Income and Assets · Income

Royalties and related expenses

Royalties are enumerated in the definition of gross income (IRC § 61(a)(6)) and are ordinary income. The questions that decide real returns are elsewhere: which schedule they belong on, which decides self-employment tax; what may be deducted against them, which for natural resources means depletion; and whether the payment is a royalty at all, because a transfer of an entire patent produces capital gain rather than royalty income.

The rule

Two reporting routes, and the difference is employment tax. Royalties from copyrights, patents and oil, gas and mineral properties are taxable as ordinary income and are in most cases reported on Schedule E — but a taxpayer who holds an operating oil, gas or mineral interest, or who is in business as a self-employed writer, inventor or artist, reports the income and expenses on Schedule C instead (Publication 525, Royalties). The consequence follows from § 1402: royalties earned in a trade or business are net earnings from self-employment, while a passive royalty interest is not.

Expenses follow the route. Where the royalty is a business, expenses are ordinary business deductions reaching adjusted gross income through IRC § 62(a)(1). Where it is not, IRC § 62(a)(4) puts deductions attributable to property held for the production of rents or royalties above the line — so the expenses are still deducted in arriving at adjusted gross income even though the activity is not a trade or business.

Depletion is the deduction peculiar to natural resources. A reasonable allowance for depletion is allowed for mines, oil and gas wells, other natural deposits and timber (IRC § 611(a)). Percentage depletion is a statutory percentage of gross income from the property, excluding rents or royalties the taxpayer paid on it, and cannot exceed a stated share of taxable income from the property — with a different ceiling for oil and gas (IRC § 613(a)).

Oil and gas percentage depletion is confined to small producers. Section 613A generally denies percentage depletion for oil and gas, but § 613A(c)(1) restores it for independent producers and royalty owners up to a depletable quantity, deeming a set percentage into § 613 for that purpose. The tentative quantity is expressed in barrels of average daily production (IRC § 613A(c)(3)(B)), and a second ceiling limits the resulting deduction by reference to taxable income computed without oil and gas depletion, without the § 199A deduction, and without net operating loss or capital loss carrybacks (IRC § 613A(d)(1)(A)–(D)).

Percentage depletion is not cost recovery. Because it is computed from gross income rather than from basis, it may be claimed after basis has been exhausted — which is why it exists as an incentive rather than as a timing rule.

A patent transfer is not a royalty. A transfer, other than by gift, inheritance or devise, of property consisting of all substantial rights to a patent, or an undivided interest in it that includes a part of all such rights, by a holder is treated as the sale or exchange of a capital asset held for more than one year — regardless of whether the payments are periodic over a period coterminous with the transferee’s use, or contingent on productivity, use or disposition (IRC § 1235(a)(1), (2)). Payments that look exactly like royalties are capital gain if the transfer qualifies.

Royalties can be portfolio income. In determining income or loss from an activity, royalties not derived in the ordinary course of a trade or business are not taken into account (IRC § 469(e)(1)(A)(i)(I)) — so a passive royalty stream cannot absorb a suspended passive loss.

Current figures

How it works in practice

Settle the schedule first, because everything else follows from it. The test is not the type of property but the taxpayer’s relationship to it: a novelist writing books is in business and reports on Schedule C with self-employment tax; a novelist’s heir receiving royalties on the same books is not, and reports on Schedule E with none. The same royalty stream changes character when it changes hands.

For oil and gas, get the operating-versus-royalty distinction from the instrument. An operating working interest is a business; a non-operating royalty interest usually is not. That single fact decides self-employment tax, and — through IRC § 469(c)(3)(A), which takes working interests out of the passive definition — it also decides whether losses are passive.

Depletion needs two computations, not one. Compute cost depletion from basis and percentage depletion under § 613, and take the greater, subject to the § 613(a) taxable income ceiling and, for oil and gas, the further § 613A(d)(1) limitation. Operators supply a depletion figure on their statements, but it is computed at the property level and does not know the taxpayer’s other income, so the taxable-income ceilings have to be applied on the return.

