What Are Royalties?

How Royalties Work

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 also protect the buyer from claims by the owner for improper use.

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); these are generally based on the number of units sold.
• Royalties for oil, gas, and mineral properties; these 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 because sales are low. As sales increase, the royalty percentage might increase to a maximum amount.

Some royalties are paid for public licenses. The Copyright Office collects royalty fees in several scenarios, including:

• Cable operators retransmitting TV and radio broadcasts
• Satellite carriers retransmitting network and non-network signals
• Distribution of digital audio recording devices and media

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 such as Getty Images, you would describe your images in detail (maybe with a listing), 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 contract will also include the payments (the royalties themselves). The section covering payments should include:

• When the payments are to be made
• How the amount of payments is determined
• How records are to be kept
• Any advance payments

The contract could also establish an "earnout" arrangement that bases royalty payments on the performance of the property being licensed. In an author contract, for example, there may be 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.

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). 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 you receive them.

If you are paying royalties or licensing fees, these payments might fall under 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.

Examples and 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.

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.

Frequently Asked Questions (FAQs)