Royalties are payments made to a party for the use of property. The property that one pays royalties for can be physical such as oil and gas royalties or intellectual such as franchise or music royalties. Royalties are always deductible as a business expense for franchisees but there are a variety of other tax laws governing royalties.
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Royalties as Income
One who receives royalties must report them as income. Royalties can either be reported as passive income to an individual on their form 1040 schedule E or they can be reported as business revenue to a corporation, partnership, or LLC. Royalties are taxed at ordinary income tax rates.
Exclusion From Other Taxes
When claiming royalties as income the royalties are considered passive income. No self employment, FICA, FUTA, Medicaid, or Medicare taxes are due on this income. These taxes typically amount to 15.3% of gross income.
Those who harvest oil or minerals from the ground are liable for state severance taxes. These taxes vary from state to state but are typically based upon the quantity or production or total dollar amount of production.
Ad Valorem Tax
Ad Valorem taxes are levied at the county level. These taxes are treated similarly to property taxes on land or a personal residence.
Owners of mineral or natural gas rights that pay royalty taxes do have a strategy to reduce their tax bills: the depletion allowance. Depletion allowances for natural resources are similar to depreciation deductions for physical business equipment. Just like equipment wears out--natural resources are eventually consumed.
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