What are royalties and how do they work in small businesses?

Published Friday 5 December 2025

Table of contents

• What is a royalty?
• Business royalties: a definition
• Types of royalty payments
• How royalties work in practice
• Factors affecting royalty rates
• Tax implications of royalties for business
• Understanding royalty agreements
• Simplify royalty payments and business finances with Xero
• FAQs on royalties for business

Key takeaways

• Negotiate comprehensive royalty agreements that include performance-based termination clauses, clear geographic and usage scope, and specific payment terms to protect both parties and prevent future disputes.

• Calculate royalty payments using one of three main structures: percentage of revenue (typically 2-15%), fixed fee per unit sold, or usage-based payments, with rates varying significantly by industry and asset value.

• Maintain detailed records of all royalty transactions and usage data for tax compliance, as royalty income is taxable for recipients while royalty payments are generally tax-deductible business expenses for payers.

• Understand international tax implications when licensing across borders, including withholding tax requirements (up to 30% for foreign licensors) and potential treaty benefits that can reduce or eliminate these taxes.

What is a royalty?

A royalty is a payment made to the owner of an asset for the right to use that asset. Think of it like paying rent, but for things like a song, a brand name, or a patented invention.

These payments are usually calculated as a percentage of the revenue generated from using the asset, or as a fixed amount per item sold.

Business royalties: a definition

Royalties are payments made to asset owners for the right to use their property, typically intellectual property or business assets. These payments compensate the owner for allowing others to profit from their creation or brand.

Royalty payments work in two main ways:

• Percentage-based: A portion of revenue generated from using the asset
• Fixed fee: A set amount per unit sold or time period used

The asset owner (licensor) receives royalty payments. The business using the asset (licensee) pays these fees for permission to use the property.

Royalty agreements are most common in industries with intangible assets:

• Music and entertainment: Song licensing, film distribution rights, streaming royalties
• Publishing: Book licensing, article syndication, digital content rights
• Technology: Patent licensing, software usage rights, trademark licensing
• Franchising: Brand usage, operational systems, business model licensing

Types of royalty payments

Royalties come in different forms, depending on the nature of the asset and the business model. Here are three common types.

Franchise royalties

Franchisees pay royalties to the franchisor for the right to use their business model and its elements, like branding, intellectual property (IP), and operational systems

The franchise business model is popular in fast food – 93% of McDonald's restaurants are franchised, for example.

Franchisees usually pay royalties as a percentage of their gross or net revenue, although some agreements use flat fees.

Learn more about franchises

Intellectual property royalties

Licensees pay intellectual property royalties for the right to use or sell protected assets like patents, trademarks, and copyrighted works. They're commonly seen in tech and manufacturing, while copyright royalties are particularly common in the publishing, music, and film industries.

Examples include a tech company licensing patented software or an author licensing their work to a publisher and earning royalties in return.

Licensing royalties for creative works

These royalties apply to music, films, artwork, writing, and other creative media. Instead of selling the work directly, businesses pay licensing fees to use it in a different context, often in advertising, entertainment, or product design. For example, a brand might license a song for a TV ad, or a publisher might license illustrations for a children's book

How royalties work in practice

The royalty process turns intellectual property into recurring revenue streams through six structured steps:

Establish a royalty agreement

Negotiating your royalty agreement requires strategic planning and clear terms:

Essential negotiation strategies:

• Include performance-based termination clauses: Protect against underperforming arrangements with specific revenue thresholds
• Define geographic and usage scope: Specify countries, regions, and platforms where rights apply
• Negotiate exclusivity terms: Exclusive rights command 25-50% higher rates but limit licensor flexibility
• Set agreement duration: Longer terms provide stability, shorter terms allow rate renegotiation

Learn more about business negotiation strategies.

Define the payment terms

Royalty payment structures determine how much and when you'll receive compensation:

Three main payment methods:

• Percentage of revenue: Fast-food franchisee pays 5% of monthly sales ($10,000 sales = $500 royalty)
• Fixed fee per unit: Author earns $2 per book sold (1,000 books = $2,000 royalty)
• Usage-based payments: Musician earns $0.004 per stream (100,000 streams = $400 royalty)

Payment timing considerations:

• Monthly payments improve cash flow but increase administrative costs
• Quarterly payments balance cash flow with administrative efficiency
• Annual payments work for stable, high-value agreements

Track your usage or sales

Royalty reporting requirements ensure accurate payments and maintain trust:

Licensee reporting responsibilities:

• Track revenue generated: Record all sales, usage, or income from the licensed asset
• Provide detailed statements: Include sales figures, deductions, and royalty calculations
• Meet reporting deadlines: Submit reports monthly, quarterly, or as specified in contract
• Maintain supporting records: Keep receipts, sales data, and transaction records for audits

Reporting benefits:

• Builds trust between licensor and licensee through transparency
• Provides data for future rate negotiations and contract renewals
• Creates clear audit trail for tax compliance and dispute resolution

Calculate your payments

Next, the licensee calculates what royalty revenues are owed. According to US accounting standards, you only recognize revenue from a usage-based royalty when the related sale or usage actually occurs. This helps make sure your calculations are based on real performance

Several factors can affect the final amount:

• Minimum guarantees: a set amount the licensor is paid regardless of performance
• Advances: payments made upfront and recouped on future royalties
• Deductions: adjustments for returns and refunds
• Escalators: higher royalty rates that apply after reaching certain sales or revenue thresholds

Make payments

Finally, the licensee makes the payment according to the agreed schedule.

