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Who's the Employer?

Answers are provided by S. Derrin Watson, JD, APM

Royalties as Compensation

(Posted April 1, 2002)

Question 150: I have a professional corporation, which has two sources of income: (1) about $100K income from my professional services, and (2) about $20K royalty income from a book I wrote. My accountant has advised to have my publisher pay me separately, as a sole proprietor, for the royalties, so as to avoid Medicare taxes on the royalty income. Because the sole proprietorship will be under common control with my corporation, will this change my compensation for plan purposes?

Answer: Unless you have substantial other income, yes.

The treatment of royalties can be tricky. How you treat them can have significant retirement plan consequences. The central issue is whether the royalty income derives from a trade or business.

Revenue Ruling 68-498 says:

Whether or not an individual is engaged in a trade or business depends upon the facts in the particular case. As a general rule, a person who is regularly engaged in an occupation or profession for profit which constitutes his livelihood, in whole or in part, and who is not regarded as an employee for Federal Insurance Contributions Act purposes, is engaged in a trade or business for self-employment tax purposes. 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, and, if it is not one of the excluded professions of section 1402(c) of the Self-Employment Contributions Act, the income from it is includible in computing net earnings from self-employment, subject to the limitations of section 1402(b) of the Act.

So, if you have a trade or business as a self-employed writer, then the income is reportable on Schedule C and is subject to self-employment tax. If you do not have a trade or business, then the income is reportable on Schedule E and is exempt from self-employment tax.

If, as your accountant suggests, the royalty income would be exempt from employment tax, you may still have earned income for retirement plan purposes. IRC §401(c)(2)(C) provides that income from the sale of property created by the author are earned income, whether or not they are net earnings from self-employment. Thus, you can have your cake and eat it too.!

I discuss issues relating to earned income and other issues affect self-employed individuals in Chapter 1 of my book, Who's the Employer. A special thanks to fellow author Gary Lesser, who pointed out the Revenue Ruling cited above.

Important notice:

Answers are provided as general guidance on the subjects covered in the question and are not provided as legal advice to the questioner or to readers. Any legal issues should be reviewed by your legal counsel to apply the law to the particular facts of this and similar situations.

The law in this area changes frequently. Answers are believed to be correct as of the posting dates shown. The completeness or accuracy of a particular answer may be affected by changes in the law (statutes, regulations, rulings, court decisions, etc.) that occur after the date on which a particular Q&A is posted.