Are Royalties Subject to Self-Employment Tax?

Royalties are payments made for the use of intellectual property, such as copyrights, patents, or trademarks, or for the extraction of natural resources like oil, gas, and minerals. These payments grant another party the right to use your property in exchange for a share of the revenue or a fixed fee. The tax treatment of royalty income can vary significantly, particularly regarding its susceptibility to self-employment tax.

Basics of Self-Employment Tax

Self-employment tax represents the Social Security and Medicare taxes for individuals who work for themselves. This tax funds Social Security and Medicare benefits. Unlike traditional employees, whose employers withhold and contribute a portion of these taxes, self-employed individuals are responsible for both the employee and employer shares.

The self-employment tax rate is 15.3% of net earnings from self-employment. This rate comprises 12.4% for Social Security and 2.9% for Medicare. For the 2024 tax year, the Social Security portion applies to net earnings up to $168,600, while the Medicare portion applies to all net earnings. Individuals owe self-employment tax if their net earnings from self-employment are $400 or more.

When Royalties Are Subject to Self-Employment Tax

Royalties are subject to self-employment tax when they are considered “net earnings from self-employment” derived from an active trade or business. This means the individual receiving the royalties is actively involved in creating, producing, or marketing the property that generates the income.

For example, an author who actively writes, promotes, and publishes books as an ongoing business treats their book royalties as self-employment income. An inventor who continuously develops and licenses patents as part of a regular business operation pays self-employment tax on those royalties. The Internal Revenue Service (IRS) views royalty income derived from a Schedule C business as subject to self-employment tax. This applies if the individual is in the business of being a writer, inventor, or artist, or holds an operating interest in oil, gas, or mineral properties.

When Royalties Are Exempt from Self-Employment Tax

Royalties are exempt from self-employment tax when they are considered passive income, received without active involvement in a trade or business. This occurs when the income is derived from investments or from property where the recipient is not actively engaged in its creation, production, or ongoing management. For instance, inherited royalties from a book or patent, where the recipient has no active role in the intellectual property’s continued exploitation, are exempt.

Another common scenario involves mineral, oil, or gas royalties received by a landowner not actively involved in the extraction operations. These are considered passive income and reported on Schedule E, not subject to self-employment tax. Under Internal Revenue Code Section 1402, certain real estate and mineral royalties are excluded from net earnings from self-employment if the recipient is not actively involved in the property’s operation. Royalties from a one-time sale of intellectual property, without ongoing business activity, also fall under this exemption.

Reporting Royalty Income

The method for reporting royalty income on tax forms depends on whether the income is considered active (subject to self-employment tax) or passive (exempt from self-employment tax). For active royalties, the income and related expenses are reported on Schedule C, Profit or Loss from Business. The net earnings calculated on Schedule C then flow to Schedule SE, Self-Employment Tax, where the self-employment tax is computed. Taxpayers can deduct one-half of their self-employment tax from their gross income, which helps reduce their overall income tax liability.

Conversely, passive royalties are reported on Schedule E, Supplemental Income and Loss. This schedule is used for income from rental real estate, royalties, partnerships, and S corporations. Royalty income from copyrights, patents, and oil, gas, or mineral properties is reported in Part I of Schedule E. Many individuals receive Form 1099-MISC, Miscellaneous Information, reporting royalty payments in Box 2. This form assists in accurately reporting royalty income on either Schedule C or Schedule E.