Royalty income is one of the more complex areas of tax law. It’s reported on your tax return in different ways depending on a variety of factors, and it's subject to numerous rules. Exactly what are the payments for? Are you a business owner? If so, your earnings would be reported elsewhere. Many types of royalties are reported to the Internal Revenue Service on Schedule E, but not all of them.
The royalties you report on Schedule E are the ones you earn from passive income.
What Are Royalties?
Technically, royalties are income you receive because someone has paid you to use property that you own. You might be paid for the use of something you’ve copyrighted, such as a book or a song that you wrote. You might earn money from a patent for something you've invented. You’d receive a portion of the money from each unit sold in these cases. You might also receive royalties for selling natural resources from land that you own.
Schedule E royalties are taxable as ordinary income according to your tax bracket unless you totally surrender your right to the income-producing asset. It’s not royalty income if you sell the land that’s full of minerals or you sell your right to receive a percentage of the sales price for every copy of that book that’s sold. In this case, you’ve realized capital gains or losses and these are treated differently.
What Is Schedule E?
Royalties are reported to the IRS on Schedule E, along with a few other sources of similar income like rental payments you receive because you’re leasing out a home or commercial real estate you bought. Schedule E also reports income from participation in a partnership or S corporation.
The total income – or loss – that you arrive at after completing Schedule E is then transferred to your 1040 tax return. But determining deductible losses can be tricky. You can only deduct as much as you’re “at risk” for. In IRS parlance, this typically means that you made a monetary investment in the asset that’s producing royalties, and you lost some or all of it because your enterprise bombed.
Difference Between Schedule C and Schedule E
You would use Schedule C, not Schedule E, to report royalties if you’re a self-employed writer, songwriter or artist. The key phrase here is “self-employed.” You created something with the intention that it would earn you a livelihood. It's an ongoing endeavor, not a one-shot effort. Schedule E is appropriate for reporting passive income.
You must pay self-employment tax on the income reported on Schedule C. The self-employment tax is the equivalent of the Social Security and Medicare taxes you and your employer would have shared responsibility for, if you were employed by someone else. The self-employment tax encompasses both because you are your employer. On the bright side, you can deduct all your costs of doing business on Schedule C, unlike the limited losses you can claim on Schedule E.
What About Schedule D?
You actually have a third option for reporting royalty income – but in this case, the earnings wouldn’t technically be royalties any longer, because you no longer own the asset. It’s a capital gain or loss if you outright sell the right to collect royalties – maybe you sold your copyright to that book – so now you’d use Schedule D.
How to Complete and File Schedule E
You won’t have to fill out the complete tax form if your royalties aren't the result of something you actively worked at. Just address the part or parts that relate to your particular type of royalties. The form is broken up into sections, one for each type of royalty income. Then transfer the total from Schedule E to your 1040 tax return and file the schedule with your return. You can find an example of Schedule E on the IRS website, along with directions to follow.
Don’t get confused if you’re an artist or writer who receives a Form 1099-MISC with your royalty income appearing in the royalty box of that form. This doesn’t automatically mean that you qualify to file Schedule E rather than Schedule C so you can dodge the self-employment tax. Consult with a tax professional if you’re still not sure, but your best bet is to report the income on Schedule C and include a statement to the IRS explaining that the income appropriately appears there, not on Schedule E.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.