Why is the royalty payment under our contract not considered a royalty for tax purposes?

We provide services to customers using a product sold by a company we are partnering with. We negotiated a contract where we provide those services at a reduce rate and the company pays us a royalty on sales of the product as compensation for the reduced service rate. Our auditors have told us that the income we receive from these royalty payments is taxable as ordinary income rather than at the lower tax rate for royalties, but we are struggling to understand why.

A true royalty is a payment made to an owner of property (real or intangible) in exchange for rights to use that property to generate income - such as a licensing arrangement. Sometimes the term gets used loosely in contracts and elsewhere to signify what is really just a revenue sharing or other performance-based compensation arrangement. It does not sound like your company owns the product that the "royalty" paid to you is based on, so it is unlikely that the payments you are receiving are royalties as defined by the IRS.

In addition, it sounds like there is some confusion about the tax treatment of royalty payments because royalties are taxable as ordinary income and not at a reduced rate. You may hear discussion about favorable royalty tax treatment for passive investors but this only applies in specific scenarios where a passive investor is receiving royalty payments that are not subject to self-employment tax (but they are still taxed at ordinary income rates).