Key Takeaways:

  • Royalty payments are compensation made to the owner of intellectual property or natural resources, in exchange for the right to use the asset.
  • They apply to a range of industries, including music, publishing, technology, oil and gas, and franchising.
  • Royalties can be based on revenue, unit sales, or a flat fee and are often subject to negotiation.
  • Copyright royalties are managed by agencies like ASCAP, BMI, and the U.S. Copyright Office.
  • Patent royalties ensure inventors receive compensation when others manufacture or use their innovations.
  • Tax treatment of royalty payments can be complex, often categorized as ordinary income and requiring 1099-MISC reporting.
  • International royalty payments may involve tax treaties and withholding requirements.
  • Advances against royalties are common in book publishing and music, serving as upfront payments deducted from future earnings.
  • Monitoring and auditing are crucial to ensure accurate royalty calculations and compliance.
  • Consulting a legal professional can help ensure proper royalty agreements and compliance with tax regulations—UpCounsel connects clients with experienced attorneys for such needs.

Royalty law refers to a type of law that governs royalty payments in a licensing agreement. In such an agreement, the licensee is usually required to pay the licensor a certain amount of money as a royalty for the right to manufacture, use, or sell the licensed product.

Royalties can be applicable to:

  • Copyrighted works
  • Patented items
  • Other types of intellectual property

The payment of royalty is common in the music, television, movie, publishing, and software industries.

What Is a Royalty?

A royalty refers to a fixed amount per sale or a percentage of profit that a creator is entitled to receive from the distributor, manufacturer, publisher, or agent that he or she has entered into a licensing agreement with. Inventors, moviemakers, authors, scriptwriters, musicians, music composers, and other creators contract with distributors, manufacturers, producers, publishers, and movie production companies to receive royalty fees in exchange for licenses to manufacture or to sell their products.

Royalties are payments the licensee makes to the licensor in exchange for the legal right to use his or her intellectual property or assets. For instance, Microsoft created the Windows operating system to facilitate operations and file management in personal computers. IBM, Compaq, and other computer manufacturers pay royalty fees to Microsoft to obtain permission to use Windows in their computers. Some other industries where royalties are common include:

  • Fashion industry
  • Book publishing industry
  • Music industry
  • Television industry
  • Oil and gas industry

Types of Royalty Payments 

Royalty payments can take various forms depending on the industry and agreement. Common types include:

  • Revenue-Based Royalties: A percentage of gross or net revenue generated from the use of the intellectual property.
  • Unit-Based Royalties: A fixed amount per unit sold, often used in manufacturing and product licensing.
  • Usage-Based Royalties: Payments tied to the volume of usage, such as radio airplay for music.
  • Minimum Guarantee Royalties: A minimum amount paid regardless of actual sales or usage, providing security to the rights holder.
  • Advances Against Royalties: Upfront payments made to the rights holder and recouped from future royalties.

Each structure impacts the profitability and risk for both the licensor and licensee.

Royalties for the Use of Copyrighted Items

Perhaps the most common application of royalties people can relate to is the payment of royalties for the use of copyrighted materials. For example, a radio station is required to pay a royalty fee every time it plays a song. Also, a cable television provider has to pay a television station a royalty each time it transmits the station's signal. Every newspaper, magazine, and book published in the U.S. has a copyright protection. A royalty fee must be paid every time someone other than the publisher reproduces a part of a print product.

In the U.S., a number of organizations are responsible for overseeing and managing royalty agreements that involve copyrighted materials. They include government agencies and nonprofit organizations that monitor intellectual property rights and sometimes collect royalties on behalf of member companies. The U.S. Patent and Trademark Office and the U.S. Copyright Office are the two main government agencies that deal with situations involving royalties. While they are not directly involved in the payment of royalties, they both play a vital role in the process.

The U.S. Copyright Office ensures that all original authored works have full protection under the law. Only the person or the business organization that owns the copyright for a work is allowed to license it and receive royalties for it. In addition, the Copyright Office is the agency that decides when royalties are required.

Royalty Payments in the Music and Entertainment Industry 

Royalty payments are especially critical in music, television, and film, with distinct categories such as:

  • Mechanical Royalties: Paid to songwriters and publishers when music is reproduced or distributed (e.g., CDs, streaming platforms).
  • Performance Royalties: Generated when music is publicly performed on radio, television, or live venues. Organizations like ASCAP, BMI, and SESAC collect and distribute these payments.
  • Synchronization (Sync) Royalties: Fees for using music in visual media like commercials, movies, and video games.
  • Master Recording Royalties: Paid to recording artists and labels when recordings are sold, streamed, or licensed.
  • Residuals: Payments made to actors, writers, and directors when content is re-aired or sold internationally.

