Dear Tax Talk:
I receive royalties from an invention (software) and want to know if I am required to pay Social Security taxes on the royalties from the software sales. I am not self-employed but unemployed at this time. Do the royalties I receive qualify as a capital gain at a 15 percent tax rate or at the regular tax rate?
Royalties from copyrights on literary, musical or artistic works, and similar property, or from patents on inventions, are amounts paid to you for the right to use your work over a specified period of time.
Royalties generally are based on the number of units sold, such as the number of books, tickets to a performance or machines sold. You generally report royalties in Part I of Schedule E (Form 1040), Supplemental Income and Loss. However, if you are in business as a self-employed writer, inventor, artist, etc., report your income and expenses on Schedule C. The significant difference between reporting royalty income on Schedule C and Schedule E is that Schedule C income is subject to the dreaded 15.3 percent self-employment tax.
In order for royalties to be considered self-employment income, the recipient has to be considered regularly engaged in that business or profession. Revenue Ruling 68-498 provides the following example, which should help you contrast your situation:
"If an individual writes only one book as a sideline and never revises it, he would not be considered to be 'regularly engaged' in an occupation or profession and his royalties therefrom would not be considered net earnings from self-employment. However, where an individual prepares new editions of the book from time to time, and writes other books and materials, such activities reflect the conduct of a trade or business, the earnings of which would be subject to self-employment tax."
Royalty income is considered ordinary income and not capital gains, except for musical works.