Are Royalties as a Retiree Subject to Self-Employment Tax?
Retired Musician Royalties - IRS Treatment
Let's assume a retiree earns $45,000 from music royalties - are these considered earned income? It depends.
First, let’s examine what royalties are. Royalties proceeds from the sale of intellectual property are considered earned income. An author/creator of work may receive extended royalties from the result of their personal service.
There are exceptions where royalties from creative work are not subject to self-employment tax. This happens where creating the intellectual property is incidental and not typical for the taxpayer profession. For example. a math teacher who once published a book of poetry will report royalties on Schedule E. If he had published a math tutorial then royalties would be self-employment income.
This is why the taxpayer occupation field is so important.
In the case of a retiree, we must examine what their occupation was in their younger years to determine whether they constitute self-employment. In the case of the taxpayer, were he a journalist in the past, then the royalties would be self-employment.
Royalties and Expats
Why does this matter so much? Let’s examine two key factors. Imagine the retiree had moved from California. As readers may already know, California is famous for their ‘safe-harbor’ rule. This protection is only offered for earned income (self-employment counts, too) - retirees do not qualify.
If they recently moved abroad, and they do not have any earned/self-employment income, then they may be subject to CA tax on all worldwide income they receive, not just the passive income from royalties (i.e. dividends, capital gains).
Whereas If the retiree’s royalites were to qualify for self-employment income, then they would be able to claim Safe Harbor protection and be considered non-residents of CA. The net result from paying a self-employment tax: complete exemption from CA state tax on worldwide income including income from royalties.
Taxpayer may be subject to CA tax on passive income from royalties