Tax planning is a critical part of any investment strategy. And while most investors are familiar with the tax implications of traditional assets and securities, few understand the unique tax treatment of Intellectual Property derived royalties.
A useful analog to understanding royalty assets might be Real Estate. The tax benefits of owning real estate can have a material impact on taxable income. In a nutshell, the tax code allows investors to depreciate property over a number of years.
This depreciation offsets income, which reduces the income the IRS considers taxable. Often this can have a dramatic effect on an individual’s total tax burden.
It turns out that music royalty investors could benefit from some of the same favorable tax treatment enjoyed by real estate investors. Music royalties are a depreciable asset, much like real estate. This means the cost of acquisition can be amortized, offsetting the income produced and reducing overall tax liability.
IMPORTANT: Every individual situation and every royalty stream is a bit different. Royalty Exchange is not authorized or qualified to offer tax advice. So it is critical that you discuss these issues with your tax advisor to accurately apply them to your unique situation.
How to Amortize Royalties
Investors acquiring royalties on the Royalty Exchange marketplace will receive a 1099 for any year the royalties paid exceeds $10. From the 1099, you’ll have to report the royalty income on your 1040. If you hold the royalties in a business, all income and amortization are reported on your Schedule C. Amortization is calculated and reported on Form 4562.
Unlike real estate, music royalty investments are considered “intangible” assets. Amortization of intangibles is governed primarily by sections 197 or 167 of the Internal Revenue Code. However, section 197 does not apply to the direct purchase of copyrights or any interest in them. Section 197 only applies to copyrights (or interests of) acquired in connection with the purchase of a trade or business.
So for our purposes, we’ll stick with section 167. There are two amortization methods available under section 167.
- Straight-line method: Under this method, simply divide the cost of the royalty by the number of years of its useful life. With royalties, we typically use 10 years.
- Income forecast method: Under this method, each year's depreciation deduction is equal to the cost of the asset, multiplied by a fraction. The numerator of the fraction is the current year's net income, with the denominator the total income anticipated from the royalty through the end of the 10th taxable year after it was acquired. Since the anticipated income may change based on actual results over the time you own the asset, you’ll need to update your income forecast every three years.
Let's examine both more closely
To calculate amortization on a straight-line basis, divide the cost by 10 years, and apply the result to each year’s amortization. In other words, 1/10th of the cost of the royalty is amortized each year for 10 years.
Here’s an example of how a straight-line amortization method might look like. For this example, the purchase price is $1,000, the expected royalties over 10 years is $1,200, and the variable earnings per year are listed each year in the “Cash Flow” row:
Income Forecast Method
The Straight-Line method is a bit simpler, but another approach available to royalty asset investors is the Income Forecast Method.
To calculate amortization under the Income Forecast method, you would multiply the price you paid for the royalty stream by a custom fraction. The numerator of this fraction is the amount of anticipated income the royalty stream would earn in a given year. The denominator is the total anticipated income you expect the royalty will receive over 10 years.
For example, let’s say you acquired a royalty stream for $1000, and it earned you $100 in 2018, and you expect it to generate $1,200 over 10 years. The formula for 2018 depreciation would then be:
Here’s an example of how this might look using the same royalty income schedule used in the Straight-Line method example above.
Note: Under a “look-back” rule, you would still have to pay (or be entitled to receive) interest if the actual royalty earnings differ substantially from the estimates used in applying the income forecast method (more than 10%). This interest is computed at the end of the third and tenth years. A hypothetical underpayment or overpayment of tax is computed for each prior year, based on a substitution of the recomputed depreciation for the depreciation actually taken. Interest on the hypothetical underpayment or overpayment, computed at the rates for overpayments of tax (compounded daily), must be paid by the taxpayer to the IRS or vice versa.
What This Means For You
As you can see, the amount of taxable income is far less than the cash flow generated by the royalty stream.
For instance, for every $100 of regular income you receive, you’re taxed at a rate of about 40%, which means $60 of that ends up in your pocket. With royalty assets that benefit from the amortization offset, only a small portion of that $100 in income is considered taxable. As illustrated in the Income Forecast table above, in the first year only $17 of $100 is taxable. At a 40% tax rate, that’d reduce your tax due from $40 to about $7.
Combined with the opportunity for high yields at relatively lower risks, the tax treatment described here illustrates why music royalty assets are one of the most attractive investment opportunities available to investors today.
Again, please review this information with a tax advisor or attorney to ensure these details are appropriate to your individual situation.