Royalties are how people make money from their assets, creations, inventions, and intellectual property. They are licenses or agreements signed by landowners, creators, intellectual property owners, and innovators when a third party wants to use something that belongs to them.
Generally, you can earn royalties on assets such as music, books, and franchises in the form of franchises, patents, or copyrights. Do you want to know more? Read on to learn about royalties, how they are calculated, and how they affect your taxes, among other things.
What Are Royalties?
Royalties are payments made by a third party for permission to use another person’s property. They are derived from licensing, which refers to the process of acquiring or giving consent to use, produce, or have property owned or created by someone else. Simply put, licensing allows you to maintain possession of your property and receive payments (royalties) every time someone uses it.
Royalties can be granted to the asking party through agreements that give them user permission while assuring the owner of income. They apply in many industries, including music, science, and arts. Generally, royalties also protect the user from improper use claims.
Understanding Royalties (How They Work)
Royalty payments can be a fixed amount or a percentage of the income earned through the use of someone else’s property. When franchising, for example, the person using the franchise might be required to pay the franchise owner a fixed amount every period (usually above the royalty minimum) or a percentage of their gross earnings.
Another common way to price royalties is through a variable percentage, which is typical for relatively new assets. The user is charged a lower percentage in the beginning when sales are still low, and the rate is increased as sales rise until it reaches the maximum amount.
Royalties come in all shapes and colors as they apply to a wide range of industries. However, the most common forms of royalty payments are:
- Specific product royalties: Paid depending on the number of units sold on items like books, music, or patented inventions.
- Mineral property royalties: Paid depending on units sold or revenue earned from the sale of mineral products like oil, coal, and gas.
- Public license royalties: Collected by the Copyright Office from audio product manufacturers and importers, satellite carriers, and cable operators for retransmission.
Examples of Royalty
- Franchises: If you open a franchise store such as a McDonald’s restaurant, you will be required to pay a $45,000 initial franchise fee and a 1 to 2-million-dollar initial investment to the corporation.
- Books: If you write a book, you can sign an agreement that allows you to get a share of your books’ gross sales. Hardbacks typically come with higher royalty rates than paperbacks.
- Broadcasting: When a satellite or cable TV service wishes to broadcast superstation or network channels, they will have to pay these networks.
- Music: This is the most common and popular example of royalties. An artist may receive payments every time their song is played, downloaded, or featured in a movie.
Types of Royalties
As already mentioned, royalties apply in a wide variety of industries. However, the most common types of royalties include:
- Performance royalties – These are payments made to the owner of copyrighted music every time it is played, streamed, downloaded, or used in a movie.
- Book royalties – Publishers pay these royalties to book authors at a rate on every book the publisher sells. It could also be a fixed amount.
- Franchise royalties – When a business owner opens a branch under another company’s name (franchising), they must pay the franchisor royalties.
- Patent royalties – When someone creates or invents something and patents it, any third-party user who wishes to use it must pay the patent owner royalties.
- Mineral royalties – The government or other extractors looking to exploit minerals on personal property must pay the property owner royalties as a fixed fee or rate per unit.
Royalty Contracts and Taxes
The third party is looking to use another person’s property, and the property owner usually enters into a contract defining the relationship. These contracts will vary from case to case but typically include the following information:
- A detailed property description
- The property owner’s details
- The scope of use, e.g., one-time or continuous
- The payment method and how they will be calculated
- A preferred recordkeeping system
Royalty contracts will be created under and governed by state laws, so it is crucial to consult an attorney before signing one.
Because they are business payments, royalties are considered taxable income and business expenses and must be reported when filing taxes. If you pay royalties, you can claim the payments as business expenses. The payments can be claimed as business income if you receive them for the use of your property. Other royalties (minerals, patents, etc.) can be claimed as ordinary income.
When filing royalties in your taxes, it is important to consult a tax attorney to ensure you are in compliance with all state and federal laws.
Frequently Asked Questions
How are royalties calculated and paid?
Royalty calculation and payment rules are usually set in the license agreement signed by the property owner. Typically, the method described can be a fixed amount or a royalty percentage, which is a share of the gross revenue earned from the use of the property.
Do you have to report royalties on taxes?
Yes. The federal government considers royalties as income regardless of how or why you receive them, meaning you have to report them on your taxes. If your royalties are one-time or related to mineral assets, you should report them on Schedule E. Work-related royalties, on the other hand, must be reported as self-employment income.
What are the two types of royalties?
There are many forms of royalties, all relating to different industries. Generally, royalties can be paid for specific products such as books, music, or inventions or assets such as minerals.
How much tax do you pay on royalties?
The amount of tax you pay on your royalties will depend on how they are reported to the federal government. Royalties earned from your work are reported as self-employment income and tend to be taxed at higher rates.
Royalties are payments made to property owners for the right to use their book, music, art, or invention, among other things. The terms of payment are usually laid out in a licensing agreement signed by the property owner. If you receive royalty payments – either as a fixed value or percentage of revenue – you must report them on your taxes as they are considered income.