Where to report royalty income on individual form 1040 tax returns for performers and writers of music is not always clear. Are the payments to artists for personal service of the artist, or payments for the rental, license, use, or sale of their work?
The choices are form 1040 schedule C, E, and D. Schedule C is the only one of the three that are subject not only to income tax, but also to the self-employment tax, and is where you report net profit or loss from business or profession.
Schedule E is where you report rent and royalty income. But just because the title of schedule E has the word “royalty” in it does not mean you can use that form to avoid the self-employment tax on your royalty income. Schedule D is for royalty or other income from the sale of intangible assets or copyrights – and is ordinary income unless you elect otherwise.
Royalties paid to most musical artists should be reported as business income on form 1040 schedule C, subject to self-employment tax. Artist royalties (including advance royalties) paid to a recording artist by a record label, performance royalties, and royalties paid to a song writer from a publishing company, both generally get reported on schedule C for most musical performers.
It is a rare case for even an occasional or part-time writer and/or performer to be able to exclude royalty income from self-employment tax. That person would have to prove to the IRS that they are not engaged in an occupation or profession for profit. If they are in the trade or business of being a performer or writer, then royalties, net of deductible business expenses, are subject to self-employment and income tax and are reported on form 1040 schedule C.
At the heart of the matter is what the IRS rules and court cases say about royalty income. Royalties earned by the creator of intellectual property are either classified as business or non-business income. Individuals engaged full or part-time in the trade or business of writing and/or performing music, report royalties as business income, which includes most musical performers.
Business income is included on form 1040 schedule C and subject to the self-employment tax, while non-business income is reported either on schedule E (the creator still owns the property) or on schedule D (the creator sells all rights to the property.) Even if you’re retired from the music business, you still report royalties as business income on schedule C, subject to self-employment tax, if you were engaged in a schedule C business at the time you created the property that is still currently generating royalties.
As mentioned above, income from the sale or exchange of intellectual property (i.e. , your song) can be reported on schedule D, but only if all rights to the property are relinquished. That means you retain no interest in the copyrights after the sale. However, that schedule D income does not normally get the reduced long-term capital gain tax rate regardless of when you created it – it is still subject to the same ordinary income tax table rates as your business and wage income. You can, however, elect under IRC sec. 1221(b)(3) to treat the sale or exchange of musical compositions or copyright in musical works created by the taxpayer’s personal efforts as long-term capital gains and get the lower rate.
The 1221 election is made each year, and on a property-by-property basis, and is due along with the tax return, including extensions, for the year of the sale or exchange. But remember, before the transaction can even make it to schedule D in the first place, you have to have owned the property before the transaction, and have relinquished all of your rights as a result of the sale or exchange transaction.
Also, to qualify as a schedule D sale or exchange, the payer/purchaser of your property must report the transaction on their tax return as a purchase, consistent with the treatment of it as a sale on your return. That is, the purchaser cannot count it as compensation to you. Otherwise, one of you might get a call from IRS. So, it is important that proper tax treatment be addressed in the buy-sell agreement.
Finally, that leaves schedule E. You would like to report it there, because it would save you the self-employment tax. But rarely can you report net royalty income from music on schedule E unless you can prove that you are more of a non-business, passive investor type, that doesn’t provide significant services.
A note of caution though about schedule E. If your royalty income is reported to you on a 1099 in the royalty box, the IRS computer will look for it on schedule E – the IRS computer and the IRS can’t tell that you reported it on schedule C or D – and will send you a letter from its matching program telling you that you left it off of your tax return. You can either wait for the letter and mail them back the reason, or attach a statement to your return explaining that it is properly counted on your schedule C and why.