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Tax implications of paying royalties versus dividends [Finance
Posted on January 25, 2013 @ 09:37:00 AM by Paul Meagher

Entrepreneurs can compensate investors in the form of dividends or royalties. There are significant tax advantages for entrepreneurs if they compensate investors in the form of royalties rather than dividends. To see why, lets first define these terms.

Wikipedia defines a Royalty as:

Royalties (sometimes, running royalties, or private sector taxes) are usage-based payments made by one party (the "licensee") to another (the "licensor") for the right to ongoing use of an asset, sometimes an intellectual property (IP). Royalties are typically agreed upon as a percentage of gross or net revenues derived from the use of an asset or a fixed price per unit sold of an item of such, but there are also other modes and metrics of compensation.

Wikipedia defines a Dividend as:

Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be distributed to shareholders. There are two ways to distribute cash to shareholders: share repurchases or dividends. Many corporations retain a portion of their earnings and pay the remainder as a dividend.

An eHow article entitled Income Statement Classification of Royalty Expense has this to say about classifying royalty expensies:

Since royalties fall under the overall heading of "Compensation" they can be written off as an expense for each tax period. Royalty payment rates are outlined in a contract between the company and the individual being paid, and are therefore determined based on sales figures for the applicable product. Necessary expenses, including any form of compensation, decrease a company's net income. Royalty payments are classified as current expenses on the income statement.

In contrast, Wikipedia says this about paying dividends:

For the joint stock company, paying dividends is not an expense; rather, it is the division of after tax profits among shareholders.

So entrepreneurs wanting to claim investor compensation as an expense might want to consider entering into a royalty arrangement rather than a dividend relationship with investors. Consult the above Wikipedia links for a wealth of information about royalties and dividends as methods of payment.

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