What Is Royalty Income and How Is It Taxed?
Learn how royalty income is taxed. The key is determining if your activity is a business, which dictates how you report income and claim deductions.
Royalty income consists of payments you receive for allowing someone to use your property, which the Internal Revenue Service (IRS) defines as being tied to the income generated from the use of that asset. This is different from rent, which is a payment for simply using a property. Royalty payments can be structured as a percentage of the revenue earned or on a per-unit basis, such as for each book sold.
Sources of Royalty Income
Intellectual Property
A source of royalty income comes from intellectual property, which are creations of the mind. Copyrights protect literary, musical, or artistic works, and when you allow a publisher to print your book or a company to use your song, the payments you receive are royalties. These payments compensate you for the right to use your creative work over a specific period.
Similarly, patents protect inventions and generate royalties when you license another party to manufacture and sell your patented product. Trademarks also generate this type of income when you permit a business to use your established brand name, logo, or trade name.
Natural Resources
Another category of royalty income is derived from natural resources. If you own land with valuable resources, you can lease the rights to an energy company, and the payments you receive for the extraction of oil, gas, or minerals are royalties. These royalties are based on the amount of production or the revenue generated from the sale of the extracted resources.
When you own an economic interest in mineral deposits or oil and gas wells and retain an interest for the property’s entire life, any cash you receive for assigning these interests is treated as royalty income. This structure allows landowners to benefit from the resources beneath their property without undertaking the process of extraction themselves.
Determining Your Tax Treatment
The way your royalty income is taxed depends on whether the activity generating it is considered a trade or business. The IRS determines this based on the regularity and continuity of your activity. If you are an author who writes and publishes books as your main profession, your royalty income is considered business income.
Business income is subject to self-employment tax, which covers Social Security and Medicare taxes, in addition to regular income tax. Conversely, if your involvement is passive, the income is not from a trade or business and is not subject to self-employment tax. For instance, if you inherit the rights to a book’s royalties and have no active role in its promotion, the income is not business-related.
The consequences of this determination extend beyond self-employment tax. Losses associated with non-business royalty income reported on Schedule E can only offset other supplemental income sources. Business losses, on the other hand, can be used to offset other types of income.
Information Needed for Tax Reporting
To file your taxes, you need to gather specific documents and calculate figures related to your royalty income. You will likely receive Form 1099-MISC, where royalty payments are reported in Box 2. You may also receive a Form 1099-NEC if the payer considers the payments compensation for services.
You must also identify all deductible expenses. For natural resource royalties, a deduction is depletion, an allowance that lets you recover your investment in mineral deposits or wells as the resources are used up. Calculating your depletion allowance is a necessary step.
Other deductible expenses can include fees paid to agents, legal costs for contract negotiation, or copyright and patent registration fees. If you are in a trade or business, you can also deduct ordinary business expenses, such as home office expenses, supplies, and professional development costs.
How to Report Royalty Income on Your Tax Return
The tax form you use depends on whether the income is from a trade or business. For royalty income that is not from a trade or business, you will use Schedule E (Form 1040), Supplemental Income and Loss. On this form, you report your gross royalty income and enter your deductible expenses to arrive at your net income or loss.
If your royalty income is from a trade or business, you must report it on Schedule C (Form 1040), Profit or Loss from Business. Here, you will list your gross royalty receipts and all related business expenses to calculate your net profit or loss. This amount is then subject to both income tax and self-employment tax.