According to The Free Dictionary, a royalty is "A right or prerogative of the crown," "The granting of a right by a monarch to a corporation or an individual," or "The payment for such a right." Substitute the words "company," "owner" or "copyright holder" for the words "crown" or "monarch," and the definitions fit how the word royalty is used in the business world today. In our society, royalties carry with them tax obligations either as income or deductions.
In general, royalties are percentage-based payments that a licensee makes to the licensor. The amount of the percentage varies from one royalty agreement to another and is usually tied to gross revenue the licensee generates from the licensor's products or services. Typical instances where royalty fees and payments are used are in the arts, the oil industry and business franchises.
An important way artists earn a living is through royalties. Royalties are charged specifically when a work of art is performed or broadcast. Broadcast stations, performing arts organizations, theater companies and dance troupes must pay royalty fees to arts licensing organizations like the American Society of Composers, Arrangers and Publishers and Broadcast Music International. These organizations then distribute these royalty fees to the individual copyright holders of the works. These royalties are considered income for the copyright holders and business expenses (and therefore tax deductions) for those who have to pay them.
In the oil industry, a company may want to drill on property that it doesn't own. In this case, it often pays an annual or monthly royalty fee to the property owner for the right to use the property. The royalty fee is considered a business expense to the company (the licensee). The royalty payment can be in cash or through delivery of service (free oil or gas for the property). In either case, the payment or value of the service received must be declared as income by the property owner (the licensor).
A company like Subway or McDonald's sells franchises to individual business entrepreneurs. The entrepreneur gets to leverage the parent company's proven business model, products and brand, and the parent company receives a steady stream of income from the franchisee through the charging of royalty fees. These royalty fees are usually a fixed percentage of the franchisee's gross revenue. Franchise royalty fees paid by the franchisee are deductible because they are a business expense. The franchiser must report any royalty fees received as income.