Are Royalties as a Retiree Subject to Self-Employment Tax?
What Is Royalty Income?
A royalty Income is a legally binding payment made to an individual or company for the ongoing use of their assets, including copyrighted works, franchises, and natural resources.
An example of royalties would be payments received by musicians when their original songs are played on the radio or television, used in movies, performed at concerts, bars, and restaurants, or consumed via streaming services. In most cases, royalties are revenue generators specifically designed to compensate the owners of properties when they license out their assets for another party's use.
How does the Royalty income is reported to the owners?
Royalties are reported to the owner of the property (either intellectual, artistic, or real) in Box 2 of Form 1099-Misc. The amount reported on the 1099-MISC represents the taxpayer's income associated with the underlying activity.
How is the Royalty income taxed?
The owners can negotiate their royalties in different ways. For example, you can sell your work (also called property) to an investor in return for a constant percentage of royalties on the revenue the investor makes. Or you can simply receive a royalty any time anyone uses your property to make money (called licensing.) No matter how or why you receive royalties, the federal government sees them as income and expects you to report that income on your taxes.
The taxability of the royalty income depends on many factors, including the following:
- Whether the creative work (property) is a trade or a business
- The timing and kind of income received
- Who owns the property (an individual or a corporation, for example)
Should Royalties be taxed as Self-employment income?
Generally, the royalties received from your work are reported as self-employment income and are taxed at a higher rate. You report these on Schedule C of IRS form 1040.
Royalties from one-time earnings or mineral interests are reported on Schedule E of IRS Form 1040. Let us look at a few examples for better understanding.
Example 1 - a performing artist or photographer may receive royalties as part of their regular business and such royalties would be part of their gross receipts on a Schedule C. Any resulting income would then be considered earned income, subject to self-employment tax and Qualified Business Income Deduction.
Yet similar taxpayers may have to report the royalty income on a Schedule E, if they are not actively engaged in the business that generated the royalty. In this situation, the royalty is an investment and not considered earned income.
Example 2 - A math teacher who once published a book of poetry will report royalties on Schedule E. If he had published a math tutorial then royalties would be self-employment income.
Retired Musician Royalties - IRS Treatment
How are musician royalties taxed? Let's assume a retiree earns $45,000 from music royalties - are these considered earned income? It depends.
Royalties proceeds from the sale of intellectual property are considered earned income. An author/creator of work may receive extended royalties from the result of their personal services.
There are exceptions where royalties from creative work are not subject to self-employment tax. This happens where creating the intellectual property is incidental and not typical for the taxpayer profession. Same as example 2 above, a math teacher who once published a book of poetry will report royalties on Schedule E. If he had published a math tutorial then royalties would be self-employment income.
This is why the taxpayer occupation field is so important.
In the case of a retiree, we must examine what their occupation was in their younger years to determine whether they constitute self-employment. In the case of the taxpayer, were he a journalist in the past, then the royalties would be self-employment.
Royalties and Expats
Why does this matter so much? Let’s examine two key factors. Imagine the retiree had moved from California. As readers may already know, California is famous for its ‘safe-harbor’ rule. This protection is only offered for earned income (self-employment counts, too) - retirees do not qualify.
If they recently moved abroad, and they do not have any earned/self-employment income, then they may be subject to CA tax on all worldwide income they receive, not just the passive income from royalties (i.e. dividends, capital gains).
Whereas If the retiree’s royalties were to qualify for self-employment income, then they would be able to claim Safe Harbor protection and be considered non-residents of CA. The net result from paying a self-employment tax: complete exemption from CA state tax on worldwide income including income from royalties.
Taxpayer may be subject to CA tax on passive income from royalties