How do I document book royalties?

Ordinary and necessary business expenses of authors, composers, musicians, and other creators of intellectual property are deductible under Sec. 162. Additionally, costs incurred by writers (including musical composers), photographers, and artists in creating writing (including musical compositions), photographs, pictures, paintings, sculpture, etc., are exempt from the uniform capitalization rules that govern the treatment of costs incurred in the production of property for resale. On the other hand, patent creation costs must be capitalized under Sec. 263 or in certain cases may be deductible as research expenditures under Sec. 174. 

Individuals who have not yet generated income from their creative activities should make sure that their business deductions are not limited by the hobby loss rules in Sec. 183. Generally, an activity is presumed to be a hobby if a profit is not earned in at least three tax years of a consecutive five-year period. However, a taxpayer can overcome this presumption if she or he can show the activity was operated with the intent to make a profit. Fortunately, the courts recognize that economic success in the creative arts frequently takes longer to achieve and thus focus on the manner in which the taxpayer pursues the activity to determine profit motive. 

Regs. Sec. 1.183-2(b) lists factors to be considered to determine whether the taxpayer is seeking to make a profit. A detailed explanation of these factors and the case law is beyond the scope of this article. The reader should consult IRS Publication 535, Business Expenses, and Audit Technique Guide IRC § 183 Activities Not Engaged in for Profit for additional guidance. Historically, the IRS has aggressively litigated hobby activity cases. However, taxpayers in the creative fields who have shown they operated the activity in a businesslike manner (maintained business records and appropriate documentation) and had relevant expertise have been able to prove profit motive.