The Bureau of Internal Revenue taxes income received from royalties a bit differently than other types of income. Because of that, if your business collects royalties, you need to know how they’re taxed, but you also need to ensure that you don’t accidentally confuse royalties with service fees. Here’s an overview of the essentials.
What Are Royalties?
Basically, a royalty is a payment for the use of proprietary information. For instance, when a theater group pays a playwright to use their script, that is a royalty payment. Similarly, when a TV station pays a production company to air their films, that’s also a royalty payment. However, royalties aren’t just related to the entertainment industry. They are also widely used in science, technology, industry, and commercial fields.
Businesses that use patented products often pay royalties to the whoever owns the patent. Even the fees that a franchisee pays to their franchisor are considered to be royalty fees.Â Other examples of items that may involve royalties include software, models, secret formulas, and plans.
Royalties vs. Fees for Service
Some services seem similar to royalties, but the payments for those services don’t fall under the royalties category. In particular, that includes the following:
- Service after a sale
- Services provided under a guarantee
- Technical assistance
- Opinions provided by a professional such as an accountant or engineer
How do you tell the difference? Royalties only apply when the payee has proprietary (ownership) interest in the intellectual property. This includes processes or information unique to that person and not available to the general public. As a general rule of thumb, services related to skills that many people know or can learn falls under personal services rather than royalties.
To explain, imagine that you pay someone to take photographs for your business brochures. Although that requires special skills, it’s a task many people can do, and you are paying that individual for their services. In contrast, imagine that a photographer has taken a beautiful photograph that you want to turn into greeting cards to sell in your business. The photographer wants to continue owning the rights to the photograph so you don’t buy the rights, but you pay the photographer some royalties so that you can use the image. Again, in the first situation, you are paying the photographer for their services, and in the second situation, you are paying for the right to use the photographer’s images.
Taxation on Royalty Payments
The top tax rate for corporations that collect royalties is 30% plus a 12% value-added tax. That typically applies to active royalties, which the business actively pursues. In contrast, if your business collects royalties as passive income, the tax rate is usually only 20%. Books, literary works, and musical compositions are the exception. Those items are taxed at a rate of just 10%.
To ensure you pay the right tax rate, you first need to determine if you’re collecting a royalty or a service fee. Then, you need to figure out if the income is passive or active. To keep track of it all, consider using a product like QuickBooks to help with the numbers.