Royalty payments exist in many different types of business, including music sales, book sales and various inventions. The inventor of the antihistamine drug Benadryl received a five percent royalty payment on all sales of Benadryl until the 17-year patent expired. Royalty arrangements vary substantially, and some of the highest royalty rates are paid for Beatles’ music products. The IRS has specific rules about how to record royalty expense, and it may not always qualify as a current period expense.


Royalties involve payment for the use of something that produces income. A user or licensee makes the payments to another, the licensor. The payments might be for a share of proceeds from the sale of a writer's or composer’s work, for example, or a share of payments that goes to inventors or service providers for the right to sell their invention or service. Another example is payment to a state or country for rights granted to mine and sell its natural resources.

Section 1.263A

According to revenue rulings from the Treasury Department and the IRS, companies that produce tangible property need to capitalize all direct costs related to manufacturing and an allocated portion of all the indirect costs related to the produced property. Indirect costs consist of administrative or support costs, and must be allocated to products using reasonable allocation methods as described in detail in IRS Regulations section 1.263A.

Royalty Expenses

Treatment of royalty expense depends on the type of royalty paid and the terms, as well as the allocation method. If producing or manufacturing products where royalty expense is directly involved in production, such as the company’s sole right to market, sell or distribute a product, the royalty would be excluded from capitalizing under section 1.263A. In other words, the royalty costs represent indirect costs that may be expensed. Section 1.263A allows expense or deduction for marketing, selling and distribution costs.


If the manufacturer or taxpayer determines royalty costs were paid as part of production related activities, or to benefit them, costs are considered direct costs of producing product and must be capitalized, according to IRS section 1.265A-1(e)(3)(ii)(U). Franchise or licensing costs are considered indirect costs to be capitalized to inventory. Many companies allocate royalty expense between indirect deductible expense and direct capitalizable costs, as required by section 1.263A-1(c)