Careful Use of Royalty Income Can Save You in Taxes

One of the perks of living in San Miguel de Allende, Mexico, is that I am surrounded by creative people. It makes for interesting conversations at parties, where I’ve rubbed elbows with actors, artists, and authors. As a former attorney for the Internal Revenue Service (IRS), I always remind these innovators that they should not get creative with their taxes. Even though they live overseas, they are still required, as U.S. citizens, to report and pay U.S. tax on their worldwide income.

For some, this income includes money they are paid for the sale or use of intellectual property they have created in the past, such as a book, a song, or a painting. A royalty is a periodic payment made to an owner of property for the right to use or sell the property. To give you an example, Spotify pays Lady Gaga about a half a penny each time one of her songs is streamed on the platform. Another example, a landowner receives a percentage of the overall sales of a natural resource extracted from her property by a third party.

Although these payments are both properly termed royalties, and reported as such on IRS Form 1099-MISC, Miscellaneous Income, they arise from different circumstances. The landowner exerted little effort to realize her income, while the songwriter probably spent long hours actively crafting her song. Should the amounts be taxed similarly given the different level of engagement by each person in the activity that led to the royalty? Does it matter? These questions were highlighted for me recently when I was preparing a tax return for one of my artist clients.

Daniel has been a self-employed children’s book illustrator for many years. He earns income each year for the art he creates for books on which he is actively working. He properly reports this money as business income on Schedule C, Profit or Loss from Business. He also receives royalties from the sales of books which he illustrated in previous years. I knew Daniel would pay less taxes if his royalties were treated as part of his business income rather than as a passive royalty. But would the IRS agree this was the proper treatment for that income?

Fortunately for Daniel, the IRS looks to the facts and circumstances of the activity resulting in the royalty to determine whether the royalty is active or passive income. Since Daniel has been in the business of illustrating books for years, including the years he made the art that generated the royalty, any payment he receives related to that work, now or in the future, is considered by the IRS as income from that business.

Treating the royalty as business income allows Daniel to deduct ordinary and necessary expenses incurred during the year related to that business, such as the costs of advertising, materials and supplies, and expenses related to a home office. Thus, the $1,000 Daniel earned in royalties is offset by the $250 of related business expenses, and so he reports only $750 of net income.

Additionally, business income is considered earned income for the purposes of the Foreign Earned Income Exclusion (FEIE). Under the FEIE, Daniel, who lives in Mexico, is able to exclude his $750 net royalty income ($1,000 royalty less $250 of business expenses) from U.S. income tax. (See the sidebar below for the requirements to qualify for the Foreign Earned Income Exclusion.)

Earned income is also counted for purposes of calculating the amount Daniel can contribute annually to his retirement accounts, including traditional or Roth IRAs, and increases his Social Security earnings for the year, which will increase the Social Security benefit he is entitled to upon retirement.

What if Daniel was not actively engaged in the business of illustrations? For example, what if he was otherwise employed and had illustrated only one book as a favor for a friend? In that case, the IRS considers the royalties he received from that book to be passive income, similar to what the landowner received in the above example. The royalty in that case is reportable on Schedule E, Supplemental Income or Loss. As passive income, Daniel wouldn’t be entitled to any of the deductions for expenses and earned income benefits that I described above.

Fortunately, the facts in Daniel’s case were clearly drawn and this tax attorney didn’t have to get creative.