Federal Tax Rules for Royalty and License Fee Income
Most people who create a work of art or an invention hope to reap financial rewards from their creation. U.S. copyright and patent laws give these creators certain exclusive rights to commercial development and profit from their creations. However, as a practical matter, most artists and inventors do not have the resources to develop and market their creations. Frequently they may sell, assign or license their rights to another for marketing and development.
Tax Treatment of License Fees or Royalties
One option is a license or similar agreement. This is typically a written agreement between, for example, an author and a publisher, where the publisher produces and markets the book. The owner of the rights to the work is commonly paid a periodic license fee or “royalty,” usually on a per unit basis, based on the contract’s terms. Writers are frequently given an “advance” against their royalties.
The treatment of this income for tax purposes may depend in part on options selected by the author. If the author remains just an individual, the royalties usually are treated as ordinary income; even the advance will be treated as ordinary income. The position of the Internal Revenue Service (IRS) is that the advance must be treated as current income, even if a portion of it may have to be paid back later because of disappointing sales of the work; in that event, the money repaid to the publisher may be deductible.
Tax Treatment Depending on Who Owns the Copyright or Patent
A person who is self-employed has certain responsibilities regarding prepayment of federal taxes on income, and this can apply to recipients of royalties and license fees as well. Generally, payments of estimated income taxes must be made quarterly in the year the income is received. If the pre-payments are much lower than the actual taxes, penalties may be assessed by the IRS. In addition, “self-employment taxes,” must be paid for Medicare, Social Security, etc. Employers of ordinary workers usually pay a portion of these taxes, but the self-employed may have to pay the full amount of these taxes on their own.
A copyright or patent holder may also choose to create an entity, such as a corporation or partnership, to hold the patent or copyright. In that case, the income from royalties or license fees is still taxable for the entity, but the copyright or patent can be treated as an asset of the entity and eligible to be “depreciated” over a period of time, i.e., a percentage of the value of the asset may be deducted for tax purposes each year. In addition, an entity may have more options for deducting expenses and the costs of developing the copyright or patent from income. An individual may also be able to deduct expenses, but this can depend on whether the IRS considers the individual to be running a business or merely engaged in a “hobby;” i.e., whether there is a profit motive for the activity.
Tax Treatment of Proceeds of Sale
The holder of a patent or trademark also has the option of selling all or a portion of their rights. For example, the right to distribute a book or other product or use a patent may be granted only for North America, with marketing rights in Europe being sold to another buyer. When a patent or copyright is sold, the proceeds of the sale may be eligible to be taxed as “capital gains,” instead of ordinary income, depending on the circumstances (for transfers of less than “all substantial rights” in a patent, the payments received may be taxed as ordinary income). Capital gain tax rates for an individual are currently very low; significantly lower than for ordinary income. However, capital gains for corporations are taxed at the same rate as ordinary income.
Tax Treatment of Copyrights and Patents Donated to Charity
Another option for patent and copyright holders is to donate the rights to a qualified charitable organization. The person or entity donating may then be able to deduct the fair market value of the donated rights from income for tax purposes, subject to limitations and depending on the status of the taxpayer, the asset given, and the type of charitable organization receiving the contribution. In general, no deduction is allowed for contributions of only a partial interest in the patent or copyright. The amount of the deduction may also be subject to reduction under certain circumstances.
The Federal American Jobs Creation Act of 2004 made some changes in the law relating to charitable donations, which are applicable to donations of patents and copyrights:
- Stricter donor reporting is required for contributions of property other than cash, inventory, or publicly traded securities. Corporations and individuals giving property valued at more than $5,000 must obtain a qualified appraisal, and for donations over $500,000 in value, the appraisal must be attached to the tax form.
- If the taxpayer contributes a patent or other intellectual property (other than certain copyrights or inventory) the initial deduction is limited to the lesser of the taxpayer’s “basis,” usually what was paid for it or the costs of developing it, or its fair market value. The donor may, however, also be able to deduct additional amounts later based on specific percentages (which decline for years after the donation) of income received by the charity from the donated property, subject to restrictions.
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