Royalties are payments for the right to use another person’s property, which is often some form of intellectual property.

Some of the most common forms of royalties apply to the use of the following assets:

  • Song or Music Royalties
  • Book Publishing Royalties
  • Franchise Fees
  • Patent Royalties
Example of Book Publishing Royalties

Jane Doe is an author of children’s books. Jane enters into a “Publication Agreement” with Publisher ABC where Jane grants the publisher the exclusive right to publish and sell the book worldwide. Jane will still retain copyright ownership over her book and is only granting a license to the publisher.

Under the terms of the Publication Agreement, the publisher will pay Jane a royalty for each book sold. The royalty will be 60% of the net cost to publish and sell each book. The calculation is as follows:

SOFTCOVER BOOK
$20.00 – suggested retail price
$11.00 – wholesale price (55% wholesale rate)
($3.35) – print price costs
$7.65 – Net
$4.59 – Author Royalty per 60% of Net

HARDCOVER BOOK
$25.00 – suggested retail price
$13.75 – wholesale price (55% wholesale rate)
($6.75) – print price costs
$7.00 – Net
$4.20 – Author Royalty per 60% of Net

For every softcover book Jane sells, she will receive a royalty payment of $4.59. For every hardcover book Jane sells, she will receive a royalty payment of $4.20.

Example of Patent Royalties

John Smith is a doctor and inventor who developed a new allergy medication. John enters a “Patent License and Royalty Agreement” with a large pharmaceutical company to sell the medication to retail customers.

Under the agreement, the pharmaceutical company must pay John a fixed $100,000 annual payment for the exclusive rights to use the patent. In addition, the agreement provides that for every box of allergy medication sold to consumers, the pharmaceutical company will pay John $2 per box.

U.S. Federal Income Tax Consequences

When a company pays a royalty, the royalty payment is a deductible expense under Section 162 of the Internal Revenue Code (IRC).

The recipient of royalty income generally treats the income as portfolio investment income subject to ordinary federal income tax rates. If the royalty income is portfolio income, the recipient cannot claim any trade or business deductions against the royalty income. The recipient is effectively subject to income taxes on their gross royalty income. The individual would report their gross royalty income on Schedule E (Supplemental Income & Loss).   

Alternatively, suppose the recipient of the royalties is actively engaged in writing, performing, or creating an intellectual property, which generates the royalty income. In that case, the individual may recharacterize the receipts as ordinary trade or business income, which allows the person to deduct expenses against their gross receipts. The individual taxpayer would report their royalty income as ordinary income on Schedule C (Profit or Loss From Business) and claim any ordinary and necessary expenses in connection with the business activity.  

Additional Information

Taxpayer’s seeking more information on reporting royalty income and expense can review the Form 1040 Schedule E Instructions on the IRS website.