1. Types of Royalties
2. Terms of Royalty Agreements
3. Tax Implications of Royalty Payments
4. Royalty Income Trusts

Updated November 5, 2020:

Royalty income is a type of payment for an intangible work or other intellectual property that is patented, trademarked, or copyrighted. These payments occur when another person is profiting from something you've created with your permission. You'll also receive royalty income if you invest in a mineral operation such as gas or oil. Simply put, you can profit from other person using your property by charging royalties. In most cases, royalty agreements are legally binding. 

Types of Royalties

Common types of royalties include:

  • Performance royalties for the use of copyrighted music
  • Royalties for the use of online images and artworks, such as stock photography
  • Book royalties that publishers pay to a book's author
  • Patent royalties paid to the owner of a patented invention by a third party who makes and sells the invention
  • Franchise royalties paid to the owner of a business' name and assets
  • Mineral rights paid when natural resources are extracted from a person's land by a utility company
  • Royalties paid to celebrities who use their name to promote a fashion line

Terms of Royalty Agreements

While royalty contracts can vary in terms, most require payment of a percentage of the revenue earned while using the property in question. The license agreement must specify the length of the agreement, the product that is given in exchange for the royalty payment, the amount of the royalty payment, and any geographic limitations for use of the product. Note whether the property is being licensed for one-time or perpetual use. 

This agreement should also indicate when payments will be made, how records should be kept, and whether an advance payment (sometimes called an earn-out) is required. A common example is with an author contract; he or she receives an advance from the publisher and after royalty amounts exceed that advance, the author will begin receiving royalty payments.

The description of the property in question must be given in detail, and the name of the existing owner provided. For example, if you are licensing a group of stock images, the contract would describe each of them in detail and note that they would heretofore be referred to as "the Images."

Royalty rates vary depending on a number of factors including exclusivity, market demand, and the existence of available alternatives to the product in question. The rate is often a fixed or variable percentage of gross sales and may be subject to a minimum royalty amount. With a royalty agreement, you are selling the property itself and receiving payments depending on the revenue it generates. You can also make an arrangement, called licensing, in which you retain ownership of the property but charge another entity money to use it. 

Tax Implications of Royalty Payments

Royalties are both taxable as income and deductible as a business expense. These payments must be reported to the IRS and are usually recorded on Schedule E: Supplemental Income and Loss. However, this depends on whether you own a business, the type of property in question, and who retains ownership of the property.

If you own a business as a sole proprietor or single-member LLC, the income must be reported on Schedule C. Corporations must show royalty income on their balance sheets. An advance on future royalty income is also taxable in the year it is received.

Royalties you pay another entity for the use of intellectual property can be deducted as a business expense. If you are purchasing the property itself and not just the license, it is considered an asset and must be amortized over time. 

If you sell your royalty interest, it will likely be considered a capital gain and thus subject to capital gains tax. 

Royalty Income Trusts

Royalty income trusts are a type of legal entity known as an investment trust. This financial vehicle is used to hold investments and/or associated cash flows in an operating company. These trusts purchase royalty rights from a natural resource company and pass the profits on to owners of units in the trust. This investment provides a higher yield than bonds and stocks do and are thus attractive to companies that want to sell assets that produce cash flow.

If you need help with royalty income, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.