What Are Royalties?

Definition and Examples of Royalties

What is a royalty?
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Royalties are payments to owners of property for use of that property. Royalties often deal with payments for the right to use intellectual property (IP), such as copyrights, patents, and trademarks.

Keep reading to learn more about why royalties exist, how they affect your taxes, and examples of them in the real world.

What Are Royalties? 

Royalties are payments that buy the right to use someone else's property. Royalties stem from licensing, which is the process of giving or getting permission to have, produce, or use something that someone else has created or owns.

In other words, when you keep the ownership of the property and get royalties from someone for use of that property, that is licensing. Licensing your business's intellectual property and getting royalties from these licenses is a common way to increase your business income.

Royalties appear in many different industries, but they serve a similar purpose in all uses. 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.

How Royalties Work

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. Some common forms of royalty payments include:

  • Royalties for specific products (like a book, a piece of music, a patented product, or a concert) are generally based on the number of units sold.
  • Royalties for oil, gas, and mineral properties may be based on either revenue or on units, such as barrels of oil or tons of coal.

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.

Some royalties are paid for public licenses. The Copyright Office collects royalty fees from:

  • Cable operators retransmitting TV and radio broadcasts
  • Satellite carriers retransmitting network and nonnetwork signals
  • Importers or manufacturers distributing digital audio recording products

Royalty Contracts

Each type of royalty payment has benefits and drawbacks for each party. The owner of the property will negotiate the specifics of royalty payments with potential buyers as they create a contract.

While royalty contracts differ depending on the type of royalty, there are some common features in royalty contracts.

The contract will include a detailed description of the subject matter (the property) and who owns it. 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 then the following references to the photos could simply call them "the Images." 

The contract will detail the scope and limits of the use of the property. For example, you might allow someone just one-time use, or you might allow perpetual use of your images.

The payments (the royalties themselves) will also be included in the contract. The section covering payments should include 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.

The contract could also establish an "earn-out" arrangement that bases royalty payments on the performance of the property being licensed. In an author contract, for example, there is commonly an advance. When the author's portion of royalties from book sales exceeds the amount of the advance, the author will begin receiving additional royalty payments.

Like other legal business contracts, licensing and royalty contracts may vary based on state laws. Check with an attorney who practices in your state to get more details.

Taxes

Like other forms of payment in a business, royalties are taxable income and also a business expense.

If you receive royalties from someone for use of your property, you must claim these payments as business income, usually on Schedule E (Form 1040 or Form 1040-SR). Royalties from copyrights, patents, and oil, gas, and mineral properties are taxable as ordinary income. In general, any royalties you receive are considered as income in the year when you receive them.

If you are paying royalties or licensing fees, 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 the payments might need to be amortized. If you pay more than $10 in royalties in a year, you must give the payee a 1099-MISC form to show the total of your payments for the year.

The question of how this expense is entered on your business tax return depends on the specifics of your situation. Before you attempt to include any of these royalties or licensing fees as expenses, check with your tax professional.

Types of Royalties

In music, royalties are paid to owners of copyrighted music. These are called performance royalties. You may pay this royalty if you want to play a song on your radio station or use the song in your movie.

A musician may register a trademark or copyright with a private performing rights organization (PRO) like ASCAP or BMI. The PRO assumes responsibility for collecting royalties, and then it distributes the royalties to the owner.

Royalties may be paid for the use of images, such as when you want to add stock photography to your website. Another type of royalty is a book royalty, which publishers pay to authors for every book they sell.

If someone wants to make or use a patented product, like a new invention, they will have to pay a royalty to the person who owns the patent

In franchised businesses, such as 7-Eleven convenience stores, 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. For example, oil and gas producers in the U.S. pay a royalty of 12.5% of production value for onshore operations.

Key Takeaways

  • Royalties are payments that buy the right to use someone else's property.
  • Licensing agreements outline the details of royalty payments.
  • Royalty payments may cover many different types of property, including patented inventions, the use of artwork, or the mining of resources.
  • Royalties may be reported as business income or expenses.

Article Sources

  1. Internal Revenue Service. "Publication 525: Taxable and Nontaxable Income," Page 17. Accessed June 29, 2020.

  2. Copyright Office. "Circular 75: The Licensing Division of the Copyright Office," Page 1. Accessed June 29, 2020.

  3. Internal Revenue Service. "2020 Instructions for Form 1099-MISC and 1099-NEC," Page 5. Accessed June 29, 2020.

  4. Department of the Interior. "Revenues." Accessed June 29, 2020.