Songwriting royalties are to be reported by songwriters as gross income, just like salary, interest, dividends and the like. Each year you should receive from your music publishers and performing rights organization a form showing your gross earnings of royalties for the prior tax year. The form is the 1099-Miscellaneous. When filing tax returns, you must submit to the government copies of these 1099s. Publishers, incidentally, must submit to the I.R.S. copies of the forms they send to you. So the I.R.S. can see the money coming and going and will (theoretically) know if you fail to report the royalties.
Under the I.R.S.'s "Hobby Rule",
an activity is a business, and not a hobby,
only if it earned income in 3 of the last 5 years.
To the extent that your songwriting is a business, your expenses related to songwriting may be partly or wholly deductible as business expenses. Such expenses might includes amounts spent on instruments, recording equipment, lead sheets, blank tape, studio time, musicians, and even travel and lodging when going on a trip to New York, Los Angeles or Nashville. Other legitimate expenses could include costs of copyright registration and fees paid to agents who collect royalties for you.
Before any of these deductions will be allowed, you must show the I.R.S. that your songwriting is a business. If it's not a business, the I.R.S. considers it to be a hobby, and that gives the name to the rule the I.R.S. uses in assessing your activity. Under the "Hobby Rule", an activity is a business, and not a hobby, only if it earned income in three of the last five years. "Income" does not have to mean "profit". If your expenses on songwriting exceeded your income from songwriting, you generated a loss, but you still had income, so you pass the test. If you had no income from songwriting, you fail, and your expenses will not be deductible.
Naturally, things can get complicated. Perhaps you also earned money as a performer or record producer or engineer. Those activities are not songwriting, but they are within the field of music, so you might be able to apply songwriting expenses against engineering income. Then again, you might not. Also, expenses on equipment may have to be "amortized" over several years, rather than deducted all at once. It depends on the kind of equipment you buy.
The point of going over these possibilities is, quite frankly, to scare you into finding an experienced accountant to advise you and prepare your tax returns. A good accountant should be as much a part of your team as a collaborator, lawyer or manager. Let the professionals do their jobs. You write the songs.
In addition to regular accountants, in the entertainment field, where artists spend so much time on the road or writing or rehearsing, a kind of specialist has developed called a business manager. The duties of a business manager are as varied as their clients. In addition to advising on tax matters and preparing tax returns, business managers will help their clients set up and run companies, pay employees, buy homes, develop and stick to budgets, shelter income, suggest and track investments, audit publishers and record companies, receive income and pay bills. When a business manager has this kind of close relationship with a client, they often get paid with a percentage of the client's earnings during the term of service, rather than a flat rate or hourly rate.