Complex agreements often involve multiple stakeholders, requiring careful monitoring to ensure accurate payment distribution.

Royalties for the Use of Patented Items

The U.S. Patent and Trademark Office provides protection for inventors and their inventions. When someone invents a new product, service, or process, he or she may apply for a patent to establish that he or she is indeed the inventor. This entitles him or her to full protection under the law. In the event the product or process is too similar to an existing patent or exists, the inventor will not be granted a patent. Similar to a copyright, a patent gives its holder the right to license the patented item and receive royalties for it.

Royalty Payments in the Technology and Software Sector

Patent royalties play a significant role in technology and software licensing. Common practices include:

  • Software Licensing: Developers often license software products to businesses, receiving recurring royalty payments based on subscriptions, installations, or users.
  • Technology Transfer Agreements: Universities and research institutions frequently license patented technologies to private companies in exchange for royalties.
  • Standards-Essential Patents (SEP): Patents necessary to comply with industry standards (e.g., 5G technology) often involve licensing under fair, reasonable, and non-discriminatory (FRAND) terms.
  • Cross-Licensing: Companies with complementary patents sometimes exchange licenses and royalties, facilitating innovation while avoiding litigation.
  • Royalty Audits: Ensuring accurate tracking and reporting of technology usage is vital, as underreporting can lead to legal disputes.

Negotiating precise licensing terms helps safeguard both parties' interests.

How Royalties Work

If you decide to license an invention, you will continue to be the owner of the work. This means you will own the copyright or patent while the licensee produces and sells the item. After granting the license, you are entitled to royalty payments, which are continuous payments typically based on a percentage of the income generated from the licensed item. For instance, you may keep 20 percent of the gross revenue, while the licensee receives 80 percent.

You also have the option of assigning the copyright or patent for your creation. It may give you a big lump-sum payment, but you will have to forego royalties from future sales.

Tax Considerations for Royalty Payments 

Royalty payments are generally considered ordinary income for tax purposes and must be reported to the IRS. Key tax aspects include:

  • 1099-MISC Reporting: U.S. businesses must issue a 1099-MISC form to rights holders if royalty payments exceed $10 in a year.
  • Deductibility: Licensees can typically deduct royalty expenses as business costs, reducing taxable income.
  • Withholding Tax: Payments to non-resident individuals or foreign entities may require withholding taxes, often reduced by tax treaties.
  • Capital Gains Treatment: In some cases, transferring all rights to intellectual property may qualify for capital gains tax rates instead of ordinary income.
  • International Tax Compliance: Multinational licensing agreements may involve Value Added Tax (VAT) and compliance with local tax laws.

Consulting a tax professional ensures compliance with federal and international tax regulations.

Royalty Payment Disputes and Enforcement 

Royalty agreements can lead to disputes if either party perceives underpayment, miscalculation, or breach of contract. Common issues include:

  • Underreported Sales: Licensees may inaccurately report sales figures, intentionally or inadvertently reducing royalties.
  • Ambiguous Contract Terms: Vague definitions of sales, revenue, or territory can cause disagreements.
  • Audit Rights: Many contracts grant licensors the right to audit licensee records to verify royalty payments.
  • Breach of Agreement: Failure to pay royalties or unauthorized use of intellectual property may result in legal action.
  • Alternative Dispute Resolution (ADR): Arbitration or mediation often resolves royalty disputes more efficiently than litigation.

Clear contract terms and regular audits help prevent disputes, while legal counsel can assist in resolving conflicts.

Frequently Asked Questions

  1. What are royalty payments? 
    Royalty payments are compensation paid to a rights holder for using intellectual property, such as patents, copyrights, trademarks, or natural resources.
  2. How are royalty rates determined? 
    Rates depend on factors like industry standards, revenue projections, product lifecycle, and negotiation between the licensor and licensee.
  3. Are royalty payments taxable? 
    Yes, they are typically considered ordinary income and must be reported to tax authorities. Certain transfers may qualify for capital gains treatment.
  4. What happens if royalty payments are not made? 
    Failure to pay royalties may result in breach of contract, leading to lawsuits, termination of licensing rights, or financial penalties.
  5. How can I ensure accurate royalty payments? 
    Regular audits, clear contractual definitions, and legal counsel help ensure proper royalty reporting and compliance.

If you need help understanding royalty law, 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.