What are Royalties and How Do They Work
Royalties and Your Business
What Are Royalties?
Royalties are payments of various types to owners of property for use of that property. Royalties usually deal with payments for the right to use intellectual property, like copyrights, patents, and trademarks.
- In music, royalties are paid to owners of copyrighted music, for its use. These are called performance royalties.
- In art and online, royalties may be paid for the use of images (sometimes called "stock photography").
- Another type of royalty is a book royalty, paid to authors by publishers.
- Patented products are commonly licensed and royalties are paid to the patent holders.
- In franchised businesses, the franchise holder pays franchise royalties to the main company for the use of the name and other assets.
- Royalties may also be paid in the context of rights to take minerals from the property of someone else. These are often called mineral rights, rather than royalties, but they work the same way.
Why Do We Have Royalties?
Royalties protect the owner of intellectual property (like copyrights, patents, and trademarks) and other types of property. These royalties are granted by agreement, and they allow others to use the property, giving the owner the benefit of an income from this use. Royalties also protect the buyer from claims by the owner for improper use.
The word "royalty" comes from the Middle Ages, when kings (royals) had rights because they owned land on which there were minerals. The person who wanted the minerals would pay for the right to take these minerals out of the land.
Today royalties might be paid for the right to use various types of intellectual property, as noted above. In each case there are two parties:
- The person or business that owns the intellectual property (the owner)
- The person or business that wants to use this property (the licensee)
How Are Royalties Paid?
If you have intellectual property (copyright, trademark, or patent) that you want to receive royalties from, there are two ways to do this:
- You may sell the property and receive payments from the buyer based on a percentage of the revenue generated from that property. For example, you can sell the copyright to a book outright and receive royalties up front and receive a continuing stream of revenue based on the sales of the book.
- You may keep the ownership to the property and get royalties from someone for use of the property. This is called licensing.
Royalty fees and payment amounts can be set in a variety of ways. For example, in a franchise situation, fees can be set as a fixed or variable percentage of gross sales. In many cases, there is a minimum royalty.
A variable percentage is often used for newly created IP. In this case, the royalty percentage might be small in the beginning as sales are low. Then, as the sales increase the royalty percentage might increase to a maximum amount.
Each type of royalty payment has benefits and drawbacks for each party. The discussion is part of the negotiation process.
How Do Royalties Differ From Licenses?
A license is right to use something that is owned by someone else, while royalties are the payments for that use. At its simplest, you have a license to drive a car or a license to own a business. The payments you make to the state agency are in effect like royalties.
If your business owns a patent on a new product, you can grant a license to someone to produce that product and sell it. Your business is paid in one of several ways by the licensee; these are royalties.
Licensing your business's intellectual property and getting royalties from these licenses is a common way to increase your business income.
What Is Included in a Royalty Contract?
While royalty contracts differ depending on the type of royalty, there are some common features in royalty contracts:
- A detailed description of the subject matter (the property) and who owns it, in detail, with a term that describes the property in the contract. For example, if you are selling the right to use a group of your images to an online image company like Getty Images, you would describe your images in detail (maybe with a listing) and say, "the Images" throughout.
- The scope and limits of the use of the property. For example, you might allow someone just a one-time use, or a perpetual use (license) of your images.
- The payments (the royalties themselves), including when the payments are to be made, how the amount of payments is determined, and how records are to be kept. Sometimes there is an advance payment made, which the owner works off (called an "earn out").
- In an author contract, for example, there is commonly an advance. Then, when the author's portion of royalties from book sales exceeds the amount of the advance, additional royalties are paid on sales.
TheBalance has more details on what an author contract might contain and how book royalties are determined.
How Do Taxes Work on Royalty Payments and Income?
Like other forms of payment in a business, royalties are taxable income and also a business expense.
Royalty Receipts as Income
If you receive royalties from someone for use of your property, you must claim these payments as business income. In general, any royalties you receive are considered as income in the year when you receive them. If you receive royalty payments as income, where that income is recorded depends on whether or not you are in a business and the type of business.
- If you own a business and you are self-employed, you must record the income from royalties on your business tax form, depending on your business type. For example, if you are a sole proprietor or single-member LLC, you would record the income on Schedule C, as part of your personal tax return.
- If your business is a corporation, the corporation must show the income on its balance sheet and on tax documents.
- If you don't own a business, your income from royalties is recorded on Schedule E - Supplemental Income, on your personal tax return. In this example, maybe you have written a book and you have a publisher, but you haven't set up a business structure.
If you sell the right to the intellectual property, the sales price is considered business income in the year it is received. If you receive an advance on future income from royalties, this is also business income.
Royalty Payments as Expenses
If you are paying royalties to someone for purchase or use of intellectual property, these payments are legitimate business expenses. If the payments are for the purchase of property, the property becomes an asset on your business balance sheet, and they might need to be amortized (spread out over time) over time. The royalty payments are an expense on the profit and loss statement.
If you are paying royalties as part of a license agreement, the royalty payments are an expense on your business tax return.
Do I Need an Attorney for a Royalty Contract?
Royalties are, like other types of business contracts, more complicated than they might seem. If you are considering a licensing agreement or royalties agreement, use a service like Avvo to find an attorney who specializes in intellectual property law to help you through the process.
For More Information on Royalties
The IRS has some court cases relating to royalties that you might want to review.
The Balance has a listing of terms used in music royalties.