What are Royalties and How Do They Work

Royalties and Your Business

What is a Royalty - How a Royalty Works in Business
••• Kevin Hauff/Getty Images

What Are Royalties? 

Royalties are payments of various types to owners of property for use of that property over a specific period of time. 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) 

In copyrighted works, for example, the author and publisher of a work make a payment arrangement with the user of the author's work. 

How Are Royalties Paid? 

If you have intellectual property (copyright, trademark, or patent) that you want to receive royalties from, you can get paid in several ways.

  • Royalties on specific products (like a book, piece of music, a patented product, or the number of tickets to a concert) are generally based on the number of units sold. 
  • Royalties for oil, gas, and mineral properties are based on units, such as barrels, tons, etc.
  • u 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 upfront and receive a continuing stream of revenue based on the sales of the book. 
  • You may keep the ownership of the property and get royalties from someone for use of the property. This is called licensing. 
  • Royalties on the use of extracted natural resources are determined by a percentage of the resources' production value (see question mark)

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.

Some royalties are paid for public licenses. The Licensing Board of the U.S. Copyright Office collects royalty fees from:

  • Cable operators for retransmitting TV and radio broadcasts
  • From satellite carriers for retransmitting network and nonnetwork signals, and
  • From importers or manufacturers for distributing digital audio recording products. 

Each type of royalty payment has benefits and drawbacks for each party. The discussion is part of the negotiation process.

An Example: Music Royalties

Registering a trademark or copyright and also registering with a private performing rights organization (PRO) like ASCAP or BMI can help make sure that a musician or songwriter receives payment. The PRO collects and distributes royalties to the owner. 

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.

Licensing is the process of giving and getting permission to have, produce, or use something that someone else has created or owns. 

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 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. 

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

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. 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.

I most cases, you report income from royalties on Schedule E - Supplemental Income, on your personal tax return. 

Royalty Payments as Expenses

If you are paying royalties or licensing fees 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. 

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

if you make royalty payments over $10 in a year, you must give the payee a 1099-MISC form to show the total of your payments for the year. 

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

Article Sources

  1. IRS. Publication 525 Taxable and Nontaxable Income. "Royalties." Page 16. Accessed Oct. 5, 2019.

  2. U.S. Department of the Interior. Natural Resources Revenue Data. "Revenues." Accessed Oct. 5, 2019.

  3. U.S. Copyright Office. Services of the Copyright Office. "How do I collect royalties?" Accessed Oct. 5, 2019.

  4. U.S. Copyright Office. "Circular 75 The Licensing Division of the Copyright Office." Page 1.Accessed Oct. 5, 2019.

  5. U.S. Patent and Trademark Office. Musicians and Artists Profile. "Music: Royalties." Accessed Oct. 5, 2019.

  6. Cambridge Dictionary. "Licensing." Accessed Oct. 4, 2019.

  7. Robinson Knife Manufacturing Company, Inc. v. Commissioner of Internal Revenue. T.C. Memo 2009-9. "Opinion." Accessed Oct. 5, 2019.

  8. IRS. Instructions for Form 1099-MiSC. "Box 2. Royalties," Page 5. Accessed Oct. 4, 2019.