The licensee may issue a royalty statement or request that the licensor raises an invoice for the payment amount to document the transaction.

Use one of Xero's free invoice templates

Auditing and compliance

Most royalty agreements give the licensor the right to audit the licensee's records (on request, or every so often) to make sure payments are correct.

This is an extra layer of protection that gives the licensor comfort they're receiving the payments they agreed.

Factors affecting royalty rates

Royalty rates typically range from 2-15% of revenue, but vary significantly based on several key factors:

• Industry standards: Music royalties often fall between 8-15%, while franchise royalties typically range 4-8%
• Asset value: High-value patents or popular brands command premium rates
• Negotiating power: Established brands and proven licensees secure better terms
• Exclusivity: Exclusive licensing rights cost 25-50% more than non-exclusive deals
• Market demand: In-demand assets can charge higher rates

Learn more about real-world royalty rates

Tax implications of royalties for business

Royalty tax treatment affects both parties differently:

For licensors (receiving royalties):

• Royalty income is typically taxable as ordinary income, according to the IRS
• Report royalties on your business tax return, which the IRS specifies is generally done on Part I of Schedule E.
• May qualify for certain deductions related to asset maintenance

For licensees (paying royalties):

• Royalty payments are generally tax-deductible business expenses
• Deduct payments in the year they're made
• Keep detailed records of all royalty agreements and payments

International tax considerations

International royalty payments involve two key tax considerations:

Withholding tax requirements:

• US businesses must withhold 30% tax on payments to foreign licensors by default
• Example: $1,000 royalty payment requires $300 sent to IRS, $700 to licensor
• Withholding rates vary by country and tax treaty agreements

Double taxation agreements:

• Tax treaties between countries can reduce or eliminate withholding tax
• UK-US agreement: UK licensors can receive 100% of payments with proper documentation
• Required paperwork: Certificate of residence and Form W-8BEN for treaty benefits

Tips to stay compliant

Here are some tips to help you stay compliant while getting the most out of your royalty arrangement

• Keep detailed records of royalty payments, dates, and signed agreements.
• Think about your taxes when negotiating royalty rates and payment terms.
• Speak with your tax professional – especially when licensing across borders or negotiating with unfamiliar tax jurisdictions.

Learn more tax deductions , and here's extra information on how royalties are taxed

Understanding royalty agreements

Strong royalty agreements protect both parties and prevent disputes. Essential contract elements include:

Key agreement components:

• Clear usage rights: Specify exactly how the asset can be used
• Payment terms: Define rates, payment schedule, and calculation methods
• Territory and duration: Outline where and how long rights apply
• Performance standards: Set minimum sales or usage requirements
• Termination clauses: Define conditions for ending the agreement

Legal protection requirements:

• Both parties should review contracts with qualified attorneys
• Include dispute resolution procedures and governing law clauses
• Define consequences for contract breaches or non-payment

Get legal advice

Both parties should ask a lawyer to review the contract before signing.

• For the licensee, who is likely drafting the agreement, the contract needs to be legally compliant, and accurately reflect the terms of the specific arrangement.
• For the licensor, it's more about understanding each clause fully and ensuring your rights, payments, and protections are clearly outlined.

Learn the specific rules in the US

Simplify royalty payments and business finances with Xero

Xero simplifies royalty management for both licensors and licensees:

For royalty recipients:

• Create professional invoices: Generate branded royalty invoices with automatic calculations
• Track payment status: Monitor which royalties are paid, pending, or overdue
• Automate recurring billing: Set up automatic monthly or quarterly royalty invoices

For royalty payers:

• Organize expense tracking: Categorize royalty payments for easy tax deduction claims
• Schedule payments: Never miss royalty deadlines with automated payment reminders
• Generate tax reports: Export royalty payment summaries for year-end tax filing

Take the hassle out of royalty management with Xero

FAQs on royalties for business

Still have questions about how royalties work? Here are answers to some common queries.

What does a 5% royalty mean?

A 5% royalty means the person using the asset (the licensee) must pay 5% of their revenue to the asset's owner (the licensor). For example, if a franchisee earns $100,000 in sales, they would pay $5,000 in royalties to the franchisor.

Who is entitled to royalties?

The owner of the asset is entitled to royalties. This could be an inventor with a patent, a musician with a copyrighted song, an author with a book, or a business owner who franchises their brand.

Are royalties considered income?

Yes, royalties are a form of income for the person or business receiving them and are generally taxable. For the business paying them, royalties are typically considered a tax-deductible business expense.