Royalty payments help to encourage and protect creativity around the globe. The image on your wall, your radio song, or even the fuel that powers your car are all royalties. The creators and owners are paid royalties to ensure they get the right compensation.

Many royalties deal with payments for the right to use intellectual property (IP), such as copyright, patents and trademarks.

Table of Content

What are Royalties?

How royalties work

Royalty Contracts

Types of royalties

How do royalty payments work?

How are Royalties Calculated?

How are royalties taxed?

What are Royalties?

Royalties are a mode of payment that allows you to use another person’s property. Royalties are earned through licensing. It is the act of granting or getting permission for someone else’s creations or property.

Licensing is when you retain the ownership of the property and receive royalties from another for the use of that property. Licensing your company’s intellectual property and receiving royalties is a common way for you to increase your business’s income.

Although royalties can be found in many industries, they all serve the same purpose. These royalties can be granted through an agreement. They allow others to use the property and give the owner an income. Royalties also protect the buyer from claims of the owner for improper use.

How royalties work

There are many ways to set royalty fees or payment amounts. In a franchise, fees could be fixed or a variable percentage of gross sales. The following are some common forms of royalty payments:

  • Royalties for oil, natural gas, and mineral properties can be based either on revenue or units such as barrels or tons of oil.

For newly-created IP, a variable percentage is used. This is because sales are very low at the beginning, so the royalty percentage may be lower. As sales rise, the royalty percentage may increase to a maximum.

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

  • Retransmitting radio and TV broadcasts  by cable operators
  • Satellite carriers transmit network and non-network signals to satellites
  • Distributors or importers of digital audio recording products

Royalty Contracts

Each royalty payment has its benefits and drawbacks. As you make a contract, as the owner of the property, you will discuss the details of royalty payments with potential buyers.

Although royalty contracts can be different depending on the type, there are certain common elements to all royalty contracts.

A contract will contain a description of the subject matter (the properties) and its owner. If you sell the right to use a set of images to Getty Images, for example, you will describe the images in detail.

The contract will outline the limits and scope of the property’s use. You might permit someone to use your images for a single time or allow them to use them forever.

The contract will also include the payments (the royalties). This section should cover payments, including when they are due, how they are calculated, and how records will be kept. Sometimes, advance payment is made.

A “earn-out arrangement” could be included in the contract that bases royalties on the performance of the property being licensed. An advance is often included in an author’s contract. The author will receive additional royalties payments if the author’s share of royalties from book sales exceeds the advance.

Types of royalties

Music owners who own copyrighted music are entitled to royalties. These are known as performance royalty. This royalty can be paid if you wish to use a song in your movie or on your radio station.

Images may attract royalties if they are used on a website. A book royalty is another type of royalty that publishers pay authors for each book they sell.

A royalty will be paid to the owner of the patent if someone wishes to use or make a patented product.

Franchise royalties are paid to the main company by franchise holders for the use and promotion of the name and other assets.

In the case of rights to extract minerals from another person’s property, royalties are also be paid. They are sometimes called mineral rights and not royalties. However, they function in the same way. 

How do royalty payments work?

The royalty payments are made through a legal agreement. They are paid on a regular basis by licensees to the owners of intellectual property and assets that have been granted a license to use them for the duration of the license period. Many times, royalty payments are calculated as a percentage of a net or gross revenues.

What’s a Royalty Deal?

A royalty deal is where an investor provides funds to a company, not the individual, in exchange for a percentage of total sales. Let’s take, for example, a beer company where an investor invests and gets 5% of the gross sales. The investor will earn $2.50 for every $50 beer that is sold.

How are Royalties Calculated?

Royalties for established brands are usually higher than those for new independent brands. A new product or service that has a high engagement rate might command a higher overall price. When calculating royalty payments, it is helpful to know how the market views your assets and property.

Because royalties are calculated on a percentage basis, it is relatively simple to calculate them.

  • Step 1. Find your annual sales and share them with the party who pays you royalties
  • Step 2. Multiply this amount by your contractual royalty rate
  • Step 3. The final output shows how much royalties you are owed.

Royalty payments can be calculated manually according to each product. You can also automate your tracking by sending data to a system that will validate your calculations against the contract terms.

How are royalties taxed?

All royalties are taxable as ordinary income. The Internal Revenue Service (IRS), therefore, requires that you report them in Part 1 of Schedule E on Forms 1040-SR or 1040-SR. They tax royalty income differently from other forms of income sources and depend on a variety of factors.

Some of these varying factors that play a role in royalty payment taxation include:

  • Profitability at work
  • Reported revenues
  • Ownership of assets

There is no universal formula for taxing royalty income. However, royalties from your work are usually reported as self-employment income. These are reported on Schedule C of the IRS form 1040.

You must declare any self-employment income exceeding $400, including royalties. Schedule E on the IRS Form 1040 can be used to report royalty income from one-time earnings or mineral interests.