For intellectual property, read the transfer document before treating anything as a royalty. Section 1235 turns on whether all substantial rights passed, not on how the payments are described or calculated. A licence retaining geographic or field-of-use limits generally produces royalties; an outright assignment producing identical periodic payments produces long-term capital gain.

How this has changed

The depletion provisions are among the oldest in the Code still doing daily work, and they have not moved. Their internal cross-references have, and that is where care is needed: the § 613A(d)(1) ceiling is computed without regard to the § 199A deduction, and § 199A itself was rewritten for 2026 — so the figure excluded from the computation changes even though § 613A does not.

Royalty reporting is also where a genuinely new category has appeared without any new provision. Publication 525 now carries a discussion of name, image and likeness compensation for student-athletes — autograph signings, endorsements, licensing and merchandising, advertising, social media and camps. Nothing in the Code was enacted for it; the money is compensation or royalty income under existing rules, and the schedule question is the same one this page starts with. The interest of it is that a large new population of taxpayers is receiving royalty-like income for the first time, with no withholding and often no information return.

Section 1235 is unchanged and worth knowing precisely for that reason. Its treatment survives whatever happens to capital gain rates, and it is one of the few provisions that converts what looks like ordinary recurring income into long-term capital gain by operation of law rather than by election.

Exam focus

Know the two reporting routes and what turns on them. Expect a question giving two taxpayers with the same royalty stream — one in business, one not — and asking about self-employment tax.

Know that percentage depletion is computed from gross income from the property and can exceed basis, that cost and percentage depletion are compared and the greater taken, and that oil and gas carries a second ceiling under § 613A(d)(1).

Know IRC § 1235 exactly: all substantial rights, by a holder, other than by gift, inheritance or devise — and that periodic or contingent payments do not defeat it.

Know that royalties outside a trade or business are portfolio income under § 469(e)(1)(A)(i)(I), while a working interest is outside the passive definition altogether under § 469(c)(3)(A).

Check yourself

1. A retired musician receives royalties on recordings made decades ago and does no current work. Are the royalties subject to self-employment tax?

Answer: no. They are reported on Schedule E rather than Schedule C, because he is not currently in business as a self-employed artist — Publication 525 directs Schedule C only where the taxpayer holds an operating interest or is in business. Without a trade or business there are no net earnings from self-employment under IRC § 1402, though the royalties remain ordinary income under IRC § 61(a)(6).

2. A royalty owner’s basis in a gas property is zero. May percentage depletion still be claimed?

Answer: yes. IRC § 613(a) computes percentage depletion as a percentage of gross income from the property, not as a recovery of basis, so it continues after basis is exhausted. IRC § 613A(c)(1) preserves percentage depletion for independent producers and royalty owners despite the general denial for oil and gas. The § 613(a) and § 613A(d)(1) ceilings still apply.

3. An inventor assigns all substantial rights in a patent in exchange for payments of two percent of sales for fifteen years. What is the character of the payments?

Answer: long-term capital gain. IRC § 1235(a) treats a transfer of all substantial rights to a patent by a holder — other than by gift, inheritance or devise — as the sale or exchange of a capital asset held for more than one year, and paragraphs (1) and (2) provide that this holds whether the payments are periodic over a period coterminous with the transferee’s use or contingent on productivity, use or disposition.

4. A taxpayer has $30,000 of suspended passive losses and receives $12,000 of royalties from a mineral interest in which they do nothing. Can the royalties absorb the losses?

Answer: no. IRC § 469(e)(1)(A)(i)(I) excludes from the computation gross income from royalties not derived in the ordinary course of a trade or business, so the royalties are portfolio income rather than passive income. They are taxable, but they cannot free the suspended losses, which continue to wait for passive income or a qualifying disposition.