Do Royalties Qualify for QBI Deduction?

The Qualified Business Income (QBI) deduction, introduced by the Tax Cuts and Jobs Act of 2017, offers eligible taxpayers a significant tax break. It allows for a deduction of up to 20% on qualified business income from certain pass-through entities, aiming to reduce the tax burden on small businesses and self-employed individuals.

Determining whether royalties qualify for this deduction is important for those earning such income. With various types of royalties, each carrying distinct characteristics, assessing eligibility can be complex.

QBI Criteria

The QBI deduction applies to income from a qualified trade or business, as defined under Section 199A of the Internal Revenue Code. This income must come from a domestic business operating as a sole proprietorship, partnership, S corporation, or certain trusts and estates. The deduction is not available for income earned through C corporations.

To qualify, the income must be connected to a trade or business actively conducted within the United States. The business activities generating the income should be substantial and regular, as opposed to sporadic or passive. The IRS requires active engagement in producing income, which can complicate the inclusion of royalty income depending on its source.

Certain types of income—such as capital gains, dividends, and interest—are excluded from QBI. For royalty income, the distinction between active and passive income is critical. Only royalties derived from active business operations may qualify for the deduction.

Royalty Income Classification

The classification of royalty income determines its eligibility for the QBI deduction. Royalties can originate from diverse sources, which influence their tax treatment. For instance, royalties from intellectual property, such as patents or copyrights, may qualify if the owner is directly involved in activities like development, management, or promotion of the property.

Conversely, royalties from passive investments, such as mineral rights or non-participatory license agreements, generally do not qualify, as they lack the active engagement required under QBI rules. For example, licensing software that the taxpayer actively updates or supports could meet the active participation requirement, potentially qualifying the income.

Comprehensive documentation is critical to support the classification of royalty income. Taxpayers should retain records detailing their involvement in generating royalties, along with relevant agreements or contracts, to demonstrate active participation if questioned by the IRS.

Types of Royalties

Royalties come from various sources, each with unique tax implications and eligibility considerations for the QBI deduction. Understanding these distinctions is crucial for proper classification.

Mineral Royalties

Mineral royalties are payments for the extraction of natural resources like oil, gas, or minerals from land owned by the taxpayer. These royalties are typically classified as passive income, as landowners often do not actively participate in extraction activities. Under Section 469 of the Internal Revenue Code, passive income is excluded from the QBI deduction. However, if the landowner is actively involved in managing extraction operations—such as overseeing drilling or negotiating contracts—the income may be reclassified as active. Proper documentation of such involvement is essential to determine eligibility.

Intellectual Property Royalties

Intellectual property royalties stem from licensing patents, trademarks, copyrights, or other proprietary rights. These royalties may qualify for the QBI deduction if the taxpayer actively engages in related business activities, such as developing or marketing the intellectual property. Passive income from intellectual property, such as long-term licensing agreements with no ongoing involvement, does not qualify. Taxpayers should maintain detailed records of their activities to support claims for the deduction.

License Agreement Royalties

License agreement royalties result from granting permission to use a product, service, or brand. Their classification depends on the taxpayer’s level of involvement. Actively managing the licensing process—such as negotiating terms, monitoring compliance, or providing support—may qualify the income as active business income. Passive arrangements, where the taxpayer has no active role, are excluded from the deduction. Evaluating the nature of the licensing agreement and documenting involvement is critical for proper classification.

Income Thresholds

Income thresholds play a significant role in determining eligibility for the QBI deduction. In 2023, the taxable income thresholds are $182,100 for single filers and $364,200 for married couples filing jointly. Beyond these thresholds, the deduction may be limited or phased out, especially for Specified Service Trades or Businesses (SSTBs), such as law, healthcare, and consulting.

For non-SSTB activities, the deduction remains available above the thresholds but is subject to limitations. The calculation shifts to the lesser of 20% of QBI or the greater of 50% of W-2 wages paid by the business or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property. This formula highlights the importance of precise tax planning to maximize the deduction.

Key Exclusions

Certain types of income are explicitly excluded from QBI eligibility under Section 199A of the Internal Revenue Code. Investment income—including capital gains, dividends, and interest—is excluded, as it is not tied to active business operations. For instance, dividend payments from owning corporate shares do not qualify, even if the corporation itself operates a qualified trade or business. Similarly, interest earned on savings accounts or bonds is excluded.

Reasonable compensation and guaranteed payments are also excluded. For S corporation shareholders, wages paid to themselves are not considered QBI. Similarly, guaranteed payments to partners in a partnership are excluded, as they are treated separately from the net business income of the entity. For example, an S corporation owner paying themselves a salary cannot include that amount in the QBI calculation, ensuring the deduction applies solely to residual business income, not fixed payments.