When an artist, writer or musician receives royalty payments in exchange for the use of intellectual property, there are specific tax implications that should be considered. What are some of the implications and potential impacts for royalty recipients? Topics such as self-employment income, net investment income tax and advance royalties need to be considered.
Self-Employment Income
An individual’s net earnings derived from his or her trade or business are subject to self-employment tax, in addition to regular income tax. There is an exception for services performed as an employee, but this usually does not apply for artists, writers or musicians. The rate of this additional tax is currently up to 16.2 percent. If it can be shown that the royalty income is not related to the individual’s trade or business (for example, in the case of an individual writing only one book as a side activity and never revising it), they may not be considered to be “regularly engaged” in an occupation or profession and the royalties therefor would not be subject to self-employment tax. For a successful artist with $100,000 of royalty income, this could mean a tax difference of $16,200 just for one year.
It’s important to note that the determination of whether the royalties are subject to self-employment tax is made at the time the material generating the revenue was created. So if a musician has long-since retired but continues to receive royalty payments, they could still be considered self-employment income even though the musician is no longer working.
Net Investment Income Tax
Beginning in 2013, there is an additional federal tax – beyond the regular income tax – assessed on certain forms of income. One of the income forms subject to this tax – known as the Net Investment Income Tax (NIIT) – is royalty income. The tax is a flat rate of 3.8 percent, and applies to royalties other than those received in the course of your trade or business.
Going back to the $100,000 of royalties mentioned above, this creates an additional tax of $3,800 per year. There is an exception for royalties received in a taxpayer’s trade or business, which are not subject to the NIIT.
However, as noted in the section above, if royalties are received in a trade or business, then they are probably subject to self-employment tax. So either way the artist is hit with one tax or the other.
Advance Royalties
Most individual taxpayers use the cash method to determine their income, which means amounts are taxable in the year the cash is received and not necessarily when the income is earned. This distinction is relevant in the case of advance royalty payments. Frequently, in order to acquire the rights to intellectual property, a publisher may advance book or music royalties to the author or musician before the property is created. These advances are then recouped by the publisher when the property is sold and begins to generate income – with future royalties due only after the initial advance is recouped.
For a cash method taxpayer, the advance royalties are taxable in the year they are received, even though the intellectual property may not be completed or exploited until the following year. If the artist ends up having to repay the publisher in a subsequent year due to lack of sales, that repayment may be deductible for the artist in the year it is repaid. This could create an unfavorable timing difference for an artist that receives advance payments near the end of the year and then repays a portion at the beginning of the following year.
Although these advance payments are commonly referred to as “advance royalties,” they are more appropriately classified as compensation for services, rather than royalties. As such, they would be reported as trade or business income by the taxpayer and most likely subject to self-employment tax.
These are some of the tax concepts to be aware of when receiving royalty payments as an artist or entertainer. It is always wise to consult a tax adviser to determine the specific tax consequences in each individual situation.
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About Daniel Rowe (principal at GHJ)
Daniel specializes in partnership and S corporation taxation and real estate development and investment. Prior to joining GHJ, Daniel served as tax partner at a local firm in Georgia and as tax manager at JH Cohn, LLP in New York, where he provided year-round tax planning and guidance for high-net-worth individuals, advised on trust and estate matters, and represented clients in federal, state and local audits. He began his career with Deloitte & Touche, LLP as an assurance and advisory services senior in Baltimore.
